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DROPBOX, INC.

2020-02-21

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 section titled “Selected Consolidated Financial and Other Data” and the consolidated financial statements and related notes thereto included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below and those discussed in the section titled “Risk Factors” included elsewhere in this Annual Report on Form 10-K. Overview Our modern economy runs on knowledge. Today, knowledge lives in the cloud as digital content, and Dropbox is building the world's first smart workspace where businesses and individuals can create, access, and share this content globally. We serve more than 600 million registered users across 180 countries. Since our founding in 2007, our market opportunity has grown as we’ve expanded from keeping files in sync to keeping teams in sync. Our smart workspace is a digital environment that brings all of a team’s content together with the tools they love, helping users cut through the clutter and surfacing what matters most. In a world where using technology at work can be fragmented and distracting, the smart workspace makes it easy to focus on the work that matters. By solving these universal problems, we’ve become invaluable to our users. The popularity of our platform drives viral growth, which has allowed us to scale rapidly and efficiently. We’ve built a thriving global business with 14.3 million paying users. Our Subscription Plans We generate revenue from individuals, teams, and organizations by selling subscriptions to our platform, which serve the varying needs of our diverse customer base. Subscribers can purchase individual licenses through our Plus and Professional plans, or purchase multiple licenses through a Standard, Advanced, or Enterprise team plan. Each team represents a separately billed deployment that is managed through a single administrative dashboard. Teams must have a minimum of three users, but can also have more than tens of thousands of users. Customers can choose between an annual or monthly plan, with a small number of large organizations on multi-year plans. A majority of our customers opt for our annual plans. We typically bill our customers at the beginning of their respective terms and recognize revenue ratably over the term of the subscription period. International customers can pay in U.S. dollars or a select number of foreign currencies. Our premium subscription plans, such as Professional and Advanced, provide more functionality than other subscription plans and have higher per user prices. Our Standard and Advanced subscription plans offer robust capabilities for businesses, and the vast majority of Dropbox Business teams purchase our Standard or Advanced subscription plans. While our Enterprise subscription plan offers more opportunities for customization, companies can subscribe to any of these team plans for their business needs. In the first quarter of fiscal 2019, we acquired HelloSign, an e-signature and document workflow platform. The acquisition of HelloSign expands our content collaboration capabilities to include additional business-critical workflows. HelloSign has several product lines, and the pricing and revenue generated from each product line varies, with some product lines priced based on the number of licenses purchased (similar to Dropbox plans), while others are priced based on a customer’s transaction volume. Depending on the product purchased, teams must have a minimum of a certain number of licenses, but can also have hundreds of users. Customers can choose between an annual or monthly plan, with a small number of large organizations on multi-year plans. HelloSign also typically bills customers at the beginning of their respective terms and recognizes revenue ratably over the subscription period. HelloSign primarily sells within the United States and sells only in U.S. dollars. Our Customers Our customer base is highly diversified, and in the period presented, no customer accounted for more than 1% of our revenue. Our customers include individuals, teams, and organizations of all sizes, from freelancers and small businesses to Fortune 100 companies. They work across a wide range of industries, including professional services, technology, media, education, industrials, consumer and retail, and financial services. Within companies, our platform is used by all types of teams and functions, including sales, marketing, product, design, engineering, finance, legal, and human resources. Our Business Model Drive new signups We acquire users efficiently and at relatively low costs through word-of-mouth referrals, direct in-product referrals, and sharing of content. Anyone can create a Dropbox account for free through our website or app and be up and running in minutes. These users often share and collaborate with other non-registered users, attracting new signups into our network. Increase conversion of registered users to our paid subscription plans We generate over 90% of our revenue from self-serve channels-users who purchase a subscription through our app or website. To grow our recurring revenue base, we actively encourage our registered users to convert to one of our paid plans based on the functionality that best suits their needs. We do this via in-product prompts and notifications, time-limited free trials of paid subscription plans, email campaigns, and lifecycle marketing. Together, these enable us to generate increased recurring revenues from our existing user base. Upgrade and expand existing customers We offer a range of paid subscription plans, from Plus and Professional for individuals to Standard, Advanced, and Enterprise for teams. We analyze usage patterns within our network and run hundreds of targeted marketing campaigns to encourage paying users to upgrade their plans. We prompt individual subscribers who collaborate with others on Dropbox to purchase our Standard or Advanced plans for a better team experience, and we also encourage existing Dropbox Business teams to purchase additional licenses or to upgrade to premium subscription plans. Key Business Metrics We review a number of operating and financial metrics, including the following key metrics to evaluate our business, measure our performance, identify trends affecting our business, formulate business plans, and make strategic decisions. Total annual recurring revenue We primarily focus on total annual recurring revenue (“Total ARR”) as the key indicator of the trajectory of our business performance. Total ARR represents the amount of revenue that we expect to recur, enables measurement of the progress of our business initiatives, and serves as an indicator of future growth. In addition, Total ARR is less subject to variations in trends that may not appropriately reflect the health of our business. Total ARR is a performance metric and should be viewed independently of revenue and deferred revenue, and is not intended to be a substitute for, or combined with, any of these items. Total ARR consists of contributions from all of our revenue streams, including subscriptions and add-ons. We calculate Total ARR as the number of users who have active paid licenses for access to our platform as of the end of the period, multiplied by their annualized subscription price to our platform. We adjust the exchange rates used to calculate Total ARR on an annual basis at the beginning of each fiscal year. The below tables set forth our Total ARR using the exchange rates set at the beginning of each year, as well as on a constant currency basis relative to the exchange rates used in 2019. Revaluing our ending Total ARR for fiscal 2019 using exchange rates set at the beginning of fiscal 2020, Total ARR at the end of fiscal 2019 would be $1,811 million. We undertook several business initiatives that positively impacted Total ARR in the periods presented. These initiatives include the renewal of our grandfathered existing Dropbox Business teams into the Dropbox Business Advanced plan starting in the second quarter of 2018, and the repricing and repackaging of our existing Dropbox Plus plans in the second quarter of 2019. In addition to these business initiatives, we also acquired HelloSign in the first quarter of 2019, resulting in a benefit to Total ARR beginning in that period. We also undertook several conversion related initiatives and saw benefits in Total ARR as we expanded opportunities for our users to try Dropbox through trial flows on more surfaces. Supplemental Information Paying users We define paying users as the number of users who have active paid licenses for access to our platform as of the end of the period. One person would count as multiple paying users if the person had more than one active license. For example, a 50-person Dropbox Business team would count as 50 paying users, and an individual Dropbox Plus user would count as one paying user. If that individual Dropbox Plus user was also part of the 50-person Dropbox Business team, we would count the individual as two paying users. We have experienced growth in the number of paying users across our products, with the majority of paying users for the periods presented coming from our self-serve channels. We acquired HelloSign in the first quarter of fiscal 2019. HelloSign has several product lines and the pricing and revenue generated from each product line varies, with some product lines priced based on the number of licenses purchased (similar to Dropbox plans), while others are priced based on a customer’s transaction volume. For purposes of HelloSign results, we include as paying users either (i) the number of users who have active paid licenses for access to the HelloSign platform as of the period end for those products that are priced based on the number of licenses purchased (which is the same method we use to evaluate existing Dropbox plans) or (ii) the number of customers for those products that are priced based on transaction volumes. The below table sets forth the number of paying users as of December 31, 2019, 2018, and 2017: Average revenue per paying user We define average revenue per paying user, or ARPU, as our revenue for the period presented divided by the average paying users during the same period. For interim periods, we use annualized revenue, which is calculated by dividing the revenue for the particular period by the number of days in that period and multiplying this value by 365 days. Average paying users are calculated based on adding the number of paying users as of the beginning of the period to the number of paying users as of the end of the period, and then dividing by two. We undertook two business initiatives over the last two fiscal years that have positively impacted ARPU in the periods presented. In the second quarter of 2019, we repackaged our existing Dropbox Plus plans to include additional features and, as a result, increased the price for new and existing users on this plan. For certain existing users, the increase in price will be effective on their next renewal date. As a result of the price increase, and combined with an increased mix of sales towards our higher-priced subscription plans, we experienced an increase in our average revenue per paying user for the year ended December 31, 2019, compared to the year ended December 31, 2018. In 2017, we launched our Dropbox Business Advanced plan. At the time of launch, we grandfathered existing Dropbox Business teams into the Dropbox Business Advanced plan at their legacy price. During 2018 and early 2019, almost all of those grandfathered teams renewed at a higher price. As a result of these renewals, and combined with an increased mix of sales towards our higher-priced subscription plans, we experienced an increase in our average revenue per paying user for the year ended December 31, 2019, compared to the year ended December 31, 2018. The below table sets forth our ARPU for the years ended December 31, 2019, 2018, and 2017. Non-GAAP Financial Measure In addition to our results determined in accordance with U.S. generally accepted accounting principles, or GAAP, we believe that free cash flow, or FCF, a non-GAAP financial measure, is useful in evaluating our liquidity. Free cash flow We define FCF as GAAP net cash provided by operating activities less capital expenditures. We believe that FCF is a liquidity measure and that it provides useful information regarding cash provided by operating activities and cash used for investments in property and equipment required to maintain and grow our business. FCF is presented for supplemental informational purposes only and should not be considered a substitute for financial information presented in accordance with GAAP. FCF has limitations as an analytical tool, and it should not be considered in isolation or as a substitute for analysis of other GAAP financial measures, such as net cash provided by operating activities. Some of the limitations of FCF are that FCF does not reflect our future contractual commitments, excludes investments made to acquire assets under finance leases, and may be calculated differently by other companies in our industry, limiting its usefulness as a comparative measure. Our FCF increased for the year ended December 31, 2019, compared to the year ended December 31, 2018, primarily due to an increase in cash provided by operating activities, which was driven by increased subscription sales, as a majority of our paying users are invoiced in advance. These cash inflows were partially offset by higher capital expenditures related to our new corporate headquarters and datacenter build-outs. Our FCF increased for the year ended December 31, 2018, compared to the year ended December 31, 2017, primarily due to higher cash provided by operating activities, which was driven by increased subscription sales, as a majority of our paying users are invoiced in advance. These cash inflows were partially offset by an increase in capital expenditures primarily related to the build-out of our new corporate headquarters. We expect our FCF to fluctuate in future periods as we purchase infrastructure equipment to support our user base and continue to invest in our new and existing office spaces to support our plans for growth. We expect our capital expenditures related to our new corporate headquarters to decline as the majority of the project is now complete. The following is a reconciliation of FCF to the most comparable GAAP measure, net cash provided by operating activities: Components of Our Results of Operations Revenue We generate revenue from sales of subscriptions to our platform. Revenue is recognized ratably over the related contractual term generally beginning on the date that our platform is made available to a customer. Our subscription agreements typically have monthly or annual contractual terms, although a small percentage have multi-year contractual terms. Our agreements are generally non-cancelable. We typically bill in advance for monthly contracts and annually in advance for contracts with terms of one year or longer. Amounts that have been billed are initially recorded as deferred revenue until the revenue is recognized. Our revenue is driven primarily by conversions and upsells to our paid plans. We also generate revenue from transaction-based products and fees from the referral of users to our partners. We generate over 90% of our revenue from self-serve channels. No customer represented more than 1% of our revenue in the periods presented. Cost of revenue and gross margin Cost of revenue. Our cost of revenue consists primarily of expenses associated with the storage, delivery, and distribution of our platform for both paying users and free users, also known as Basic users. These costs, which we refer to as infrastructure costs, include depreciation of our servers located in co-location facilities that we lease and operate, rent and facilities expense for those datacenters, network and bandwidth costs, support and maintenance costs for our infrastructure equipment, and payments to third-party datacenter service providers. Cost of revenue also includes costs, such as salaries, bonuses, employer payroll taxes and benefits, travel-related expenses, and stock-based compensation, which we refer to as employee-related costs, for employees whose primary responsibilities relate to supporting our infrastructure and delivering user support. Other non-employee costs included in cost of revenue include credit card fees related to processing customer transactions, and allocated overhead, such as facilities, including rent, utilities, depreciation on leasehold improvements and other equipment shared by all departments, and shared information technology costs. In addition, cost of revenue includes amortization of developed technologies, professional fees related to user support initiatives, and property taxes related to the datacenters. During the first quarter of 2018, based on considerations including our asset replacement cycle and our ongoing infrastructure optimization efforts, we revisited the useful life estimates of certain infrastructure equipment. These optimization efforts included efficiencies that allow us to utilize certain infrastructure equipment for longer periods of time. As a result, we determined that the useful lives of the impacted infrastructure equipment, which are depreciated through cost of revenue, should be increased from three to four years. We accounted for this as a change in estimate that was applied prospectively, effective as of January 1, 2018. This change in useful life resulted in a reduction in depreciation expense within cost of revenue of $16.1 million during the year ended December 31, 2018. We plan to continue increasing the capacity and enhancing the capability and reliability of our infrastructure to support user growth and increased use of our platform. We expect that cost of revenue, will increase in absolute dollars in future periods. Gross margin. Gross margin is gross profit expressed as a percentage of revenue. Our gross margin may fluctuate from period to period based on the timing of additional capital expenditures and the related depreciation expense, or other increases in our infrastructure costs, as well as revenue fluctuations. As we continue to increase the utilization of our internal infrastructure, we generally expect our gross margin, to remain relatively constant in the near term and to increase modestly in the long term. Operating expenses Research and development. Our research and development expenses consist primarily of employee-related costs for our engineering, product, and design teams, compensation expenses related to key personnel from acquisitions and allocated overhead. Additionally, research and development expenses include internal development-related third-party hosting fees. We have expensed almost all of our research and development costs as they were incurred. We plan to continue to hire employees for our engineering, product, and design teams to support our research and development efforts. We expect that research and development costs will increase in absolute dollars in future periods and vary from period to period as a percentage of revenue. Sales and marketing. Our sales and marketing expenses relate to both self-serve and outbound sales activities, and consist primarily of employee-related costs, brand marketing costs, lead generation costs, sponsorships and allocated overhead. Sales commissions earned by our outbound sales team and the related payroll taxes, as well as commissions earned by third-party resellers that we consider to be incremental and recoverable costs of obtaining a contract with a customer, are deferred and are typically amortized over an estimated period of benefit of five years. Additionally, sales and marketing expenses include non-employee costs related to app store fees and fees payable to third-party sales representatives and amortization of acquired customer relationships. We plan to continue to invest in sales and marketing to grow our user base and increase our brand awareness, including marketing efforts to continue to drive our self-serve business model. We expect that sales and marketing expenses will increase in absolute dollars in future periods and vary from period to period as a percentage of revenue. The trend and timing of sales and marketing expenses will depend in part on the timing of marketing campaigns. General and administrative. Our general and administrative expenses consist primarily of employee-related costs for our legal, finance, human resources, and other administrative teams, as well as certain executives. In addition, general and administrative expenses include allocated overhead, outside legal, accounting and other professional fees, and non-income based taxes. We expect to incur additional general and administrative expenses to support the growth of the Company. General and administrative expenses include the recognition of stock-based compensation expense related to grants of restricted stock made to our co-founders. We expect that general and administrative expenses will increase in absolute dollars in future periods and vary from period to period as a percentage of revenue. Interest income (expense), net Interest income (expense), net consists primarily of interest income earned on our money market funds classified as cash and cash equivalents and short-term investments, partially offset by interest expense related to our finance lease obligations for infrastructure and our imputed financing obligation for our liability to the legal owner of our previous corporate headquarters. We no longer incur interest expense for our imputed financing obligation as of the fourth quarter of 2018, due to the termination of our master lease for our previous corporate headquarters in the third quarter of 2018. Other income (expense), net Other income (expense), net consists of other non-operating gains or losses, including those related to equity investments, lease arrangements, which include sublease income, foreign currency transaction gains and losses, and realized gains and losses related to our short-term investments. Benefit from (provision for) income taxes Provision for income taxes consists primarily of U.S. federal and state income taxes and income taxes in certain foreign jurisdictions in which we conduct business. For the periods presented, the difference between the U.S. statutory rate and our effective tax rate is primarily due to the valuation allowance on deferred tax assets. Our effective tax rate is also impacted by earnings realized in foreign jurisdictions with statutory tax rates lower than the federal statutory tax rate. We maintain a full valuation allowance on our net deferred tax assets for federal, state, and certain foreign jurisdictions as we have concluded that it is not more likely than not that the deferred assets will be realized. Results of Operations The following tables set forth our results of operations for the periods presented and as a percentage of our total revenue for those periods: (1) Includes stock-based compensation as follows: (2) Upon the effectiveness of the registration statement for our initial public offering, which was March 22, 2018, the liquidity event-related performance vesting condition associated with our two-tier RSUs was satisfied. During the year ended December 31, 2018, we recognized the cumulative unrecognized stock-based compensation of $418.7 million. See "Significant Impacts of Stock Based Compensation" for further information regarding our equity arrangements. The following table sets forth our results of operations for each of the periods presented as a percentage of revenue: Comparison of the year ended December 31, 2019 and 2018 Revenue Revenue increased $269.6 million or 19% during the year ended December 31, 2019, as compared to the year ended December 31, 2018. The increase in revenue was driven primarily by the adoption of premium plans by our users, an increase in the price of our Plus plan, and an increase in paying users. Cost of revenue, gross profit, and gross margin Cost of revenue increased $16.3 million or 4% during the year ended December 31, 2019, as compared to the year ended December 31, 2018, primarily due to an increase of $13.7 million in infrastructure costs, $13.0 million in employee-related costs, excluding stock-based compensation, due to headcount growth, and $10.4 million in allocated overhead, which includes facilities-related costs for both our current and former corporate headquarters. Additionally, cost of revenue increased due to $5.2 million in credit card transaction fees due to higher sales, and $3.8 million in amortization of acquired intangible assets. These increases were offset by a decrease of $31.1 million in stock-based compensation, which was primarily due to the large expense recognized in the year ended December 31, 2018 due to the achievement of the performance vesting condition of our two-tier RSUs upon the effectiveness of the registration statement related to our IPO. Our gross margin increased from 72% during the year ended December 31, 2018 to 75% during the year ended December 31, 2019, primarily due to a 19% increase in our revenue during the period offset by a lesser increase in our cost of revenue described above. Research and development Research and development expenses decreased $106.1 million or 14% during the year ended December 31, 2019, as compared to the year ended December 31, 2018, primarily due to a decrease of $220.6 million in stock-based compensation, which was primarily due to the large expense recognized in the year ended December 31, 2018 due to the achievement of the performance vesting condition of our two-tier RSUs upon the effectiveness of the registration statement related to our IPO. This decrease was offset by increases of $62.0 million in employee-related costs, excluding stock-based compensation, due to headcount growth, and $36.9 million in allocated overhead, which includes facilities-related costs for both our current and former corporate headquarters. Sales and marketing Sales and marketing expenses decreased $16.3 million or 4% during the year ended December 31, 2019, as compared to the year ended December 31, 2018, due to decreases of $62.9 million in stock-based compensation, which was primarily due to the large expense recognized in the year ended December 31, 2018 due to the achievement of the performance vesting condition of our two-tier RSUs upon the effectiveness of the registration statement related to our IPO, and a decrease of $11.9 million due to brand marketing costs, lead generation costs, third-party sales representative fees, and sponsorships. These decreases were offset by increases of $22.7 million in employee-related costs, excluding stock-based compensation, due to headcount growth, and $16.5 million in allocated overhead, which includes facilities-related costs for both our current and former corporate headquarters. Additionally, the decrease in sales and marketing expenses was further offset by increases of $12.7 million in app store fees due to increased sales and due to $5.0 million in amortization of acquired intangible assets. General and administrative General and administrative expense decreased $37.8 million or 13% during the year ended December 31, 2019, as compared to the year ended December 31, 2018, primarily due to a decrease of $74.2 million in stock-based compensation, which was primarily due to the large expense recognized in the year ended December 31, 2018 due to the achievement of the performance vesting condition of our two-tier RSUs, and the performance-based vesting condition for the Co-Founder Grants in connection with our IPO. This decrease was offset by increases of $17.2 million in allocated overhead, which includes facilities-related costs for both our current and former corporate headquarters, $10.4 million in non-income based taxes, and $9.2 million in legal-related and acquisition expenses. Interest income (expense), net Interest income (expense), net increased $5.4 million during the year ended December 31, 2019, as compared to the year ended December 31, 2018, due to an increase in interest income from our money market funds and short-term investments. Other income (expense), net Other income (expense), net increased $9.2 million during the year ended December 31, 2019, as compared to the year ended December 31, 2018, primarily due to an increase of $9.0 million in gains related to disposals of infrastructure assets, and $5.0 million in gains related to an equity investment and short-term investments. These increases are partially offset by a decrease of sublease income of $6.0 million. Benefit from (provision for) income taxes Provision for income taxes decreased by $4.1 million during the year ended December 31, 2019 as compared to the year ended December 31, 2018, primarily due to a one-time tax benefit related to the acquisition of HelloSign. Fiscal 2018 Compared to Fiscal 2017 For a comparison of our results of operations for the fiscal years ended December 31, 2018 and 2017, see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, of our Annual Report on Form 10-K for the fiscal year ended December 31, 2018, filed with the SEC on February 25, 2019. Quarterly Results of Operations (Unaudited) The following table sets forth our unaudited quarterly statements of operations data for each of the last eight quarters ended December 31, 2019. The information for each of these quarters has been prepared on the same basis as the audited annual financial statements included elsewhere in this Annual Report on Form 10-K and, in the opinion of management, includes all adjustments, which includes only 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 thereto included elsewhere in this Annual Report on Form 10-K. These quarterly results of operations are not necessarily indicative of our future results of operations that may be expected for any future period. (1) Includes stock-based compensation as follows: (2) During the three months ended March 31, 2018 we recognized the cumulative unrecognized stock-based compensation of $418.7 million related to our two-tier RSUs upon the effectiveness of our registration statement for our IPO. During the quarter, we also released 26.8 million shares of common stock underlying the vested two-tier RSUs, and as a result recorded $13.9 million in employer related payroll tax expenses associated with these same awards. Refer to "Significant Impacts of Stock-Based Compensation" included elsewhere in this Annual Report on Form 10-K for further information. (3) During the year ended December 31, 2017, our Board of Directors voted to approve a modification of vesting schedules for certain unvested one-tier and two-tier RSUs to align the vesting schedules for all RSUs to vest once per quarter. As a result, we recognized an incremental $10.0 million in stock-based compensation during the three months ended March 31, 2018. Refer to "Significant Impacts of Stock-Based Compensation" included elsewhere in this Annual Report on Form 10-K for further information. Quarterly revenue trends Our revenue increased sequentially in each of the quarters presented primarily due to increases in Total ARR, paying users, and average revenue per paying user. Seasonality in our revenue is not material. Quarterly cost of revenue and gross margin trends Except for the three months ended March 31, 2018, our cost of revenue increased sequentially in the quarters presented primarily due to infrastructure costs and employee related expenses, excluding stock based compensation, which is offset by the increases in our revenue causing our gross margins to increase or remain constant. Our cost of revenue during the three months ended March 31, 2018, was higher than the other quarters due to the completion of our initial public offering, as further described in "-Significant Impacts of Stock-Based Compensation". Quarterly operating expense trends Except for the three months ended March 31, 2018, our total quarterly operating expenses increased sequentially in each of the quarters presented primarily due to headcount growth in connection with the expansion of our business and other events that are discussed herein. Our quarterly operating expenses during the three months ended March 31, 2018, was higher than the other quarters presented due to the completion of our initial public offering, as further described in "-Significant Impacts of Stock-Based Compensation". Research and development Except for the three months ended March 31, 2018, our research and development expenses increased sequentially in each of the quarters presented primarily due to employee-related expenses due to headcount growth and overhead-related costs, which includes facilities related costs for both our current and former corporate headquarters in certain periods. Our research and development expenses during the three months ended March 31, 2018, were higher than the other quarters presented, primarily due to the completion of our initial public offering, as further described in "-Significant Impacts of Stock-Based Compensation". Sales and marketing Except for the three months ended March 31, 2018, our sales and marketing expenses have generally increased in the quarters presented primarily due to employee-related expenses due to headcount growth and overhead-related costs, which includes facilities related costs for both our current and former corporate headquarters in certain quarters. Additionally, the timing of brand advertising campaigns can impact the trends in sales and marketing expenses. Our sales and marketing expenses during the three months ended March 31, 2018, was higher than the other quarters presented primarily due to the completion of our initial public offering, as further described in "-Significant Impacts of Stock-Based Compensation". General and administrative Except for the three months ended March 31, 2018, our general and administrative expenses have generally increased in the quarters presented, primarily due to increases in employee-related expenses, non-income based taxes, and legal, accounting, and other professional fees. Our general and administrative expenses during the three months ended March 31, 2018, was higher than the other quarters presented primarily due to the completion of our initial public offering. Additionally, as a result of our initial public offering, and in the same quarter, we began recognizing stock-based compensation expense related to market-based awards granted to our co-founders in 2017 ("Co-Founder Grants"), as further described in "-Significant Impacts of Stock-Based Compensation". Liquidity and Capital Resources As of December 31, 2019, we had cash and cash equivalents of $551.3 million and short-term investments of $607.7 million, which were held for working capital purposes. Our cash, cash equivalents, and short-term investments consist primarily of cash, money market funds, corporate notes and obligations, U.S. Treasury securities, certificates of deposit, asset-backed securities, commercial paper, U.S. agency obligations, supranational securities, and municipal securities. As of December 31, 2019, we had $219.3 million of our cash and cash equivalents held by our foreign subsidiaries. We do not expect to incur material taxes in the event we repatriate any of these amounts. Since our inception, we have financed our operations primarily through equity issuances, cash generated from our operations, and finance leases to finance infrastructure-related assets in co-location facilities that we directly lease and operate. We enter into finance leases in part to better match the timing of payments for infrastructure-related assets with that of cash received from our paying users. In our business model, some of our registered users convert to paying users over time, and consequently there is a lag between initial investment in infrastructure assets and cash received from some of our users. Our principal uses of cash in recent periods have been funding our operations, purchases of short-term investments, the satisfaction of tax withholdings in connection with the settlement of restricted stock units, making principal payments on our finance lease obligations, and capital expenditures. On February 19, 2020, our Board of Directors approved a stock repurchase program for the repurchase of up to $600 million of the Company’s outstanding shares of Class A common stock. Share repurchases will be subject to a review of the circumstances in place at that time and will be made from time to time in private transactions or open market purchases as permitted by securities laws and other legal requirements. The program does not obligate the Company to repurchase any specific number of shares and may be discontinued at any time. In April 2017, we entered into a $600.0 million credit facility with a syndicate of financial institutions. Pursuant to the terms of the revolving credit facility, we may issue letters of credit under the revolving credit facility, which reduce the total amount available for borrowing under such facility. The revolving credit facility terminates on April 4, 2022. In February 2018, we amended our revolving credit facility to, among other things, permit us to make certain investments, enter into an unsecured standby letter of credit facility, and increase our standby letter of credit sublimit to $187.5 million. We also increased our borrowing capacity under the revolving credit facility from $600.0 million to $725.0 million. We may from time to time request increases in the borrowing capacity under our revolving credit facility of up to $275.0 million, provided no event of default has occurred or is continuing or would result from such increase. Interest on borrowings under the revolving credit facility accrues at a variable rate tied to the prime rate or the LIBOR rate, at our election. Interest is payable quarterly in arrears. Pursuant to the terms of the revolving credit facility, we are required to pay an annual commitment fee that accrues at a rate of 0.20% per annum on the unused portion of the borrowing commitments under the revolving credit facility. In addition, we are required to pay a fee in connection with letters of credit issued under the revolving credit facility that accrues at a rate of 1.5% per annum on the amount of such letters of credit outstanding. There is an additional fronting fee of 0.125% per annum multiplied by the average aggregate daily maximum amount available under all letters of credit. The revolving credit facility contains customary conditions to borrowing, events of default, and covenants, including covenants that restrict our ability to incur indebtedness, grant liens, make distributions to our holders or our subsidiaries’ equity interests, make investments, or engage in transactions with our affiliates. In addition, the revolving credit facility contains financial covenants, including a consolidated leverage ratio covenant and a minimum liquidity balance. We were in compliance with all covenants under the revolving credit facility as of December 31, 2019. As of December 31, 2019, we had no amounts outstanding under the revolving credit facility and an aggregate of $59.7 million in letters of credit outstanding under the revolving credit facility. Our total available borrowing capacity under the revolving credit facility was $665.3 million as of December 31, 2019. We believe our existing cash and cash equivalents, together with our short-term investments, cash provided by operations and amounts available under the revolving credit facility, will be sufficient to meet our needs for the foreseeable future. Our future capital requirements will depend on many factors including our revenue growth rate, subscription renewal activity, billing frequency, the timing and extent of spending to support further infrastructure development and research and development efforts, the timing and extent of additional capital expenditures to invest in existing and new office spaces, such as our new corporate headquarters, the satisfaction of tax withholding obligations for the release of restricted stock units, the expansion of sales and marketing and international operation activities, the introduction of new product capabilities and enhancement of our platform, and the continuing market acceptance of our platform. We have and may in the future enter into arrangements to acquire or invest in complementary businesses, services, and technologies, including 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, results of operations, and financial condition would be materially and adversely affected. Our cash flow activities were as follows for the periods presented: Operating activities Our largest source of operating cash is cash collections from our paying users for subscriptions to our platform. Our primary uses of cash from operating activities are for employee-related expenditures, infrastructure-related costs, and marketing expenses. Net cash provided by operating activities is impacted by our net loss adjusted for certain non-cash items, including depreciation and amortization expenses and stock-based compensation, as well as the effect of changes in operating assets and liabilities. For the year ended December 31, 2019, net cash provided by operating activities was $528.5 million, which mostly consisted of our net loss of $52.7 million, adjusted for stock-based compensation expense of $261.2 million and depreciation and amortization expenses of $173.5 million, and net cash inflow of $145.6 million from operating assets and liabilities. The inflow from operating assets and liabilities was primarily due to an increase of $68.7 million in deferred revenue from increased subscription sales, as a majority of our paying users are invoiced in advance. Additionally, cash provided by operating activities increased due to an increase in other operating assets and liabilities of $76.9 million. Our net cash provided by operating activities for the year ended December 31, 2019 also included cash payments of $55.3 million related to tenant improvement allowance reimbursements. For the year ended December 31, 2018, net cash provided by operating activities was $425.4 million, which mostly consisted of our net loss of $484.9 million, adjusted for stock-based compensation expense of $650.1 million and depreciation and amortization expenses of $166.8 million, and net cash inflow of $83.2 million from operating assets and liabilities. The inflow from operating assets and liabilities was primarily due to an increase of $66.4 million in deferred revenue from increased subscription sales, as a majority of our paying users are invoiced in advance. Additionally, cash provided by operating activities increased due to an increase in other operating assets and liabilities of $16.8 million. Our net cash provided by operating activities for the year ended December 31, 2018 also included a payment of $13.8 million of employer payroll taxes related to the release of our two-tier RSUs in connection with our IPO, which was paid in the first quarter of 2018. Investing activities Net cash used in investing activities is primarily impacted by purchases of short-term investments, purchases of property and equipment to make improvements to existing and new office spaces, and for purchasing infrastructure equipment in co-location facilities that we directly lease and operate. For the year ended December 31, 2019, net cash used in investing activities was $320.0 million, which primarily related to purchases of short-term investments of $775.4 million, cash paid for our acquisition of HelloSign, net of cash acquired, of $171.6 million and capital expenditures of $136.1 million related to our office and datacenter build-outs. These outflows were partially offset by inflows of $750.9 million related to proceeds from maturities and sales of short-term investments. For the year ended December 31, 2018, net cash used in investing activities was $633.8 million, which primarily related to purchases of short-term investments of $850.4 million and capital expenditures of $63.0 million related to our office and datacenter build-outs. These outflows were partially offset by inflows of $283.6 million related to proceeds from maturities and sales of short-term investments. Financing activities Net cash (used in) financing activities is primarily impacted by repurchases of common stock to satisfy the tax withholding obligation for the release of restricted stock units ("RSUs") and principal payments on finance lease obligations for our infrastructure equipment. For the year ended December 31, 2019, net cash used in financing activities was $176.7 million, which primarily consisted of $92.9 million in principal payments against finance lease obligations and $85.4 million for the satisfaction of tax withholding obligations for the release of restricted stock units. For the year ended December 31, 2018, net cash provided by financing activities was $300.8 million, which primarily consisted of $746.6 million in net proceeds from the completion of our IPO and concurrent private placement. The proceeds were offset by $351.9 million for the satisfaction of tax withholding obligations for the release of restricted stock units and $109.1 million in principal payments against finance lease obligations. Contractual Obligations Our principal commitments consist of obligations under operating leases for office space and datacenter operations, and finance leases for datacenter equipment. The following table summarizes our commitments to settle contractual obligations in cash as of December 31, 2019, for the periods presented below: (1) Consists of future non-cancelable minimum rental payments under operating leases for our offices and datacenters, excluding rent payments from our sub-tenants and variable operating expenses. As of December 31, 2019, we are entitled to non-cancelable rent payments from our sub-tenants of $33.5 million, which will be collected over the next 3 years. (2) Consists of future non-cancelable minimum rental payments under finance leases primarily for our infrastructure. (3) Consists of commitments to third-party vendors for services related to our infrastructure, infrastructure warranty contracts, asset retirement obligations for office modifications, and a note payable related to financing of our infrastructure. In addition to the contractual obligations set forth above, as of December 31, 2019, we had an aggregate of $59.6 million in letters of credit outstanding under our revolving credit facility. In 2017, we entered into a new lease agreement for office space in San Francisco, California, to serve as our new corporate headquarters. We took initial possession of our new corporate headquarters in June 2018 and began to recognize rent expense in the same period. Refer to Note 9 "Leases" for further information. Off-Balance Sheet Arrangements As of December 31, 2019, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or variable interest entities, which would have been established for the purpose of facilitating off balance sheet arrangements or other contractually narrow or limited purposes. Significant Impacts of Stock-Based Compensation Restricted Stock Units We have granted restricted stock units, or RSUs, to our employees and members of our Board of Directors under our 2008 Equity Incentive Plan, or 2008 Plan, our 2017 Equity Incentive Plan, or 2017 Plan and our 2018 Equity Incentive Plan, or 2018 Plan. We have two types of RSUs outstanding as of December 31, 2019: • One-tier RSUs, which have a service-based vesting condition over a four-year period. These awards typically have a cliff vesting period of one year and continue to vest quarterly thereafter. We recognize compensation expense associated with one-tier RSUs ratably on a straight-line basis over the requisite service period. • Two-tier RSUs, which have both a service-based vesting condition and a liquidity event-related performance vesting condition. These awards typically have a service-based vesting period of four years with a cliff vesting period of one year and continue to vest monthly thereafter. Upon satisfaction of the Performance Vesting Condition, these awards vest quarterly. The Performance Vesting Condition was satisfied upon the effectiveness of the registration statement related to our IPO. Our last grant date for two-tier RSUs was May 2015. We recognize compensation expense associated with two-tier RSUs using the accelerated attribution method over the requisite service period. Upon the effectiveness of the registration statement related to our IPO, we recognized stock-based compensation related to our two-tier RSUs using the accelerated attribution method, with a cumulative catch-up in the amount of $418.7 million attributable to service provided prior to such effective date. The remaining unamortized stock-based compensation as of December 31, 2018 related to the two-tier RSUs of $0.1 million was recognized in 2019. Co-Founder Grants In December 2017, the Board of Directors approved a grant to the Company’s co-founders of non-Plan RSAs with respect to 14.7 million shares of Class A Common Stock in the aggregate (collectively, the “Co-Founder Grants”), of which 10.3 million RSAs were granted to Mr. Houston, the Company’s co-founder and Chief Executive Officer, and 4.4 million RSAs were granted to Mr. Ferdowsi, the Company’s co-founder and Director. These Co-Founder Grants have service-based, market-based, and performance-based vesting conditions. The Co-Founder Grants are excluded from Class A common stock issued and outstanding until the satisfaction of these vesting conditions. The Co-Founder Grants also provide the holders with certain stockholder rights, such as the right to vote the shares with the other holders of Class A common stock and a right to cumulative declared dividends. However, the Co-Founder Grants are not considered a participating security for purposes of calculating net loss per share attributable to common stockholders in Note 13, "Net Loss Per Share", as the right to the cumulative declared dividends is forfeitable if the service condition is not met. The Co-Founder Grants are eligible to vest over the ten-year period following the date the Company’s shares of Class A common stock commenced trading on the Nasdaq Global Select Market in connection with the Company’s IPO. The Co-Founder Grants comprise nine tranches that are eligible to vest based on the achievement of stock price goals, each of which are referred to as a Stock Price Target, measured over a consecutive thirty-day trading period during the Performance Period. The Performance Period began on January 1, 2019 and the RSUs expire at the earliest date among the following: the date on which all shares vest, the date the Co-Founder(s) cease to meet their service conditions, or the tenth anniversary of the IPO date. During the first four years of the Performance Period, no more than 20% of the shares subject to each Co-Founder Grant would be eligible to vest in any calendar year. After the first four years, all shares are eligible to vest based on the achievement of the Stock Price Targets. The Company calculated the grant date fair value of the Co-Founder Grants based on multiple stock price paths developed through the use of a Monte Carlo simulation. A Monte Carlo simulation also calculates a derived service period for each of the nine vesting tranches, which is the measure of the expected time to achieve each Stock Price Target. A Monte Carlo simulation requires the use of various assumptions, including the underlying stock price, volatility, and the risk-free interest rate as of the valuation date, corresponding to the length of time remaining in the performance period, and expected dividend yield. The weighted-average grant date fair value of each Co-Founder Grant was estimated to be $10.60 per share. The weighted-average derived service period of each Co-Founder Grant was estimated to be 5.2 years, and ranged from 2.9 - 6.9 years. The Company will recognize aggregate stock-based compensation expense of $156.2 million over the derived service period of each tranche using the accelerated attribution method as long as the co-founders satisfy their service-based vesting conditions. If the Stock Price Targets are met sooner than the derived service period, the Company will adjust its stock-based compensation to reflect the cumulative expense associated with the vested awards. The Company will recognize expense if the requisite service is provided, regardless of whether the market conditions are achieved. The Performance Vesting Condition for the Co-Founder Grants was satisfied on the date the Company’s shares of Class A common stock commenced trading on the Nasdaq Global Select Market in connection with the Company’s IPO, which was March 23, 2018. Award Modification During the year ended December 31, 2017, the Company's Board of Directors voted to approve a modification of vesting schedules for certain unvested one-tier and two-tier RSUs to align the vesting schedules for all RSUs to vest once per quarter. The modification was effective February 15, 2018, which resulted in accelerated vesting of impacted RSUs that had met their service requirement as of that date. As a result, the Company recognized an incremental $10.0 million in stock-based compensation during the first quarter of 2018 related to these modified one-tier and two-tier RSUs. See Note 1, “Description of the Business and Summary of Significant Accounting Policies” and Note 12, “Stockholders’ Equity” to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for more information regarding our equity awards. Critical Accounting Policies and Judgments Our consolidated financial statements and the related notes thereto included elsewhere in this Annual Report on Form 10-K are prepared in accordance with generally accepted accounting principles, or GAAP, in the United States. The preparation of consolidated financial statements also requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs and expenses, and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ significantly from the estimates made by management. To the extent that there are differences between our estimates and actual results, our future financial statement presentation, financial condition, results of operations, and cash flows will be affected. We believe that the accounting policies described below involve a greater degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of operations. Revenue recognition We generate revenue from sales of subscriptions to our platform. Subscription fees exclude sales and other indirect taxes. We determine revenue recognition through the following steps: • Identification of the contract, or contracts, with a customer • Identification of the performance obligations in the contract • Determination of the transaction price • Allocation of the transaction price to the performance obligations in the contract • Recognition of revenue when, or as, we satisfy a performance obligation Our subscription agreements typically have monthly or annual contractual terms, and a small percentage have multi-year contractual terms. Revenue is recognized ratably over the related contractual term generally beginning on the date that our platform is made available to a customer. Our agreements are generally non-cancelable. We typically bill in advance for monthly contracts and annually in advance for contracts with terms of one year or longer. Business combinations Accounting for business combinations requires us to make significant estimates and assumptions. We allocate the purchase consideration to the tangible and intangible assets acquired and liabilities assumed based on their estimated fair values, with the excess recorded to goodwill. Critical estimates in valuing certain intangible assets include, but are not limited to, future expected cash flows, expected asset lives, and discount rates. The amounts and useful lives assigned to acquisition-related intangible assets impact the amount and timing of future amortization expense. During the measurement period, which is not to exceed 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. Deferred commissions Certain sales commissions and the related payroll taxes earned by our outbound sales team, as well as commissions earned by third-party resellers, are considered to be incremental and recoverable costs of obtaining a contract with a customer. These costs are deferred and then amortized over a period of benefit that we have determined to be five years. We determined the period of benefit by taking into consideration our historical customer attrition rates, the useful life of our technology, and the impact of competition in our industry. Fair value of market condition awards The Co-Founder Grants contain market-based vesting conditions. The market-based vesting condition is considered when calculating the grant date fair value of these awards, which requires the use of various estimates and assumptions. The grant date fair value of the Co-Founder Grants was estimated using a model based on multiple stock price paths developed through the use of a Monte Carlo simulation that incorporates into the valuation the possibility that the market condition may not be satisfied. A Monte Carlo simulation requires the use of various assumptions, including our underlying stock price, volatility, and the risk-free interest rate as of the valuation date, corresponding to the length of time remaining in the performance period, and expected dividend yield. A Monte Carlo simulation also calculates a derived service period for each of the nine vesting tranches, which is the measure of the expected time to achieve the market conditions. Expense associated with market-based awards is recognized over the requisite service period of each tranche using the accelerated attribution method, regardless of whether the market conditions are achieved. Recent Accounting Pronouncements See Note 1, “Description of the Business and Summary of Significant Accounting Policies” to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for recently adopted accounting pronouncements and recently issued accounting pronouncements not yet adopted as of the date of this Annual Report on Form 10-K.

<s>[INST] Overview Our modern economy runs on knowledge. Today, knowledge lives in the cloud as digital content, and Dropbox is building the world's first smart workspace where businesses and individuals can create, access, and share this content globally. We serve more than 600 million registered users across 180 countries. Since our founding in 2007, our market opportunity has grown as we’ve expanded from keeping files in sync to keeping teams in sync. Our smart workspace is a digital environment that brings all of a team’s content together with the tools they love, helping users cut through the clutter and surfacing what matters most. In a world where using technology at work can be fragmented and distracting, the smart workspace makes it easy to focus on the work that matters. By solving these universal problems, we’ve become invaluable to our users. The popularity of our platform drives viral growth, which has allowed us to scale rapidly and efficiently. We’ve built a thriving global business with 14.3 million paying users. Our Subscription Plans We generate revenue from individuals, teams, and organizations by selling subscriptions to our platform, which serve the varying needs of our diverse customer base. Subscribers can purchase individual licenses through our Plus and Professional plans, or purchase multiple licenses through a Standard, Advanced, or Enterprise team plan. Each team represents a separately billed deployment that is managed through a single administrative dashboard. Teams must have a minimum of three users, but can also have more than tens of thousands of users. Customers can choose between an annual or monthly plan, with a small number of large organizations on multiyear plans. A majority of our customers opt for our annual plans. We typically bill our customers at the beginning of their respective terms and recognize revenue ratably over the term of the subscription period. International customers can pay in U.S. dollars or a select number of foreign currencies. Our premium subscription plans, such as Professional and Advanced, provide more functionality than other subscription plans and have higher per user prices. Our Standard and Advanced subscription plans offer robust capabilities for businesses, and the vast majority of Dropbox Business teams purchase our Standard or Advanced subscription plans. While our Enterprise subscription plan offers more opportunities for customization, companies can subscribe to any of these team plans for their business needs. In the first quarter of fiscal 2019, we acquired HelloSign, an esignature and document workflow platform. The acquisition of HelloSign expands our content collaboration capabilities to include additional businesscritical workflows. HelloSign has several product lines, and the pricing and revenue generated from each product line varies, with some product lines priced based on the number of licenses purchased (similar to Dropbox plans), while others are priced based on a customer’s transaction volume. Depending on the product purchased, teams must have a minimum of a certain number of licenses, but can also have hundreds of users. Customers can choose between an annual or monthly plan, with a small number of large organizations on multiyear plans. HelloSign also typically bills customers at the beginning of their respective terms and recognizes revenue ratably over the subscription period. HelloSign primarily sells within the United States and sells only in U.S. dollars. Our Customers Our customer base is highly diversified, and in the period presented, no customer accounted for more than 1% of our revenue. Our customers include individuals, teams, and organizations of all sizes, from freelancers and small businesses to Fortune 100 companies. They work across a wide range of industries, including professional services, technology, media, education, industrials, consumer and retail, and financial services. Within companies, our platform is used by all types of teams and functions, including sales, marketing, product, design, engineering, finance, legal, and human resources. Our Business Model Drive new signups We acquire users efficiently and at relatively low costs through wordofmouth referrals, direct inproduct referrals, and sharing of content. Anyone can create a Dropbox account for free through our website or app and be up and running in minutes. These users often share and collaborate with other nonregistered users, attracting new signups into our network. Increase conversion of registered users to our paid subscription plans We generate over 90% of our revenue from selfserve channelsusers who purchase a subscription through our app or website. To grow our recurring revenue base, we actively encourage our registered users to convert to one of our paid plans based on the functionality that best su [/INST] Positive. </s>

AVALARA, INC.

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 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. In addition to historical financial information, the following discussion contains forward-looking statements that reflect our plans, estimates, beliefs and expectations that involve risks and uncertainties. Our actual results and the timing of events 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 sections of this report titled “Risk Factors” and “Special Note Regarding Forward-Looking Statements.” Overview We provide a leading suite of cloud-based solutions that help businesses of all types and sizes comply with transaction tax requirements worldwide. Our Avalara Compliance Cloud offers a broad and growing suite of compliance solutions that enable businesses to address the complexity of transaction tax compliance, process transactions in real time, produce detailed records of transaction tax determinations, and reduce errors, audit exposure and total transaction tax compliance costs. During 2018, we continued our focus on maintaining and expanding our partner network, which has been an essential part of our growth. We increased our partner relationships and currently have more than 700 pre-built integrations. These integrations are designed to link our tax compliance solutions to a wide variety of business applications, including accounting, ERP, ecommerce, POS, recurring billing, and CRM systems. Partners improve our sales efficiency by bringing us qualified leads and provide for a better onboarding process and customer experience. We sell our solutions primarily through our sales force, which focuses on selling to qualified leads provided by our marketing efforts and by partner referrals. Most sales, to new and existing customers, are direct and are conducted via telephone, requiring minimal in-person interactions with customers or prospects. In some cases, particularly for customers with larger and more complex needs, we conduct in-person sales. In addition, our marketing investments and related activities generate awareness from many small businesses. In 2018, we also continued our acquisition strategy to provide best-in-class solutions and expand our market opportunity by acquiring cross-border technology to enable calculation and classification of tariffs and duties. In addition, we continued to invest organically by devoting significant resources to continuous improvement of our existing solutions, by adding innovative and new features and functionalities, building technology to support new content, and improving our customer’s product experience. We expect to continue to make significant investments to acquire accurate and relevant content and expertise to best serve the transaction tax needs of our customers. In June 2018, we completed an IPO listing our common stock on the New York Stock Exchange and sold approximately 8.6 million shares for net proceeds of $192.5 million. Following the IPO, we repaid all our outstanding borrowings consisting of $33.0 million outstanding under our revolving credit facility and $30.0 million outstanding under our term loan. As of December 31, 2018, we had no borrowings outstanding and $50.0 million remained available for borrowing under our revolving credit facility. Additionally, we ended the year with $142.3 million of cash and cash equivalents. Also, in June 2018, the U.S. Supreme Court issued its opinion in South Dakota v. Wayfair, Inc. upholding South Dakota’s economic nexus law, which requires certain out-of-state retailers to collect and remit sales taxes on sales into South Dakota. By the end of the year, 33 U.S. states, including California and Texas, along with the District of Columbia, adopted economic nexus legislation. Several more states are considering similar legislation in 2019. These developments increased awareness of transaction tax issues and we believe this increased the sense of urgency among many businesses to comply with new laws. We believe we are well-positioned to benefit from these changes in 2019 and beyond. Total revenue for 2018 was $272.1 million, an increase of 28% from $213.2 million in 2017. Most of our revenue comes from subscriptions and returns, with approximately 93% in 2018 and 94% in 2017. Our revenue growth was attributable, almost equally, to adding new customers and expanding service offerings to existing customers. While only 6% of total revenue for 2018 was generated outside the U.S., we are targeting transaction tax markets in EMEA and Brazil. We added approximately 1,580 core customers during 2018 and maintained a net revenue retention rate of 107% on average over the past four quarters. We use core customers, which represent more than 85% of our total revenue, as a metric to focus our customer count reporting on the mid-market segment, which is our primary market. We use net revenue retention rates to reflect the stability of our revenue base and to provide insight into our ability to grow existing customer revenues. While our revenue improved, our gross margin declined to 71% during 2018 from 73% during 2017. The decline in gross margin was due primarily to higher software hosting costs, and to a lesser extent, higher costs to support our international products and operations. Operating expenses increased in absolute dollars to $269.5 million in 2018 from $218.5 million in 2017, as we continued to make significant investments in our future growth. Sales and marketing expenses were $168.8 million in 2018, or 62% of total revenue, compared to $133.8 million in 2017, or 63% of total revenue. Sales commission expense increased $18.5 million to $35.2 million from $16.7 million of sales commission expense in 2017. Partner commission expense increased $7.4 million to $21.7 million from $14.3 million of partner commission expense in 2017. Commissions earned by our partners were approximately 8% of total revenue in 2018 compared to 7% of total revenue in 2017. To partially offset the impact of these investments in customer additions, we reduced our discretionary spending on advertising and marketing in 2018. Operating loss was $76.1 million during 2018 compared to an operating loss of $63.3 million during 2017. Our net loss was $75.6 million during 2018 compared to a net loss of $64.1 million during 2017. Both operating loss and net loss increased during 2018 due primarily to the decline in gross margin and higher operating expenses described above. Non-GAAP operating loss was $45.0 million during 2018 compared to non-GAAP operating loss of $37.4 million during 2017. See the section titled “Management’s Discussion and Analysis of Financial Conditions and Results of Operations-Use of Non-GAAP Financial Measures” for more information and a reconciliation of non-GAAP operating loss to operating loss. Key Business Metrics We regularly review several metrics to evaluate growth trends, measure our performance, formulate financial projections, and make strategic decisions. We discuss revenue and the components of operating results under “Key Components of Consolidated Statements of Operations,” and we discuss other key business metrics below. Number of Core Customers We believe core customers is a key indicator of our market penetration, growth, and potential future revenue. The mid-market has been and remains our primary target market segment for marketing and selling our solutions. We use core customers as a metric to focus our customer count reporting on our primary target market segment. As of December 31, 2018 and 2017, we had approximately 9,070 and 7,490 core customers, respectively. In 2018, our core customers represented more than 85% of our total revenue. We define a core customer as: • a unique account identifier in our billing system, or a billing account (multiple companies or divisions within a single consolidated enterprise that each have a separate unique account identifier are each treated as separate customers); • that is active as of the measurement date; and • for which we have recognized, as of the measurement date, greater than $3,000 in total revenue during the last twelve months. Currently, our core customer count includes only customers with unique account identifiers in our primary U.S. billing systems and does not include customers who subscribe to our solutions through our international subsidiaries or certain legacy billing systems, primarily related to past acquisitions. As we increase our international operations and sales in future periods, we may add customers billed from our international subsidiaries to the core customer metric. We have a substantial number of customers of various sizes who do not meet the revenue threshold to be considered a core customer. Many of these customers are in the small business and self-serve segment of the marketplace, which represents strategic value and a growth opportunity for us. Customers who do not meet the revenue threshold to be considered a core customer provide us with market share and awareness, and we anticipate that some may grow into core customers. Net Revenue Retention Rate We believe that our net revenue retention rate provides insight into our ability to retain and grow revenue from our customers, as well as their potential long-term value to us. We also believe it reflects the stability of our revenue base, which is one of our core competitive strengths. We calculate our net revenue retention rate by dividing (a) total revenue in the current quarter from any billing accounts that generated revenue during the corresponding quarter of the prior year by (b) total revenue in such corresponding quarter from those same billing accounts. This calculation includes changes for these billing accounts, such as additional solutions purchased, changes in pricing and transaction volume, and terminations, but does not reflect revenue for new billing accounts added during the one year period. Currently, our net revenue retention rate calculation includes only customers with unique account identifiers in our primary U.S. billing systems and does not include customers who subscribe to our solutions through our international subsidiaries or certain legacy billing systems, primarily related to past acquisitions. Our net revenue retention rate was 107% on average for the four quarters ended December 31, 2018. Key Components of Consolidated Statements of Operations Revenue We generate revenue from two primary sources: (1) subscriptions and returns; and (2) professional services. Subscription and returns revenue is driven primarily by the acquisition of customers, customer renewals, and additional product offerings purchased by existing customers. Revenue from subscriptions and returns comprised approximately 93%, 94%, and 93% of our revenue for 2018, 2017, and 2016, respectively. Subscription and Returns Revenue. Subscription and returns revenue primarily consists of fees paid by customers to use our solutions. Subscription plan customers select a price plan that includes an allotted maximum number of transactions over the subscription term. Unused transactions are not carried over to the customer’s next subscription term, and customers are not entitled to a refund of fees paid or relief from fees due if they do not use the allotted number of transactions. If a subscription plan customer exceeds the selected maximum transaction level, we will generally upgrade the customer to a higher tier or, in some cases, charge overage fees on a per transaction or return basis. Customers who purchase tax return preparation can purchase on a subscription basis for an allotted number of returns or on a per filing basis. Our subscription contracts are generally non-cancelable after the first 60 days of the contract term. We have historically experienced few cancellations during the first 60 days. We generally invoice our subscription plan customers for the initial term at contract signing and at the beginning of each new term upon renewal. Our initial terms generally range from twelve to eighteen months, and renewal periods are typically one year. Amounts that have been invoiced are initially recorded as deferred revenue. Subscription revenue is recognized on a straight-line basis over the service term of the arrangement beginning on the date that our solution is made available to the customer and ending at the expiration of the subscription term. When purchased on a per filing basis, we recognize revenue for returns when the return is filed with the tax authority. Since our customers typically file tax returns on a monthly or quarterly basis continuously through the year, the pattern of revenue recognition is similar regardless of whether returns are sold on a subscription basis or per filing basis. A greater proportion of returns are sold on a subscription basis. We generate interest income on funds held for customers. We hold customer funds in trust accounts at FDIC-insured institutions in order to provide tax remittance services to customers. We collect funds from customers in advance of remittance to tax authorities. Prior to remittance, we earn interest on these funds. Professional Services. We generate professional services revenue from providing tax analysis, configurations, data migrations, integration, training and other support services. We bill for service arrangements on a fixed fee or time and materials basis, and we recognize revenue as services are performed and are collectable under the terms of the associated contracts. Costs and Expenses Cost of Revenue. Cost of revenue consists of costs related to providing the Avalara Compliance Cloud and supporting our customers and includes personnel and related expenses, including salaries, benefits, bonuses, and stock-based compensation. In addition, cost of revenue includes direct costs associated with information technology, such as data center and software hosting costs, and tax content maintenance. Cost of revenue also includes allocated costs for certain information technology and facility expenses, along with depreciation of equipment and amortization of intangibles such as acquired technology from acquisitions. We plan to continue to significantly expand our infrastructure and personnel to support our future growth, including through acquisitions, which we expect to result in higher cost of revenue in absolute dollars. Research and Development. Research and development expenses consist primarily of personnel and related expenses for our research and development staff, including salaries, benefits, bonuses, and stock-based compensation, and the cost of third-party developers and other contractors. Research and development costs, other than software development expenses qualifying for capitalization, are expensed as incurred. Capitalized software development costs consist primarily of employee-related costs but to date have not been significant. Research and development expenses also include allocated costs for certain information technology and facility expenses. We devote substantial resources to enhancing the Avalara Compliance Cloud, developing new and enhancing existing solutions, conducting quality assurance testing, and improving our core technology. We expect research and development expenses to increase in absolute dollars. Sales and Marketing. Sales and marketing expenses consist primarily of personnel and related expenses for our sales and marketing staff, including salaries, benefits, bonuses, sales commissions, and stock-based compensation, integration and referral partner commissions, costs of marketing and promotional events, corporate communications, online marketing, solution marketing, and other brand-building activities. Sales and marketing expenses include allocated costs for certain information technology and facility expenses, along with depreciation of equipment and amortization of intangibles such as customer databases from acquisitions. We expense partner commissions as incurred rather than recognizing them over the subscription period. Our partner commission expense has historically been, and will continue to be, impacted by many factors, including the proportion of new and renewal revenues, the nature of the partner relationship, and the sales mix among similar types of partners during the period. In general, integration partners are paid a higher commission for the initial sale to a new customer and a lower commission for renewal sales. Additionally, we have several types of partners (e.g., integration and referral) that each earn different commission rates. For 2018, 2017, and 2016, we incurred $21.7 million, $14.3 million, and $9.9 million in commission expense to partners, respectively. We expense sales commissions as incurred. Sales commissions are earned when a sales order is completed. For most sales orders, deferred revenue is recorded when a sales order is invoiced, and the related revenue is recognized over the subscription term. The rates at which sales commissions are earned varies depending on a variety of factors, including the nature of the sale (new, renewal, or add-on product offering), the type of product or solution sold, and the sales channel. At the beginning of each year we set group and individual sales targets (quotas) for the full year. Additional sales commissions can be earned based on achieving or exceeding these sales quotas. We intend to continue to invest in sales and marketing and expect spending in these areas to increase in absolute dollars as we continue to expand our business. We expect sales and marketing expenses to continue to be among the most significant components of our operating expenses. General and Administrative. General and administrative expenses consist primarily of personnel and related expenses for administrative, finance, information technology, legal, and human resources staff, including salaries, benefits, bonuses, and stock-based compensation, professional fees, insurance premiums, and other corporate expenses that are not allocated to the above expense categories. We expect our general and administrative expenses to increase in absolute dollars as we continue to expand our operations, hire additional personnel, integrate acquisitions, and incur costs as a public company. We also expect to continue to incur increased expenses related to accounting, tax and auditing activities, legal, insurance, SEC compliance, and internal control compliance. Total Other (Income) Expense, Net Total other (income) expense, net consists of interest income on cash and cash equivalents, interest expense on outstanding borrowings, quarterly remeasurement of contingent consideration, realized foreign currency changes, and other nonoperating gains and losses. Interest expense on our borrowings is based on a floating per annum rate at specified percentages above the prime rate. Results of Operations The comparability of periods covered by our financial statements can be impacted by acquisitions. In May 2018, we acquired developed technology to facilitate cross-border transactions (e.g., tariffs and duties). In September 2016, we acquired a business in Brazil that provides certain tax-related compliance solutions and content for the Brazilian market. The following sets forth our results of operations for the periods presented. (1) The stock-based compensation expense included above was as follows: The amortization of acquired intangibles included above was as follows: The following sets forth our results of operations as a percentage of our total revenue for the periods presented. Year Ended December 31, 2018 as compared to the Year Ended December 31, 2017 Revenue Total revenue for the year ended December 31, 2018 increased by $58.9 million, or 28%, compared to the year ended December 31, 2017. Subscription and returns revenue for the year ended December 31, 2018 increased by $54.1 million, or 27%, compared to the year ended December 31, 2017. Professional services revenue for the year ended December 31, 2018 increased by $4.8 million, or 37%, compared to the year ended December 31, 2017. Growth in total revenue was due primarily to increased demand for our products and services from both new and existing customers. Of the increase in total revenue for the year ended December 31, 2018 compared to 2017, approximately $29.6 million was attributable to existing customers, approximately $28.3 million was attributable to new customers, and approximately $1.1 million was due to interest income on funds held for customers. Total subscription and returns revenue for 2018 included $1.2 million related to our cross-border transactions technology acquired in May 2018. Cost of Revenue Cost of revenue for the year ended December 31, 2018 increased by $20.7 million, or 36%, compared to the year ended December 31, 2017. The increase in cost of revenue in absolute dollars was due primarily to an increase of $10.3 million in employee-related costs, an increase of $4.6 million in software hosting costs, an increase of $2.2 million in allocated overhead cost, and an increase of $1.4 million in outside services expenses. Our cost of revenue headcount increased approximately 15% from December 31, 2017 to December 31, 2018 due to our continued growth to support our solutions and expand content. Employee-related costs increased due primarily to a $7.6 million increase in salaries and benefits, a $1.0 million increase in contract and temporary employees, a $0.7 million increase in stock-based compensation expense, and a $0.8 million increase in compensation expense related to our bonus plans. Software hosting costs have increased due primarily to higher transaction volumes and transitioning to a third-party hosting vendor. Allocated overhead consists primarily of facility expenses and shared information technology expenses. Facility expenses increased in 2018 due primarily to the costs associated with our new corporate headquarters in Seattle, Washington. We moved into these facilities in February 2018. Outside services expenses increased due primarily to the use of third-party consulting firms to support product and service offerings in our international operations. Gross Profit Total gross profit for the year ended December 31, 2018 increased $38.3 million, or 25%, compared to the year ended December 31, 2017. Total gross margin was 71% for the year ended December 31, 2018 compared to 73% for the same period of 2017. This decrease was due primarily to higher software hosting costs and to a lesser extent, higher costs for third-party consulting firms to support product and service offerings in our international operations. Research and Development Research and development expenses for the year ended December 31, 2018 increased $10.6 million, or 26%, compared to the year ended December 31, 2017. The increase was due primarily to an increase of $8.5 million in employee-related costs, an increase of $1.4 million in allocated overhead cost, and an increase of $0.3 million in outside services expenses. While research and development headcount increased only 4% from December 31, 2017 to December 31, 2018, employee-related costs increased due primarily to a $5.4 million increase in salaries and benefits, a $1.0 million increase in compensation expense related to our bonus plans, a $0.9 million increase in contract and temporary employees, and a $0.8 million increase in stock-based compensation expense. Outside services expenses increased due primarily to use of third-party software developers to support product enhancements and maintenance in our international operations. Sales and Marketing Sales and marketing expenses for the year ended December 31, 2018 increased $35.0 million, or 26%, compared to the year ended December 31, 2017. The increase was due primarily to an increase of $28.1 million in employee-related costs, an increase of $7.4 million for partner commission expense, and an increase of $2.7 million in allocated overhead cost offset, in part, by a decrease of $3.9 million for marketing campaign expenses. While sales and marketing headcount was essentially flat from December 31, 2017 to December 31, 2018, employee-related costs increased due primarily to an $18.5 million increase in sales commissions expense, a $9.1 million increase in salaries and benefits, and a $1.7 million increase in stock-based compensation expense. Sales commissions expense increased due to strong sales-related activity and higher average commission rates. Our average commissions rates were higher in 2018 compared to 2017 due to an increase in the percentage of eligible sales personnel exceeding their annual sales targets. We typically pay higher sales commission rates on additional sales that exceed the established sales target. Partner commission expense increased due primarily to higher revenues and an increase in the proportion of sales eligible for partner commissions, including new sales which generally earn a higher commission rate compared to renewal sales. Partner commission expense was $21.7 million for the year ended December 31, 2018 compared to $14.3 million for the year ended December 31, 2017. Marketing campaign expenses decreased due to a reduction in our discretionary spending on advertising and marketing. General and Administrative General and administrative expenses for the year ended December 31, 2018 increased $5.3 million, or 16%, compared to the year ended December 31, 2017. The increase was due primarily to an increase of $2.7 million in employee-related costs, a $0.8 million increase in merchant fees, an increase of $0.8 million in insurance expense as a result of being a public company, and a $0.5 million increase in indirect tax compliance expenses. General and administrative headcount increased 5% from December 31, 2017 to December 31, 2018. Employee-related costs increased due primarily to $1.0 million increase in stock-based compensation expense and a $1.1 million increase in compensation expense related to our bonus plans. Merchant fees, which are credit card processing fees, increased due to customers transitioning to our auto-payment program which uses credit cards for customer payment and increased payment activity. Indirect tax expenses, which are non-income tax related, increased due primarily to higher business and occupation taxes in certain tax jurisdictions. Goodwill Impairment and Restructuring Charges A goodwill impairment charge of $9.2 million was recorded in 2018 and a $8.4 million goodwill impairment charge was recorded in 2017, both of which related to our Brazilian operations (see Note 6 of the Notes to Consolidated Financial Statements). There were no restructuring charges incurred in the year ended December 31, 2018, compared to $0.8 million incurred in the year ended December 31, 2017. We incurred restructuring charges in the third quarter of 2017 associated with the closure of our Overland Park office, including termination benefits and other reorganization costs, primarily associated with integrating operations. Total Other (Income) Expense, Net Total other expense for the year ended December 31, 2018 was $0.5 million compared to $2.0 million for the year ended December 31, 2017. Interest income increased due to interest earned on investing our IPO cash proceeds in money market accounts. Interest expense remained consistent due to higher interest expense on borrowings under our credit facilities during 2018 prior to repayment of the outstanding borrowings following our IPO. We discuss borrowings under “Liquidity and Capital Resources” below. Other income remained consistent and is comprised primarily of income resulting from the change in the fair value of earnout liabilities associated with prior business acquisitions. We estimate the fair value of earnout liabilities related to acquisitions quarterly. During 2018 and 2017, the adjustments to fair value reduced the carrying value of the earnout liabilities. Provision for (Benefit from) Income Taxes Benefit from income taxes for the year ended December 31, 2018 decreased by $0.2 million compared to the year ended December 31, 2017. The effective income tax rate was a benefit of 1.3% and 1.9% for the years ended December 31, 2018 and 2017, respectively. The difference is due primarily to an update to the provisional amount recorded as of December 31, 2017. We determined that indefinite lived goodwill would provide a source of income to realize indefinite lived deferred tax assets resulting in a tax benefit of $0.9 million during the year ended December 31, 2018. We have assessed our ability to realize our deferred tax assets and have recorded a valuation allowance against such assets to the extent that, based on the weight of all available evidence, it is more likely than not that all or a portion of the deferred tax assets will not be realized. In assessing the likelihood of future realization of our deferred tax assets, we placed significant weight on our history of generating U.S. tax losses, including in 2018. As a result, we have a full valuation allowance against our net deferred tax assets, including net operating loss carryforwards, and tax credits related primarily to research and development. We expect to maintain a full valuation allowance for the foreseeable future. Year Ended December 31, 2017 Compared to Year Ended December 31, 2016 Revenue Total revenue for the year ended December 31, 2017 increased by $45.7 million, or 27%, compared to the year ended December 31, 2016. Subscription and returns revenue for the year ended December 31, 2017 increased by $45.0 million, or 29%, compared to the year ended December 31, 2016. Growth in total revenue was due primarily to increased demand for our products and services from new and existing customers. In September 2016, we acquired a business in Brazil that provides transaction tax compliance solutions and content. Excluding the impact of the Brazil acquisition, revenue increased by $42.3 million, or 25%, from 2016 to 2017. Of this increase, $23.7 million was attributable to existing customers and $18.6 million was attributable to new customers. Professional services revenue for the year ended December 31, 2017 increased $0.8 million, or 6%, compared to the year ended December 31, 2016 due primarily to the Brazil acquisition. Cost of Revenue Cost of revenue for the year ended December 31, 2017 increased $9.5 million, or 20%, compared to the year ended December 31, 2016. The increase in cost of revenue in absolute dollars was due primarily to an increase of $6.4 million in employee-related costs due to our September 2016 acquisition in Brazil and higher headcount, an increase of $1.0 million in software hosting costs, $0.9 million in higher depreciation and amortization expense, and an increase of $0.6 million in outside services expense. Our cost of revenue headcount increased approximately 19% from December 31, 2016 to December 31, 2017 due to our continued growth to support our solutions and expand content. Software hosting costs have increased due primarily to higher transaction volumes. Amortization expense increased due primarily to intangible assets acquired as part of the Brazil acquisition. As we expanded our product offerings in Europe in 2017, our outside services expenses increased as we engaged third parties to assist with certain projects. Gross Profit Total gross profit for the year ended December 31, 2017 increased $36.3 million, or 31%, compared to the year ended December 31, 2016. Total gross margin improved from 71% in 2016 to 73% in 2017. The increase in gross margin was due primarily to increased automation of compliance processes and growing revenue relative to fixed costs of operations. Research and Development Research and development expenses for the year ended December 31, 2017 increased $8.4 million, or 26%, compared to the year ended December 31, 2016. The increase was due primarily to a $6.8 million increase in employee-related costs due to our September 2016 acquisition in Brazil and higher headcount, a $1.0 million increase in allocated overhead cost, and a $0.2 million increase in outside services expense. Research and development headcount increased approximately 18% from December 31, 2016 to December 31, 2017 due primarily to increasing headcount in our U.S. operations as we continue to enhance existing solutions. Allocated overhead consists primarily of facility expenses and shared information technology expenses. Sales and Marketing Sales and marketing expenses for the year ended December 31, 2017 increased $30.3 million, or 29%, compared to the year ended December 31, 2016. The increase was due primarily to an increase of $20.3 million in employee-related costs from higher headcount, an increase of $4.9 million for marketing campaign and professional services expenses, and an increase of $4.4 million for partner commissions expense. During 2017, we engaged in a sales force reorganization and continued to expand our sales force and marketing teams as we seek to accelerate sales growth and new customer acquisition. Sales and marketing headcount increased approximately 30% from December 31, 2016 to December 31, 2017. In pursuing our strategy to accelerate sales growth, we also increased marketing spending primarily on demand generation and customer base marketing activities in 2017. Partner commission expense increased by 44%, from $9.9 million to $14.3 million, due primarily to an increase in the proportion of sales eligible for partner commissions. General and Administrative General and administrative expenses for the year ended December 31, 2017 decreased $2.6 million, or 7%, compared to the year ended December 31, 2016. The decrease was due primarily to a $3.2 million reduction in bad debt expense, a $1.5 million non-recurring charge to terminate a contract in 2016, lower depreciation of $0.7 million, and $0.7 million lower allocated overhead costs, partially offset by a $2.8 million increase in employee-related costs from higher headcount. Bad debt expense decreased due primarily to improved cash collections from our customers compared to the prior year. In 2016, we agreed to terminate a long-term software development agreement with a vendor for $1.5 million. Depreciation expenses decreased due to asset disposals for our Bainbridge Island and Harrisburg offices, which were downsized in 2016. Allocated overhead consists primarily of facility expenses and shared information technology expenses. General and administrative headcount increased approximately 21% from December 31, 2016 to December 31, 2017 as we expanded our support services personnel to effectively handle growth. Goodwill Impairment and Restructuring Charges Goodwill impairment for 2017 was $8.4 million, and restructuring charges were $0.8 million for 2017. There were no similar charges in 2016. A goodwill impairment charge of $8.4 million was recorded related to our Brazilian operations in 2017 (see Note 6 of the Notes to Consolidated Financial Statements). We also incurred restructuring charges of $0.8 million in 2017 associated with our plan to close our Overland Park office, including termination benefits and other reorganization costs, primarily associated with integrating operations. Total Other (Income) Expense, Net Total other (income) expense, net for the year ended December 31, 2017 decreased by $0.9 million compared to the year ended December 31, 2016 due primarily to the change in the fair value of earnout liabilities, partially offset by higher interest expense on borrowings under our credit facility during 2017. We estimate the fair value of earnout liabilities related to acquisitions quarterly. The $1.0 million reduction in the fair value of earnout liabilities resulted from income of $0.7 million in 2017, compared to $0.3 million of expense in 2016. Of the $0.7 million recognized in income, $0.4 million was attributable to the reduction in fair value of the VAT Applications earnout, and $0.3 million to the reduction in the fair value of the earnout for our acquisition in Brazil. Interest expense increased 12% in 2017 compared to 2016 due primarily to higher debt levels. As of December 31, 2017, we had variable rate borrowings of $30.0 million outstanding under the term loan facility and $10.0 million under the revolving credit facility bearing interest at an annual rate of 6.75% and 6.25%, respectively. Provision for (Benefit from) Income Taxes Benefit from income taxes for the year ended December 31, 2017 increased by $1.9 million compared to the provision for income taxes for the year ended December 31, 2016 due primarily to net operating losses in Brazil. In 2017, a deferred tax benefit was recorded for losses incurred up to the amount of our deferred tax liability attributable to our Brazil operations. Upon extinguishment of the deferred tax liability, additional net operating losses resulted in a deferred tax asset for which we established a full valuation allowance. Quarterly Results of Operations The following table sets forth our unaudited quarterly consolidated statements of operations data for each of the periods presented as well as the percentage of total revenue that each line item represented for each quarter. In management’s opinion, the data below have been prepared on the same basis as the audited consolidated financial statements included elsewhere in this report and reflect all necessary adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of this data. The results of historical periods are not necessarily indicative of the results to be expected for a full year or any future period. The following quarterly financial data should be read in conjunction with our audited financial statements and related notes included elsewhere in this report. (1) Interest income on funds held for customers of $493,000, $392,000, and $170,000 in the fourth, third, and second quarters of 2018, respectively, was reclassified from Interest income within Total other (income) expense, net to Subscription and returns revenue in the fourth quarter of 2018. This reclassification is presented retrospectively, and impacted the previously reported second and third quarter 2018 consolidated statements of operations. (2) The stock-based compensation expense included above was as follows: The amortization of acquired intangibles included above was as follows: (1) Free cash flow is a non-GAAP financial measure. For more information about free cash flow, see “Use of Non-GAAP Financial Measures.” Seasonality and Quarterly Trends We have historically signed a higher percentage of agreements with new customers, as well as renewal and upgrade agreements with existing customers, in the fourth quarter of each year and usually during the last month of the quarter. This can be attributed to buying patterns typical in the software industry. Since the terms of most of our customer agreement terms are annual, agreements initially entered into in the fourth quarter or last month of any quarter will generally come up for renewal at that same time in subsequent years. As a result, we have historically seen a higher percentage of customer agreement cancellations in the fourth quarter of each year. While this seasonality is reflected in our revenues, the impact to overall annual or quarterly revenues is minimal since we recognize subscription revenue ratably over the term of the customer contract. Additionally, this seasonality is reflected in commission expenses to our sales personnel and our partners. Our quarterly revenue has increased in each period presented primarily due to increased sales to new customers, as well as increased usage by our existing customers. Our operating expenses generally have increased sequentially in every quarter primarily due to increases in headcount and related expenses to support our growth primarily in our sales and marketing, and research and development expenses. Increases in our sales and marketing expenses primarily reflects personnel additions and various sales and marketing initiatives that may fluctuate from quarter to quarter. Research and development expenses have fluctuated based on the timing of personnel additions and related spending on product development. We anticipate our operating expenses will continue to increase in absolute dollars in future periods as we invest in the long-term growth of our business. We anticipate that gross profit and gross margin for professional services may also fluctuate from quarter to quarter because of variability in our professional services projects and changes in headcount. Liquidity and Capital Resources We require cash to fund our operations, including outlays for infrastructure growth, acquisitions, geographic expansion, expanding our sales and marketing activities, and working capital for our growth. To date, we have financed our operations primarily through cash received from customers for our solutions, private placements, our IPO, and bank borrowings. As of December 31, 2018, we had $142.3 million of cash and cash equivalents, most of which was held in money market accounts. Borrowings We maintain a loan and security agreement with Silicon Valley Bank and Ally Bank (the “Lenders”). The credit arrangements included a senior secured $30.0 million term loan facility that was repaid in August 2018 that is no longer available to be borrowed, and currently includes a $50.0 million revolving credit facility (collectively, the “Credit Facilities”). The $50.0 million revolving credit facility, which is subject to a borrowing base limitation and is reduced by outstanding letters of credit, must be repaid in November 2019. The obligations under the Credit Facilities are collateralized by substantially all the assets of the Company, including intellectual property, receivables and other tangible and intangible assets. Using a portion of the proceeds from our IPO, in June 2018, we repaid $33.0 million of borrowings outstanding under the revolving credit facility and in August 2018, we repaid $30.0 million of borrowings outstanding under the term loan facility, which is no longer available to be drawn. As of December 31, 2018, we had no borrowings outstanding under the Credit Facilities and $50.0 million is available to be drawn under the revolving credit facility. Collectively, the Credit Facilities include several affirmative and negative covenants, including a requirement that we maintain minimum net billings, minimum liquidity and observe restrictions on dispositions of property, changes in our business, mergers or acquisitions, incurring indebtedness, and distributions or investments. Written consent of the Lenders is required to pay dividends to shareholders, with the exception of dividends payable in common stock. As of December 31, 2018, we were in compliance with all covenants of the Credit Facilities. We are required to pay a quarterly fee of 0.50% per annum on the undrawn portion available under the revolving credit facility plus the sum of outstanding letters of credit. Under the Credit Facilities, the interest rate on the revolving credit facility is based on the greater of either 4.25% or the current prime rate plus 1.75%. Future Cash Requirements As of December 31, 2018, our cash and cash equivalents included proceeds from our June 2018 IPO. We intend to continue to increase our operating expenses and our capital expenditures to support the growth in our business and operations. We may also use our cash and cash equivalents to acquire complementary businesses, products, services, technologies, or other assets. We believe that our existing cash and cash equivalents of $142.3 million as of December 31, 2018, together with cash generated from operations and cash available under our current borrowing arrangements, will be sufficient to meet our anticipated cash needs for at least the next 12 months. Our financial position and liquidity are, and will be, influenced by a variety of factors, including our growth rate, the timing and extent of spending to support research and development efforts, the continued expansion of sales and marketing spending, the introduction of new and enhanced solutions, the cash paid for any acquisitions, and the continued market acceptance of our solutions. The following table shows our cash flows from operating activities, investing activities, and financing activities for the stated periods: Operating Activities Our largest source of operating cash is cash collections from our customers for subscriptions and returns services. Our primary uses of cash from operating activities are for employee-related expenditures, commissions paid to our partners, marketing expenses, and facilities expenses. Cash used in operating activities consists primarily of net loss adjusted for certain non-cash items, including goodwill impairment, stock-based compensation, depreciation and amortization, and other non-cash charges. For the year ended December 31, 2018, cash used in operating activities was $3.1 million compared to $3.5 million for the year ended December 31, 2017, a decrease in cash used of $0.4 million. During 2017, we received reimbursements for tenant improvements of $10.5 million compared to $1.7 million in 2018. Under the lease for our new corporate headquarters, we were granted approximately $12.3 million of tenant improvements to be paid by the landlord. We initially funded these improvements, which were recorded in investing activities as capital expenditures, and record the reimbursement of these expenditures to deferred rent, which increased cash from operating activities. Excluding reimbursements for tenant improvements, cash used in operating activities decreased by $9.1 million. This improvement in cash flows was due primarily to higher sales and improved cash collection in 2018, but was partially offset by higher operating expenses, primarily employee-related costs. See “Results of Operations” for further discussion. For 2017, cash used in operating activities was $3.5 million compared to cash used in operating activities of $21.7 million for 2016. This reduction in cash used of $18.2 million was due primarily to reimbursements for tenant improvement expenditures of $10.5 million, and a positive working capital change of $5.5 million (excluding $10.5 million of lease incentives) for 2017. In 2016, we entered a ten-year lease for our new corporate headquarters in Seattle, Washington. Our net working capital improved during 2017 compared to 2016 due primarily to higher sales and improved cash collections on accounts receivable. Investing Activities Our investing activities primarily include cash outflows related to purchases of property and equipment, changes in customer fund assets, and, from time-to-time, the cash paid for asset and business acquisitions. For the year ended December 31, 2018, cash used in investing activities was $20.4 million, compared to cash used of $16.3 million for the year ended December 31, 2017. The increase in cash used of $4.1 million was due primarily to cash paid for acquisition of intangible assets of $5.0 million and higher capital expenditures of $1.5 million, partially offset by a decrease in customer fund assets of $2.4 million. In 2018, we acquired a customer list for $0.4 million and developed technology to facilitate cross-border transactions (e.g., tariffs and duties) for total consideration of $7.1 million, which included total cash payments of $4.6 million. Capital expenditures increased $1.5 million from the prior year due primarily to expansion and related tenant improvements for our Durham, North Carolina office. For 2017, cash used in investing activities was $16.3 million compared to cash used in investing activities of $29.7 million for 2016. The decrease in cash used of $13.4 million was due primarily to cash used in 2016 for the acquisition of the Brazil business of $17.2 million, partially offset by an increase in capital expenditures of $7.3 million. Capital expenditures increased from the prior year due primarily to tenant improvements for our new corporate headquarters. Financing Activities Our financing activities primarily include cash inflows and outflows from our Credit Facilities, issuance and repurchases of capital stock, changes in customer fund obligations, and cash flows related to stock option and stock warrant exercises. For the year ended December 31, 2018, our financing activities included proceeds from our June 2018 IPO. For the year ended December 31, 2018, cash provided by financing activities was $151.4 million compared to cash provided by financing activities of $13.7 million for the year ended December 31, 2017. This increase in cash provided of $137.7 million was due primarily to cash received from our IPO net of underwriting discounts of $192.5 million and an increase of $6.1 million in cash proceeds from exercise of stock options and stock warrants, partially offset by the repayment of outstanding borrowings under our Credit Facilities of $63.0 million. Prior to repayment of our revolving credit line in June 2018 and our term loan in August 2018, we borrowed $23.0 million during the first half of 2018. For 2017, cash provided by financing activities was $13.7 million compared to cash provided by financing activities of $61.0 million for 2016. In September 2016, we raised gross proceeds of $96.2 million from the sale of our Series D-2 preferred stock. In conjunction with this financing, we repurchased with cash $43.2 million of preferred and common stock from our shareholders through a limited time tender offer. See “Borrowings” above for a discussion of our Credit Facilities. Funds Held from Customers and Customer Funds Obligations We maintain trust accounts with financial institutions, which allows our customers to outsource their tax remittance functions to us. We have legal ownership over the accounts utilized for this purpose. Funds held from customers represents cash and cash equivalents that, based upon our intent, are restricted solely for satisfying the obligations to remit funds relating to our tax remittance services. Funds held from customers are not commingled with our operating funds, but typically are deposited with funds also held on behalf of our other customers. Customer funds obligations represent our contractual obligations to remit collected funds to satisfy customer tax payments. Customer funds obligations are reported as a current liability on the consolidated balance sheets, as the obligations are expected to be settled within one year. Cash flows related to the cash received from and paid on behalf of customers are reported as follows: 1) changes in customer funds obligations liability are presented as cash flows from financing activities; 2) changes in customer fund assets (e.g., customer funds held in cash and cash equivalents and receivable from customers and taxing authorities) are presented as net cash flows from investing activities; and 3) changes in customer fund asset account that relate to paying for the trust operations, such as banking fees, are presented as cash flows from operating activities. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2018: (1) There are no outstanding borrowings under our credit facilities as of December 31, 2018. Interest payments are required on the undrawn portion available under the revolving credit facility. (2) Purchase obligations are comprised primarily of long-term software licenses, subscriptions, and software hosting services. (3) We maintain trust accounts with financial institution that are solely for satisfying the obligations to remit funds relating to our tax remittance services. Customer funds obligations represent our contractual obligations to remit collected funds to satisfy customer tax payments. At December 31, 2018, we had $13.1 million of funds held from (collected from) customers. Because of in-transit payments and changes in the amounts owed to us or to the taxing authority, the asset and liability amounts presented for any period will generally not offset. (4) Other liabilities are comprised of earnout liabilities owed to Tradestream Technologies Inc. and Wise 24 Inc for the first measurement period ended December 31, 2018. The earnout is payable in cash and common stock and has a maximum of $30.0 million over a six-year period, which is excluded from the table above. In June 2018, we repaid all borrowings outstanding under the revolving credit facility and in August 2018 we repaid all amounts outstanding under the term loan facility. Off-Balance Sheet Arrangements We did not have any off-balance sheet arrangements in 2018 or 2017. Use and Reconciliation of Non-GAAP Financial Measures In addition to our results determined in accordance with GAAP, we have calculated non-GAAP cost of revenue, non-GAAP gross profit, non-GAAP gross margin, non-GAAP research and development expense, non-GAAP sales and marketing expense, non-GAAP general and administrative expense, non-GAAP operating loss, non-GAAP net loss, and free cash flow, which are non-GAAP financial measures. We have provided tabular reconciliations of each non-GAAP financial measure to its most directly comparable GAAP financial measure. • We calculate non-GAAP cost of revenue, non-GAAP research and development expense, non-GAAP sales and marketing expense, and non-GAAP general and administrative expense as GAAP cost of revenue, GAAP research and development expense, GAAP sales and marketing expense, and GAAP general and administrative expense before the impact of stock-based compensation expense and amortization of acquired intangible assets included in each of the expense categories. • We calculate non-GAAP gross profit as GAAP gross profit before the stock-based compensation expense and amortization of acquired intangibles that is included in cost of revenue. We calculate non-GAAP gross margin as GAAP gross margin before the impact of stock-based compensation expense included in cost of revenue as a percentage of revenue and amortization of acquired intangibles included in cost of revenue as a percentage of revenue. • We calculate non-GAAP operating loss as GAAP operating loss before stock-based compensation expense, amortization of acquired intangibles, and goodwill impairments. We calculate non-GAAP net loss as GAAP net loss before stock-based compensation expense, amortization of acquired intangibles, and goodwill impairments. • We define free cash flow as net cash (used in) provided by operating activities less cash used for the purchases of property and equipment. Management uses these non-GAAP financial measures to understand and compare operating results across accounting periods, for internal budgeting and forecasting purposes, and to evaluate financial performance and liquidity. We believe that non-GAAP financial measures provide useful information to investors and others in understanding and evaluating our results, prospects, and liquidity period-over-period without the impact of certain items that do not directly correlate to our performance and that may vary significantly from period to period for reasons unrelated to our operating performance, as well as comparing our financial results to those of other companies. Our definitions of these non-GAAP financial measures may differ from the definitions used by other companies and therefore comparability may be limited. In addition, other companies may not publish these or similar metrics. Thus, our non-GAAP financial measures should be considered in addition to, not as a substitute for, or in isolation from, measures prepared in accordance with GAAP. We encourage investors and others to review our financial information in its entirety, not to rely on any single financial measure and to view non-GAAP cost of revenue, non-GAAP gross profit, non-GAAP gross margin, non-GAAP research and development expense, non-GAAP sales and marketing expense, non-GAAP general and administrative expense, non-GAAP operating loss, non-GAAP net loss, and free cash flow in conjunction with the related GAAP financial measure. The following schedule reflects our non-GAAP financial measures and reconciles our non-GAAP financial measures to the related GAAP financial measures: Critical Accounting Policies Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements. The preparation of these financial statements in accordance 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, as well as the revenue and expenses during the reporting periods. These estimates, assumptions, and judgments are necessary because future events and their effects on our consolidated financial statements cannot be determined with certainty, and are made based on our historical experience and on other assumptions that we believe to be reasonable under the circumstances. These estimates may change as new events occur or additional information is obtained, and we may periodically be faced with uncertainties, the outcomes of which are not within our control and may not be known for a prolonged period of time. Because the use of estimates is inherent in the financial reporting process, actual results could materially differ from those estimates. We believe the following critical accounting policies affect our most significant judgments and estimates used in preparation of our consolidated financial statements: • Revenue Recognition; • Stock-based Compensation; • Common Stock Valuations; and • Business Combinations, including Intangible Assets, and Goodwill. Revenue Recognition Our consolidated statement of operations includes two major revenue categories: subscriptions and returns, and professional services. We primarily generate revenue from subscriptions and returns, which consists primarily of fees paid for subscriptions to our solutions and fees paid for services performed in preparing and filing tax returns on behalf of our customers. Revenue generated from our professional services is reported under professional services. Amounts that have been invoiced are recorded in accounts receivable and deferred revenue or revenue, depending upon whether the revenue recognition criteria have been met. In most instances, the initial arrangement with customers includes multiple elements, comprised of subscription and/or professional services, along with non-refundable upfront fees for new customers. We evaluate each element in a multiple-element 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. Other than nonrefundable upfront fees, our services typically have standalone value because they are routinely sold separately. Professional services also have standalone value because there are third parties that provide similar professional services on a standalone basis. If one or more of the deliverables does not have standalone value upon delivery, the deliverables that do not have standalone value are generally combined with the final deliverable within the arrangement and treated as a single unit of accounting. Revenue for arrangements treated as a single unit of accounting is generally recognized over the period beginning upon delivery of the final deliverable and continuing over the remaining term of the subscription contract. We allocate revenue to each element in an arrangement based on the selling price hierarchy. The selling price for a deliverable is based on its vendor-specific objective evidence (VSOE), if available, third-party evidence (TPE), or best estimate of selling price (BESP), if neither VSOE nor TPE is available. As we have been unable to establish VSOE or TPE for the elements of our arrangements, we establish the BESP for each element. The determination of BESP requires significant estimates and judgments. BESP is determined by considering our overall pricing objectives and current market conditions. Other factors considered include existing pricing and discounting practices, historical comparisons of contract prices to list prices, customer demographics, and gross margin objectives. Revenue recognition begins when all the following criteria are met: • There is persuasive evidence of an arrangement; • The product or service is delivered to the customer; • The amount of fees to be paid by the customer is fixed or determinable; and • The collection of the fees is reasonably assured. Subscription and returns revenue primarily consists of contractually agreed upon fees paid to use our cloud-based solutions, as well as fees paid to us for preparing and filing sales tax returns on behalf of our customers. Included in these fees, we also provide tax remittance services for our customers. Our subscription arrangements do not provide the customer with the right to take possession of the software supporting the cloud-based application services. We generally invoice our subscription customers for the initial term at contract signing and at each renewal. Our initial subscriptions terms generally range from twelve to eighteen months, and renewal periods are typically one year. Amounts that are contractually billable and have been invoiced, or which have been collected as cash are initially recorded as deferred revenue. While most of our customers are invoiced once at the beginning of the term, a portion of our customers are invoiced quarterly or monthly. As a result, at any point in time our current deferred revenue may not necessarily represent revenue to be recognized by us over the next twelve months. Our subscription contracts are generally non-cancelable except for where contract terms provide rights to cancel in the first 60 days of the contract term. We reserve for estimated cancellations based on actual history. To date, customer cancellations have had an insignificant impact on revenue recognized. Tax returns processing services include collection of tax data and amounts, preparation of all compliance forms, and submission to taxing authorities. Returns processing services are charged on a subscription basis for an allotted number of returns to process within a given time period or per return filing. The consideration allocated to a returns subscription is recognized as revenue over the contract period commencing when the subscription services are made available to the customer. We recognize revenue when the return is filed when purchased on a per return filing basis. A greater proportion of returns are sold on a subscription basis. Since our customers typically file tax returns on a monthly or quarterly basis continuously throughout the year, the pattern of revenue recognition is similar regardless of sales method. Included in the total subscription fee for our cloud-based solutions are non-refundable upfront fees that are typically charged to each new customer. These fees are associated with work performed by us to set up a customer with our services, and do not have standalone value. We recognize revenue for these fees over the expected term of the customer relationship, beginning when services commence. For 2018, 2017, and 2016, and solely for revenue recognition purposes, we estimated an expected customer relationship term of six years. We continue to evaluate the expected customer life and it is possible that the expected term of customer relationships may change in future periods. If such a change does occur, the periods over which any remaining deferred revenue will be recognized will be increased or decreased, as appropriate. As of December 31, 2018, 2017, and 2016, a one-year increase in the estimated term of customer relationships would reduce annual revenue by $0.6 million, $0.4 million, and $0.6 million, respectively. We bill for service arrangements on a fixed fee or time and materials basis. Professional services revenue includes fees from providing tax analysis, configurations, data migrations, integration, training, and other support services. The consideration allocated to professional services is recognized as revenue when services are performed and are collectable under the terms of the associated contracts. Stock-Based Compensation Stock-based compensation expense is measured and recognized in our consolidated financial statements based on the fair value of our common stock underlying the stock-based awards. These awards include stock options, warrants to purchase common stock, restricted stock units (“RSUs”), and purchase rights issued under our 2018 Employee Stock Purchase Plan (“ESPP”). The fair value of each award, excluding RSUs, is estimated on the grant date using the Black-Scholes option-pricing model. The fair value of each RSU is determined using the fair value of the underlying common stock on the date of the grant. Stock-based compensation expense is recognized using a straight-line basis over the requisite service period, which is generally four years for stock options and RSUs and is generally six months for purchase rights issued under the ESPP. Beginning January 1, 2017, we elected to account for forfeitures upon occurrence. The determination of the grant date fair value of stock-based awards using the Black-Scholes option-pricing model is affected by our estimated common stock fair value as well as other highly subjective assumptions, including the expected term of the awards, our expected volatility over the expected term of the awards, expected dividend yield, and risk-free interest rates. The assumptions used in our option-pricing model require significant judgment and represent management’s best estimates. These assumptions and estimates are as follows: • Fair Value of Common Stock. Prior to our initial public offering, we estimated the fair value of common stock as discussed in “Common Stock Valuations” below. • Expected Term. The expected term of employee stock-based awards represents the weighted average period that the stock awards are expected to remain outstanding. To determine the expected term for stock options, we apply the simplified approach in which the expected term of an award is presumed to be the mid-point between the vesting date and the expiration date of the award. • Expected Volatility. As we have limited trading history for our common stock, the selected volatility used is representative of expected future volatility. We based expected future volatility on the historical and implied volatility of comparable publicly traded companies over a similar expected term. • Expected Dividend Yield. We have never declared or paid cash dividends and do not presently intend to pay cash dividends in the foreseeable future. As a result, we used an expected dividend yield of zero. • Risk-Free Interest Rates. We based the risk-free interest rate on the rate for a U.S. Treasury zero-coupon issue with a term that closely approximates the expected life of the stock award grant at the date nearest the stock award grant date. If any assumptions used in the Black-Scholes option-pricing model change significantly, stock-based compensation for future awards may differ materially compared with the awards granted previously. For 2018, 2017, and 2016, stock-based compensation expense was $15.9 million, $11.8 million, and $8.1 million, respectively. As of December 31, 2018, we had approximately $27.6 million of total unrecognized stock-based compensation expense related to stock options and $0.3 million of unrecognized stock-based compensation expense related to the ESPP, which we expect to recognize over a period of approximately three years and one month, respectively. The aggregate intrinsic value of stock options outstanding as of December 31, 2018 was approximately $210.5 million, of which approximately $149.2 million related to vested awards and approximately $61.3 million related to unvested awards. Common Stock Valuations Following the closing of our IPO, the fair value per share of our common stock for purposes of determining stock-based compensation is the closing price of our common stock as reported on the applicable grant date. Prior to our IPO in June 2018, the fair value of the common stock underlying our stock options and common stock warrants was estimated by our Board of Directors, with input from management. Because stock-based compensation is recognized over the requisite service period (generally four years), our 2018 stock-based compensation expense includes a significant portion attributable to the common stock valuations described below. The estimated fair value of our common stock was determined at each valuation date in accordance with the guidelines outlined in the American Institute of Certified Public Accountants Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. Each valuation of our common stock was done using significant judgment and considering a variety of factors, including the following: • contemporaneous valuations performed at periodic intervals by unrelated third-party valuation firms; • the prices, rights, preferences and privileges of our preferred stock relative to our common stock; • the lack of marketability of our common stock; • our actual operating and financial performance; • current business conditions and projections; • hiring of key personnel and the experience of our management; • our stage of development; • the likelihood of achieving a liquidity event, such as an initial public offering, a merger, or an acquisition of our business; • the market performance of comparable publicly traded companies; and • macroeconomic conditions, including U.S. and global capital market conditions. The enterprise value utilized in determining the fair value of common stock for financial reporting purposes was estimated using the market approach and the income approach. Under the market approach, we used the guideline public company method, which estimates the fair value of the business enterprise based on market prices of stock of guideline public companies and an option pricing method (OPM) that considered our September 12, 2016 Series D-2 preferred stock financing. Indications of value were estimated by utilizing revenue multiples to measure enterprise value. The guideline merged and acquired company method was not utilized in our valuation, as we regarded the method as less reliable as we believe it did not directly reflect our future prospects. The income approach estimates the enterprise value based on the present value of our future estimated cash flows and our residual value beyond the forecast period. The residual value was based on an exit (or terminal) multiple observed in the comparable company method analysis. The future cash flows and residual value are discounted to present value to reflect the risks inherent in us achieving these estimated cash flows. The discount rate was based on venture capital rates of return for companies nearing an initial public offering. The discount rate was applied using the mid-year convention. The mid-year convention assumes that cash flows are generated evenly throughout the year, as opposed to in a lump sum at the end of the year. Our indicated enterprise value at each valuation date was allocated to the shares of our convertible preferred stock, common stock, warrants, and options using either an OPM or a probability-weighted expected return method, or PWERM. An OPM treats common stock and convertible preferred stock as call options on a business, with exercise prices based on the liquidation preference of the convertible preferred stock. Therefore, the common stock has value only if the funds available for distribution to shareholders exceed the value of the liquidation preference at the time of a liquidity event, such as a merger, sale, or initial public offering, assuming the business has funds available to make a liquidation preference meaningful and collectible by shareholders. The common stock is modeled as a call option with a claim on the business at an exercise price equal to the remaining value immediately after the convertible preferred stock is liquidated. The OPM uses the Black-Scholes option-pricing model to price the call option. Under a PWERM approach, the value ascribed to each share is based upon the probability-weighted present value of expected future investment returns, considering each of the possible future scenarios available to the business enterprise, as well as the rights of each class of stock. Finally, because we were a privately held company, we also applied a non-marketability discount in determining the fair value of our common stock based on the protective put model, which we deemed appropriate because it typically results in a low discount, to derive a fair value of our common stock on a non-marketable basis. Business Combinations, including Intangible Assets and Goodwill The results of a business acquired in a business combination are included in our consolidated financial statements from the date of the acquisition. Purchase accounting results in assets and liabilities of an acquired business being recorded at their estimated fair values on the acquisition date. Any excess consideration over the fair value of assets acquired and liabilities assumed is recognized as goodwill. We perform valuations of assets acquired and liabilities assumed and allocate the purchase price to the respective assets and liabilities. Determining the fair value of assets acquired and liabilities assumed requires significant judgment and estimates, including the selection of valuation methodologies, estimates of future revenue, costs and cash flows, discount rates, and selection of comparable companies. We engage the assistance of third-party valuation specialists in concluding on fair value measurements in connection with determining fair values of assets acquired and liabilities assumed in a business combination. These estimates are inherently uncertain and unpredictable, and if different estimates were used the purchase price for the acquisition could be allocated to the acquired assets and liabilities differently from the allocation that we have made. In addition, unanticipated events and circumstances may occur which may affect the accuracy or validity of such estimates, and if such events occur we may be required to record a charge against the value ascribed to an acquired asset or an increase in the amounts recorded for assumed liabilities. Under the current accounting guidance, we are allowed a one-year measurement period from the date of the acquisition to finalize our preliminary valuation of the tangible and intangibles assets and liabilities acquired and make necessary adjustments to goodwill. Intangible Assets. We evaluate our intangible assets for indications of impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Our intangible assets consist primarily of developed technology and customer relationships arising from business acquisitions. Factors that could trigger an impairment analysis include significant under-performance relative to historical or projected future operating results, significant changes in the manner of our use of the acquired assets or the strategy for our overall business or significant negative industry or economic trends. If this evaluation indicates that the value of the intangible asset may be impaired, we assess the likelihood of recoverability of the net carrying value of the asset over its remaining useful life. If this assessment indicates that the intangible asset is not recoverable, based on the estimated undiscounted future cash flows of the technology over the remaining useful life, we reduce the net carrying value of the related intangible asset to fair value. Our updated internal cash flow forecast for the Brazil reporting unit in the third quarter of 2018 indicated a potential impairment of the asset group. Prior to performing the goodwill impairment analysis described below, we tested the recoverability of the Brazil asset group. This analysis did not result in an impairment of the tangible or intangible assets of the Brazil asset group. The carrying value of the intangible assets was $2.3 million as of December 31, 2018. Goodwill. Goodwill is assessed for impairment at the reporting unit level at least annually on October 31, or in the event of certain occurrences. We have three reporting units for purposes of analyzing goodwill, consisting of our U.S., European, and Brazilian operations. Our impairment assessment involves comparing the fair value of each reporting unit to its carrying value, including goodwill. If the fair value exceeds the carrying value, we conclude that no goodwill impairment has occurred. In assessing goodwill for impairment, we first assess the qualitative factors to determine whether events or circumstances indicate that it is more likely than not that the fair value of a reporting unit is less than its carrying value. The next step in our assessment is to perform a quantitative analysis, if necessary, which involves determining the fair value of the reporting unit. We estimate the fair value of the reporting unit using both an income approach and a market approach, which are Level 3 measurements under the fair value hierarchy. The income approach uses discounted future cash flows derived from current internal forecasts, which include assumptions for long-term growth rates and a residual value (the hypothetical terminal value) for the reporting unit. Cash flows are discounted using the weighted average cost of capital, which is risk-adjusted to reflect the specific risk profile of the reporting unit. The market approach identifies similar publicly traded companies to the reporting unit and develops a correlation, referred to as a multiple, to apply to the operating results of the reporting unit. The primary market multiple we compare to is revenue. The market approach also reflects a reasonable control premium to compute the fair value. These estimates involve inherent uncertainties and if different assumptions are used, the fair value of a reporting unit could be materially different from the amount we computed. As part of our annual impairment test, a qualitative impairment test was performed for the Company’s U.S. reporting unit. We concluded it is more likely than not that the fair value of the reporting unit exceeds its carrying value. A quantitative test was performed for the European reporting unit. The European reporting unit had goodwill with a carrying value of $10.8 million as of October 31, 2018. From our quantitative assessment, we determined that the fair value of the European reporting unit was substantially in excess of its carrying value. Our internal cash flow forecast includes significant revenue growth attributable to a single customer. While this single customer is not currently significant to our consolidated results, it is expected to be significant to the European reporting unit representing assumed future revenues in the near-term and long-term of approximately 45%. If our revenue growth assumptions are not realized or our expectations with respect to future revenue growth are reduced, the fair value of the European reporting unit would be adversely impacted. Significant estimates and assumptions used in the income approach for the European reporting unit included using a discount rate of 25% and a hypothetical terminal value of 1.75 times revenue. For the market approach, significant estimates and assumptions included our selection of an appropriate peer group, consisting of publicly traded U.S. and European companies, which allowed us to derive revenue multiples (e.g., trailing twelve months and next fiscal year) averaging approximately 3.9 times revenue and a selected control premium of 10%. During the third quarter of 2018, we concluded a triggering event had occurred and, after comparing the fair value to the carrying value, recorded a $9.2 million goodwill impairment for the Brazilian reporting unit. The goodwill impairment charge is reflected in a separate account caption in the consolidated statements of operations. Our updated internal cash flow forecast prepared in the third quarter of 2018 deferred the timing of future revenue and cash flows compared to our previous expectations. In addition to delaying positive cash flows, we also updated our internal forecast to reflect lower assumed future revenue growth rates compared to previous expectations based primarily on recent operating results. Some of the significant estimates and assumptions used in the income approach included using a discount rate of 30% and a hypothetical terminal value of 2.75 times revenue. We concluded it was not appropriate to use a market valuation approach due primarily to a lack of publicly traded companies in similar businesses. We acquired the Brazilian reporting unit in September 2016. During 2017, the Brazilian reporting unit did not meet revenue or cash flow objectives due primarily to longer than expected integration efforts and a smaller proportion of recurring revenues than previously anticipated. As a result of updating our long-term cash flow forecast as part of our annual assessment in 2017, we recorded an $8.4 million goodwill impairment for our Brazilian reporting unit. While our business strategy in Brazil remains unchanged, during the third quarter of 2018, we updated our long-term cash flow forecast for the reporting unit to reflect recent performance indicators that suggest it will take longer to execute our long-term strategies to achieve anticipated growth and cash flow objectives. The updated long-term cash flow forecast indicates a longer time horizon to positive cash flow, compared to the last update in 2017. Upon completion of the analysis, the fair value of the Brazilian reporting units was substantially less than the carrying value. As a result, management concluded that a $9.2 million impairment adjustment was required. As of December 31, 2018, we have no remaining goodwill associated with the Brazilian reporting unit. 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 are allowed to 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 (1) are no longer an emerging growth company or (2) 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. Recent Accounting Pronouncements For further information on recent accounting pronouncements, refer to Note 2 in the Consolidated Financial Statements contained within this Annual Report on Form 10-K.

<s>[INST] Overview We provide a leading suite of cloudbased solutions that help businesses of all types and sizes comply with transaction tax requirements worldwide. Our Avalara Compliance Cloud offers a broad and growing suite of compliance solutions that enable businesses to address the complexity of transaction tax compliance, process transactions in real time, produce detailed records of transaction tax determinations, and reduce errors, audit exposure and total transaction tax compliance costs. During 2018, we continued our focus on maintaining and expanding our partner network, which has been an essential part of our growth. We increased our partner relationships and currently have more than 700 prebuilt integrations. These integrations are designed to link our tax compliance solutions to a wide variety of business applications, including accounting, ERP, ecommerce, POS, recurring billing, and CRM systems. Partners improve our sales efficiency by bringing us qualified leads and provide for a better onboarding process and customer experience. We sell our solutions primarily through our sales force, which focuses on selling to qualified leads provided by our marketing efforts and by partner referrals. Most sales, to new and existing customers, are direct and are conducted via telephone, requiring minimal inperson interactions with customers or prospects. In some cases, particularly for customers with larger and more complex needs, we conduct inperson sales. In addition, our marketing investments and related activities generate awareness from many small businesses. In 2018, we also continued our acquisition strategy to provide bestinclass solutions and expand our market opportunity by acquiring crossborder technology to enable calculation and classification of tariffs and duties. In addition, we continued to invest organically by devoting significant resources to continuous improvement of our existing solutions, by adding innovative and new features and functionalities, building technology to support new content, and improving our customer’s product experience. We expect to continue to make significant investments to acquire accurate and relevant content and expertise to best serve the transaction tax needs of our customers. In June 2018, we completed an IPO listing our common stock on the New York Stock Exchange and sold approximately 8.6 million shares for net proceeds of $192.5 million. Following the IPO, we repaid all our outstanding borrowings consisting of $33.0 million outstanding under our revolving credit facility and $30.0 million outstanding under our term loan. As of December 31, 2018, we had no borrowings outstanding and $50.0 million remained available for borrowing under our revolving credit facility. Additionally, we ended the year with $142.3 million of cash and cash equivalents. Also, in June 2018, the U.S. Supreme Court issued its opinion in South Dakota v. Wayfair, Inc. upholding South Dakota’s economic nexus law, which requires certain outofstate retailers to collect and remit sales taxes on sales into South Dakota. By the end of the year, 33 U.S. states, including California and Texas, along with the District of Columbia, adopted economic nexus legislation. Several more states are considering similar legislation in 2019. These developments increased awareness of transaction tax issues and we believe this increased the sense of urgency among many businesses to comply with new laws. We believe we are wellpositioned to benefit from these changes in 2019 and beyond. Total revenue for 2018 was $272.1 million, an increase of 28% from $213.2 million in 2017. Most of our revenue comes from subscriptions and returns, with approximately 93% in 2018 and 94% in 2017. Our revenue growth was attributable, almost equally, to adding new customers and expanding service offerings to existing customers. While only 6% of total revenue for 2018 was generated outside the U.S., we are targeting transaction tax markets in EMEA and Brazil. We added approximately 1,580 core customers during 2018 and maintained a net revenue retention rate of 107% on average over the past four quarters. We use core customers, which represent more than 85% of our total revenue, as a metric to focus our customer count reporting on the midmarket segment, which is our primary market. We use net revenue retention rates to reflect the stability of our revenue base [/INST] Negative. </s>

AVALARA, INC.

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 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. In addition to historical financial information, the following discussion contains forward-looking statements that reflect our plans, estimates, beliefs and expectations that involve risks and uncertainties. Our actual results and the timing of events 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 sections of this report titled “Risk Factors” and “Special Note Regarding Forward-Looking Statements.” Overview We provide a leading suite of cloud-based solutions that help businesses of all types and sizes comply with transaction tax requirements worldwide. Our Avalara Compliance Cloud offers a broad and growing suite of compliance solutions that enable businesses to address the complexity of transaction tax compliance, process transactions in real time, produce detailed records of transaction tax determinations, and reduce errors, audit exposure and total transaction tax compliance costs. We sell our solutions primarily through our sales force, which focuses on selling to qualified leads provided by our marketing efforts and by partner referrals. Our marketing investments and related activities generate awareness from many businesses, both large and small, and enhance communications with our existing customers. We focus on maintaining and expanding our partner network, which has been an essential part of our growth. We continue to increase the available number of partner integrations, which are designed to link our tax compliance solutions to a wide variety of business applications, including accounting, ERP, ecommerce, POS, recurring billing, and CRM systems. Partners also improve our sales efficiency by bringing us qualified leads and provide for a better onboarding process and customer experience. During 2019, we continued to benefit from the adoption of economic nexus legislation by many U.S. states following the June 2018 U.S. Supreme Court decision in South Dakota v. Wayfair, Inc., which requires certain out-of-state retailers to collect and remit sales taxes on sales into South Dakota. Since that decision, many U.S. states have adopted similar economic nexus legislation. These developments have increased awareness of transaction tax issues and increased the sense of urgency among many businesses to comply with new laws. We believe we are well-positioned to continue to benefit from these changes in 2020 and beyond. During 2019, we continued our acquisition strategy to provide new solutions and expand our market opportunity. We acquired a provider of U.S. compliance services, technology, and software to the beverage alcohol industry, an artificial intelligence company to expand and maintain our tax content database, and a provider of Harmonized System classifications and outsourced customs brokerage support services to expand our cross-border solutions. In addition to acquisitions, we continued to invest organically by devoting significant resources to continuous improvement of our existing solutions, by adding new features and functionalities, building technology to support new content, and improving our customers’ experience with our products. We expect to continue to make significant investments, both organically and through acquisitions, to gain new and relevant content, technology, and expertise that best serve the transaction tax needs of our customers. We also will continue making significant investments to improve our existing solutions and customer experience. Total revenue for 2019 was $382.4 million, an increase of 41% from $272.1 million in 2018. Most of our revenue comes from subscriptions and returns, with approximately 93% in both 2019 and 2018. Our revenue growth was attributable to adding new customers and expanding service offerings to existing customers. While only 6% of total revenue for 2019 was generated outside the U.S., we are aggressively targeting and investing internationally, including in Europe and Latin America. We added approximately 2,890 core customers during 2019 and delivered a net revenue retention rate of 111% on average over the past four quarters. We use core customers, which represent more than 80% of our total revenue, as a metric to focus our customer count reporting on the mid-market segment, which is our primary market. We use net revenue retention rate to reflect the stability of our revenue base and to provide insight into our ability to grow existing customer revenues. Despite improved revenue during 2019, our gross margin declined to 70% compared to 71% in 2018. The decline in gross margin was due primarily to higher software hosting costs and, to a lesser extent, higher costs to support our international products and operations. Operating expenses increased to $323.0 million in 2019 from $269.5 million in 2018, as we continued to make significant investments in our future growth. Sales and marketing expenses were $168.6 million in 2019, or 44% of total revenue, compared to $168.8 million in 2018, or 62% of total revenue. The decrease in sales and marketing expenses as a percentage of revenue in 2019 is partially due to the deferral of sales commission and partner commission expense resulting from our adoption of ASC 606. Excluding these deferrals, sales and marketing expenses were $187.8 million, or 49% of total revenue during 2019, reflecting strong improvement in our sales and marketing efficiency from the prior year. Operating loss was $55.9 million during 2019 compared to an operating loss of $76.1 million during 2018. Our net loss was $50.2 million during 2019 compared to a net loss of $75.6 million during 2018. Operating loss decreased during 2019 due primarily to the deferral of sales and partner commission expenses of $19.1 million. In addition to the benefit to our operating loss from deferred commissions, our net loss in 2019 included $6.0 million of interest income, compared to $1.6 million in 2018. Non-GAAP operating loss, excluding the benefit from deferred commissions, was $32.9 million during 2019 compared to non-GAAP operating loss of $45.0 million during 2018. During 2019, we generated positive free cash flow of $12.2 million compared to negative free cash flow of $18.5 million in 2018. See the section titled “Use and Reconciliation of Non-GAAP Financial Measures” for more information about our non-GAAP financial measures. In June 2019, we completed a follow-on public offering of our common stock and sold 4.1 million shares for net proceeds of $274.7 million. As of December 31, 2019, we had no borrowings outstanding. We ended the year with $467.0 million of cash and cash equivalents. We believe our strong balance sheet positions us well to continue to make additional investments to grow and expand both our products and services, along with the customers we serve. Key Business Metrics We regularly review several metrics to evaluate growth trends, measure our performance, formulate financial projections, and make strategic decisions. We discuss revenue and the components of operating results under “Key Components of Consolidated Statements of Operations,” and we discuss other key business metrics below. Number of Core Customers We believe core customers is a key indicator of our market penetration, growth, and potential future revenue. The mid-market has been and remains our primary target market segment for marketing and selling our solutions. We use core customers as a metric to focus our customer count reporting on our primary target market segment. As of December 31, 2019 and 2018, we had approximately 11,960 and 9,070 core customers, respectively. In 2019, our core customers represented more than 80% of our total revenue. We define a core customer as: • a unique account identifier in our billing system, or a billing account (multiple companies or divisions within a single consolidated enterprise that each have a separate unique account identifier are each treated as separate customers); • that is active as of the measurement date; and • for which we have recognized, as of the measurement date, greater than $3,000 in total revenue during the last twelve months. Currently, our core customer count includes only customers with unique account identifiers in our primary U.S. billing systems and does not include customers who subscribe to our solutions through our international subsidiaries or certain legacy billing systems, primarily related to past acquisitions that have not been integrated into our primary U.S. billing systems. As we increase our international operations and sales in future periods, we may add customers billed from our international subsidiaries to the core customer metric. We have a substantial number of customers of various sizes who do not meet the revenue threshold to be considered a core customer. Many of these customers are in the small business and self-serve segment of the marketplace, which represents strategic value and a growth opportunity for us. Customers who do not meet the revenue threshold to be considered a core customer provide us with market share and awareness, and we anticipate that some may grow into core customers. Net Revenue Retention Rate We believe that our net revenue retention rate provides insight into our ability to retain and grow revenue from our customers, as well as their potential long-term value to us. We also believe it reflects the stability of our revenue base, which is one of our core competitive strengths. We calculate our net revenue retention rate by dividing (a) total revenue in the current quarter from any billing accounts that generated revenue during the corresponding quarter of the prior year by (b) total revenue in such corresponding quarter from those same billing accounts. This calculation includes changes for these billing accounts, such as additional solutions purchased, changes in pricing and transaction volume, and terminations, but does not reflect revenue for new billing accounts added during the one year period. Currently, our net revenue retention rate calculation includes only customers with unique account identifiers in our primary U.S. billing systems and does not include customers who subscribe to our solutions through our international subsidiaries or certain legacy billing systems, primarily related to past acquisitions. Our net revenue retention rate was 111% on average for the four quarters ended December 31, 2019. Key Components of Consolidated Statements of Operations Revenue We generate revenue from two primary sources: (1) subscription and returns; and (2) professional services. Subscription and returns revenue is driven primarily by the acquisition of customers, customer renewals, and additional service offerings purchased by existing customers. Revenue from subscription and returns comprised approximately 93%, 93%, and 94% of our revenue for 2019, 2018, and 2017, respectively. Subscription and Returns Revenue. Subscription and returns revenue primarily consists of fees paid by customers to use our solutions. Subscription plan customers select a price plan that includes an allotted maximum number of transactions over the subscription term. Unused transactions are not carried over to the customer’s next subscription term, and our customers are not entitled to any refund of fees paid or relief from fees due if they do not use the allotted number of transactions. If a subscription plan customer exceeds the selected maximum transaction level, we will generally upgrade the customer to a higher tier or, in some cases, charge overage fees on a per transaction or return basis. Customers primarily purchase tax return preparation on a subscription basis for an allotted number of returns. Our standard subscription contracts are generally non-cancelable after the first 60 days of the contract term. Cancellations under our standard subscription contracts are not material, and do not have a significant impact on revenue recognized. We generally invoice our subscription customers for the initial term at contract signing and upon renewal. Our initial terms generally range from twelve to eighteen months, and renewal periods are typically one year. Amounts that have been invoiced are initially recorded as deferred revenue or contract liabilities. Subscription revenue is recognized on a straight-line basis over the service term of the arrangement beginning on the date that our solution is made available to the customer and ending at the expiration of the subscription term. We adopted the new revenue recognition accounting standard ASC 606 effective January 1, 2019 on a modified retrospective basis. The new revenue recognition standard impacts the way we recognize subscription and returns revenues related to non-refundable upfront fees charged to new customers. See Note 2 in the accompanying notes to the consolidated financial statements for additional information related to our adoption of the new revenue recognition standard. Subscription and returns revenue also includes interest income generated on funds held for customers. In order to provide tax remittance services to customers, we hold funds from customers in advance of remittance to tax authorities. These funds are held in trust accounts at FDIC-insured institutions. Prior to remittance, we earn interest on these funds. Professional Services. We generate professional services revenue from providing tax analysis, configurations, data migrations, integration, training and other support services. We bill for service arrangements on a fixed fee, milestone, or time and materials basis, and we recognize the transaction price allocated to professional services performance obligations as revenue as services are performed and are collectable under the terms of the associated contracts. Costs and Expenses Cost of Revenue. Cost of revenue consists of costs related to providing the Avalara Compliance Cloud and supporting our customers and includes employee-related expenses, including salaries, benefits, bonuses, and stock-based compensation. In addition, cost of revenue includes direct costs associated with information technology, such as data center and software hosting costs, tax content maintenance, and certain services provided by third parties. Cost of revenue also includes allocated costs for certain information technology and facility expenses, along with depreciation of equipment and amortization of intangibles such as acquired technology from acquisitions. We plan to continue to significantly expand our infrastructure and personnel to support our future growth, including through acquisitions, which we expect to result in higher cost of revenue in absolute dollars. Research and Development. Research and development expenses consist primarily of employee-related expenses for our research and development staff, including salaries, benefits, bonuses, and stock-based compensation, and the cost of third-party developers and other independent contractors. Research and development costs, other than software development expenses qualifying for capitalization, are expensed as incurred. Capitalized software development costs consist primarily of employee-related costs. Research and development expenses also include allocated costs for certain information technology and facility expenses, along with depreciation of equipment. We devote substantial resources to enhancing and maintaining the Avalara Compliance Cloud, developing new and enhancing existing solutions, conducting quality assurance testing, and improving our core technology. We expect research and development expenses to increase in absolute dollars. Sales and Marketing. Sales and marketing expenses consist primarily of employee-related expenses for our sales and marketing staff, including salaries, benefits, bonuses, sales commissions, and stock-based compensation, as well as integration and referral partner commissions, costs of marketing and promotional events, corporate communications, online marketing, solution marketing, and other brand-building activities. Sales and marketing expenses include allocated costs for certain information technology and facility expenses, along with depreciation of equipment and amortization of intangibles such as customer databases from acquisitions. We defer the portion of sales commissions that is considered a cost of obtaining a new contract with a customer in accordance with the new revenue recognition standard and amortize these deferred costs over the period of benefit, currently six years. We expense the remaining sales commissions as incurred. Sales commissions are earned when a sales order is completed. For most sales orders, deferred revenue is recorded when a sales order is invoiced, and the related revenue is recognized ratably over the subscription term. The rates at which sales commissions are earned varies depending on a variety of factors, including the nature of the sale (new, renewal, or add-on service offering), the type of service or solution sold, and the sales channel. At the beginning of each year we set group and individual sales targets. Sales commissions are generally earned based on achievement against these targets. We defer the portion of partner commissions costs that are considered a cost of obtaining a new contract with a customer in accordance with the new revenue recognition standard and amortize these deferred costs over the period of benefit. The period of benefit is separately determined for each partner and is either six years or corresponds with the contract term. We expense the remaining partner commissions costs as incurred. Our partner commission expense has historically been, and will continue to be, impacted by many factors, including the proportion of new and renewal sales, the nature of the partner relationship, and the sales mix among partners during the period. In general, integration partners are paid a higher commission for the initial sale to a new customer and a lower commission for renewal sales. Additionally, we have several types of partners (e.g., integration and referral) that each earn different commission rates. We intend to continue to invest in sales and marketing and expect spending in these areas to increase in absolute dollars as we continue to expand our business. We expect sales and marketing expenses to continue to be among the most significant components of our operating expenses. Because we began to defer a portion of the sales and partner commission costs in 2019, our sales and marketing expense will not be comparable to prior periods in which we expensed these costs. General and Administrative. General and administrative expenses consist primarily of employee-related expenses for administrative, finance, information technology, legal, and human resources staff, including salaries, benefits, bonuses, and stock-based compensation, as well as professional fees, insurance premiums, and other corporate expenses that are not allocated to the above expense categories. We expect our general and administrative expenses to increase in absolute dollars as we continue to expand our operations, hire additional personnel, integrate acquisitions, and incur costs as a public company. Specifically, we expect to incur increased expenses related to accounting, tax and auditing activities, legal, insurance, SEC compliance, and internal control compliance. Total Other (Income) Expense, Net Total other (income) expense, net consists of interest income on cash and cash equivalents, interest expense on outstanding borrowings, quarterly remeasurement of contingent consideration for acquisitions accounted for as business combinations, realized foreign currency changes, and other nonoperating gains and losses. Interest expense on our borrowings was based on a floating per annum rate at specified percentages above the prime rate. Results of Operations The comparability of periods covered by our financial statements is impacted by acquisitions and the impact of the adoption of new accounting standards. In May 2018, we acquired developed technology to facilitate cross-border transactions (e.g., tariffs and duties). In January 2019, we acquired substantially all the assets of Compli and in February 2019, we acquired substantially all the assets of Indix. In July 2019, we acquired substantially all the assets of Portway. We adopted the new revenue recognition standard ASC 606 effective January 1, 2019 on a modified retrospective basis. Our results of operations presented in the following tables include financial results for reporting periods during 2019, which are reported in compliance with the new revenue recognition standard. Historical financial results for reporting periods prior to 2019 have not been retroactively restated and are presented in conformity with amounts previously disclosed under the prior revenue recognition standard ASC 605. We have included additional information regarding the impacts from the adoption of the new revenue recognition standard for the year ended December 31, 2019 and included financial results during 2019 under ASC 605 for comparison to the prior year. See Note 2 to the accompanying notes to the consolidated financial statements for additional information related to our adoption of the new revenue recognition standard. The following sets forth our results of operations for the periods presented. (1) The stock-based compensation expense included above was as follows: The amortization of acquired intangibles included above was as follows: The following sets forth our results of operations as a percentage of our total revenue for the periods presented. Year Ended December 31, 2019 as compared to the Year Ended December 31, 2018 Revenue ASC 606 total revenue for the year ended December 31, 2019 increased $110.4 million, or 41%, compared to the year ended December 31, 2018. ASC 606 total revenue for the year ended December 31, 2019 was $382.4 million compared to ASC 605 total revenue of $383.0 million for the same period. ASC 605 total revenue for the year ended December 31, 2019 increased by $110.9 million, or 41%, compared to the year ended December 31, 2018. ASC 605 subscription and returns revenue for the year ended December 31, 2019 increased by $101.9 million, or 40%, compared to the year ended December 31, 2018. ASC 605 professional services revenue for the year ended December 31, 2019 increased by $9.0 million, or 50%, compared to the year ended December 31, 2018. Growth in total revenue was due primarily to increased demand for our services from new and existing customers. The increase in total ASC 605 revenue for the year ended December 31, 2019 compared to the same period of 2018, was due primarily to $56.3 million from existing U.S. customers, $31.1 million from new U.S. customers, $9.8 million from SST revenue growth, $6.6 million attributable to revenue growth in our international operations, $4.9 million from acquisitions made during 2019, and $2.2 million of revenue growth from interest earned on funds held for customers. Currently a small component of our total revenue, we offer SST services to businesses that are registered to participate in the program. Because we generally provide SST services at no cost to the seller, we earn a fee from the participating state and local governments based on a percentage of sales tax reported and paid. Cost of Revenue Cost of revenue for the year ended December 31, 2019 increased by $36.7 million, or 47%, compared to the year ended December 31, 2018. The increase in cost of revenue in absolute dollars was due primarily to an increase of $18.9 million in employee-related costs from higher headcount, an increase of $6.7 million in software hosting costs, an increase of $4.5 million in allocated overhead cost, an increase of $4.1 million in outside services expenses, an increase of $0.8 million in amortization expense from acquired intangible assets, and an increase of $0.6 million in third-party purchased software costs. Excluding the impact of our Portway acquisition, cost of revenue headcount increased approximately 47% from December 31, 2018 to December 31, 2019 due to our continued growth to support our solutions and expand content. Employee-related costs increased due primarily to a $15.2 million increase in salaries and benefits, a $2.0 million increase in compensation expense related to our bonus plans, and a $1.5 million increase in stock-based compensation expense. Outside services expenses increased due primarily to third-party costs associated with Avalara Licensing, a service we began providing in the third quarter of 2018 and, to a lesser extent, the use of third-party consulting firms to support service offerings in our international operations. Software hosting costs have increased due primarily to higher transaction volumes. Allocated overhead consists primarily of facility expenses and shared information technology expenses, both of which were higher compared to the prior period. Software costs increased due primarily to additional investment in enhancing and monitoring our customer production environment. Gross Profit ASC 606 total gross profit for the year ended December 31, 2019 increased $73.7 million, or 38%, compared to the year ended December 31, 2018. ASC 605 total gross profit for the year ended December 31, 2019 increased $74.3 million, or 38%, compared to the year ended December 31, 2018. Total gross margin was 70% for the year ended December 31, 2019 compared to 71% for the same period of 2018. Research and Development Research and development expenses for the year ended December 31, 2019 increased $30.5 million, or 59%, compared to the year ended December 31, 2018. The increase was due primarily to an increase of $25.9 million in employee-related costs from higher headcount, an increase of $2.9 million in allocated overhead cost, and an increase of $1.1 million in third-party purchased software costs. Research and development headcount increased approximately 70% from December 31, 2018 to December 31, 2019. Employee-related costs increased due primarily to a $16.0 million increase in salaries and benefits, a $4.6 million increase in compensation expense related to our bonus plans, a $3.5 million increase in stock-based compensation expense, and a $0.9 million increase in contract and temporary employee costs. Software costs increased due primarily to additional investment in information technology security and data privacy tools. Sales and Marketing Sales and marketing expenses for the year ended December 31, 2019 decreased $0.2 million compared to the year ended December 31, 2018. ASC 606 sales and marketing expense for the year ended December 31, 2019 was $168.6 million compared to ASC 605 sales and marketing expense of $187.8 million for the same period. The difference of $19.1 million relates to the deferral of sales commissions costs and partner commission costs under ASC 606. All of our sales commission and partner commission costs were expensed as incurred under ASC 605. ASC 605 sales and marketing expenses for the year ended December 31, 2019 increased $19.0 million, or 11%, compared to the year ended December 31, 2018. The increase was due primarily to an increase of $9.0 million in employee-related costs, an increase of $7.3 million for partner commission expense, an increase of $2.2 million in allocated overhead cost, and an increase of $1.4 million in marketing campaign expenses, partially offset by a decrease in outside services expenses of $1.3 million. Sales and marketing headcount increased approximately 21% from December 31, 2018 to December 31, 2019. Employee-related costs increased due primarily to a $8.0 million increase in salaries and benefits, a $3.2 million increase in stock-based compensation expense, a $1.7 million increase in employer payroll tax expense on employee stock transactions, and a $1.6 million increase in compensation expense related to our bonus plans, partially offset by a $5.0 million decrease in sales commissions expense, and a $1.3 million decrease in contract and temporary employee costs. Sales commissions expense decreased due to lower average commission rates compared to 2018, which offset increases from strong sales-related activity. Our average commission rates were higher in the prior year due in part to a greater percentage of eligible sales personnel exceeding their annual sales targets. ASC 605 sales commission expense was $30.2 million for the year ended December 31, 2019 compared to $35.2 million for the year ended December 31, 2018. Partner commission expense increased due primarily to higher sales and an increase in the proportion of sales eligible for partner commissions, including new sales which generally earn a higher commission rate compared to renewal sales. ASC 605 partner commission expense was $29.0 million for the year ended December 31, 2019 compared to $21.7 million for the year ended December 31, 2018. Marketing campaign expenses increased due to an increase in our discretionary spending on customer events and lead generation activities. Outside services expenses decreased due to a reduction in our discretionary spending with external advertising and marketing agencies. General and Administrative General and administrative expenses for the year ended December 31, 2019 increased $32.3 million, or 82%, compared to the year ended December 31, 2018. The increase was due primarily to an increase of $25.2 million in employee-related costs, a $5.5 million increase in outside service expenses, a $1.8 million increase in bad debt expense, a $1.3 million increase in merchant fees, and a $0.7 million increase in insurance costs, partially offset by a decrease of $3.2 million in allocated overhead cost. General and administrative headcount increased 46% from December 31, 2018 to December 31, 2019. Employee-related costs increased due primarily to a $10.2 million increase in stock-based compensation expense, a $7.6 million increase in salaries and benefits, a $3.3 million increase in compensation expense related to our bonus plans, and a $2.7 million increase in employer payroll tax expense on employee stock transactions. Outside services expenses increased due to higher audit and internal control compliance costs and higher costs from external recruiters for job search and placement fees. Bad debt expense increased due primarily to higher U.S. customer bankruptcies and insolvencies and aging of trade receivables in our European operations. Merchant fees, which are credit card processing fees, increased due to increased payment activity from customers transitioning to our auto-payment program. Insurance costs have increased from the prior period as a result of being a public company for all of 2019. Goodwill Impairment A goodwill impairment charge of $9.2 million was recorded in 2018 related to our Brazilian operations. There were no goodwill impairment charges incurred in the year ended December 31, 2019. Total Other (Income) Expense, Net Total other income for the year ended December 31, 2019 was $6.6 million compared to $0.5 million of other expense for the year ended December 31, 2018. Interest income increased due to interest earned on investing our public offering cash proceeds. Interest expense decreased due to having no outstanding borrowings during the year ended December 31, 2019. We discuss borrowings under “Liquidity and Capital Resources” below. Other (income) expense, net was $0.9 million other income in the year ended December 31, 2019 compared to $0.6 million of other income in the year ended December 31, 2018, primarily due to our earnout liabilities. We estimate the fair value of earnout liabilities related to business combinations quarterly. During the year ended December 31, 2019, the adjustments to fair value decreased the carrying value of the earnout liability for our acquisition of Indix, resulting in other income of $1.7 million, partially offset by an increase in the carrying value of the earnout liabilities for our acquisitions of Compli and Portway, which resulted in other expense of $0.6 million. The fair value of the Indix acquisition earnout liability decreased at December 31, 2019, from the fair value at acquisition in February 2019, due primarily to the last three earnout milestones, which are nonfinancial, being more difficult to complete within the required timeframe than initially assessed. During the year ended December 31, 2018, the adjustments to fair value decreased the carrying value of the earnout liabilities for prior acquisitions, resulting in other income of $0.4 million. Provision for (Benefit from) Income Taxes The provision for income taxes for the year ended December 31, 2019 was $1.0 million compared to a benefit from income taxes of $1.0 million for the year ended December 31, 2018. The effective income tax rate was 1.9% for the year ended December 31, 2019 compared to a benefit of 1.3% for the year ended December 31, 2018. For the year ended December 31, 2019, the income tax expense related primarily to foreign tax jurisdictions. The income tax benefit for the year ended December 31, 2018 was due primarily to the determination that indefinite lived goodwill would provide a source of income to realize indefinite lived deferred tax assets, resulting in a tax benefit of $0.9 million. We have assessed our ability to realize our deferred tax assets and have recorded a valuation allowance against such assets to the extent that, based on the weight of all available evidence, it is more likely than not that all or a portion of the deferred tax assets will not be realized. In assessing the likelihood of future realization of our deferred tax assets, we placed significant weight on our history of generating U.S. tax losses, including in 2019. As a result, we have a full valuation allowance against our net deferred tax assets, including net operating loss carryforwards, and tax credits related primarily to research and development. We expect to maintain a full valuation allowance for the foreseeable future. Year Ended December 31, 2018 Compared to Year Ended December 31, 2017 Revenue Total revenue for the year ended December 31, 2018 increased by $58.9 million, or 28%, compared to the year ended December 31, 2017. Subscription and returns revenue for the year ended December 31, 2018 increased by $54.1 million, or 27%, compared to the year ended December 31, 2017. Professional services revenue for the year ended December 31, 2018 increased by $4.8 million, or 37%, compared to the year ended December 31, 2017. Growth in total revenue was due primarily to increased demand for our products and services from both new and existing customers. Of the increase in total revenue for the year ended December 31, 2018 compared to 2017, approximately $29.6 million was attributable to existing customers, approximately $28.3 million was attributable to new customers, and approximately $1.1 million was due to interest income on funds held for customers. Total subscription and returns revenue for 2018 included $1.2 million related to our cross-border transactions technology acquired in May 2018. Cost of Revenue Cost of revenue for the year ended December 31, 2018 increased by $20.7 million, or 36%, compared to the year ended December 31, 2017. The increase in cost of revenue in absolute dollars was due primarily to an increase of $10.3 million in employee-related costs, an increase of $4.6 million in software hosting costs, an increase of $2.2 million in allocated overhead cost, and an increase of $1.4 million in outside services expenses. Our cost of revenue headcount increased approximately 15% from December 31, 2017 to December 31, 2018 due to our continued growth to support our solutions and expand content. Employee-related costs increased due primarily to a $7.6 million increase in salaries and benefits, a $1.0 million increase in contract and temporary employees, a $0.7 million increase in stock-based compensation expense, and a $0.8 million increase in compensation expense related to our bonus plans. Software hosting costs have increased due primarily to higher transaction volumes and transitioning to a third-party hosting vendor. Allocated overhead consists primarily of facility expenses and shared information technology expenses. Facility expenses increased in 2018 due primarily to the costs associated with our new corporate headquarters in Seattle, Washington. We moved into these facilities in February 2018. Outside services expenses increased due primarily to the use of third-party consulting firms to support product and service offerings in our international operations. Gross Profit Total gross profit for the year ended December 31, 2018 increased $38.3 million, or 25%, compared to the year ended December 31, 2017. Total gross margin was 71% for the year ended December 31, 2018 compared to 73% for the same period of 2017. This decrease was due primarily to higher software hosting costs and to a lesser extent, higher costs for third-party consulting firms to support product and service offerings in our international operations. Research and Development Research and development expenses for the year ended December 31, 2018 increased $10.6 million, or 26%, compared to the year ended December 31, 2017. The increase was due primarily to an increase of $8.5 million in employee-related costs, an increase of $1.4 million in allocated overhead cost, and an increase of $0.3 million in outside services expenses. While research and development headcount increased only 4% from December 31, 2017 to December 31, 2018, employee-related costs increased due primarily to a $5.4 million increase in salaries and benefits, a $1.0 million increase in compensation expense related to our bonus plans, a $0.9 million increase in contract and temporary employees, and a $0.8 million increase in stock-based compensation expense. Outside services expenses increased due primarily to use of third-party software developers to support product enhancements and maintenance in our international operations. Sales and Marketing Sales and marketing expenses for the year ended December 31, 2018 increased $35.0 million, or 26%, compared to the year ended December 31, 2017. The increase was due primarily to an increase of $28.1 million in employee-related costs, an increase of $7.4 million for partner commission expense, and an increase of $2.7 million in allocated overhead cost offset, in part, by a decrease of $3.9 million for marketing campaign expenses. While sales and marketing headcount was essentially flat from December 31, 2017 to December 31, 2018, employee-related costs increased due primarily to an $18.5 million increase in sales commissions expense, a $9.1 million increase in salaries and benefits, and a $1.7 million increase in stock-based compensation expense. Sales commissions expense increased due to strong sales-related activity and higher average commission rates. Our average commissions rates were higher in 2018 compared to 2017 due to an increase in the percentage of eligible sales personnel exceeding their annual sales targets. We typically pay higher sales commission rates on additional sales that exceed the established sales target. Partner commission expense increased due primarily to higher revenues and an increase in the proportion of sales eligible for partner commissions, including new sales which generally earn a higher commission rate compared to renewal sales. Partner commission expense was $21.7 million for the year ended December 31, 2018 compared to $14.3 million for the year ended December 31, 2017. Marketing campaign expenses decreased due to a reduction in our discretionary spending on advertising and marketing. General and Administrative General and administrative expenses for the year ended December 31, 2018 increased $5.3 million, or 16%, compared to the year ended December 31, 2017. The increase was due primarily to an increase of $2.7 million in employee-related costs, a $0.8 million increase in merchant fees, an increase of $0.8 million in insurance expense as a result of being a public company, and a $0.5 million increase in indirect tax compliance expenses. General and administrative headcount increased 5% from December 31, 2017 to December 31, 2018. Employee-related costs increased due primarily to $1.0 million increase in stock-based compensation expense and a $1.1 million increase in compensation expense related to our bonus plans. Merchant fees, which are credit card processing fees, increased due to customers transitioning to our auto-payment program which uses credit cards for customer payment and increased payment activity. Indirect tax expenses, which are non-income tax related, increased due primarily to higher business and occupation taxes in certain tax jurisdictions. Goodwill Impairment and Restructuring Charges A goodwill impairment charge of $9.2 million was recorded in 2018 and a $8.4 million goodwill impairment charge was recorded in 2017, both of which related to our Brazilian operations (see Note 7 of the notes to our consolidated financial statements). There were no restructuring charges incurred in the year ended December 31, 2018, compared to $0.8 million incurred in the year ended December 31, 2017. We incurred restructuring charges in the third quarter of 2017 associated with the closure of our Overland Park office, including termination benefits and other reorganization costs, primarily associated with integrating operations. Total Other (Income) Expense, Net Total other expense for the year ended December 31, 2018 was $0.5 million compared to $2.0 million for the year ended December 31, 2017. Interest income increased due to interest earned on investing our IPO cash proceeds in money market accounts. Interest expense remained consistent due to higher interest expense on borrowings under our credit facilities during 2018 prior to repayment of the outstanding borrowings following our IPO. We discuss borrowings under “Liquidity and Capital Resources” below. Other income remained consistent and is comprised primarily of income resulting from the change in the fair value of earnout liabilities associated with prior business acquisitions. We estimate the fair value of earnout liabilities related to acquisitions quarterly. During 2018 and 2017, the adjustments to fair value reduced the carrying value of the earnout liabilities. Provision for (Benefit from) Income Taxes Benefit from income taxes for the year ended December 31, 2018 decreased by $0.2 million compared to the year ended December 31, 2017. The effective income tax rate was a benefit of 1.3% and 1.9% for the years ended December 31, 2018 and 2017, respectively. The difference is due primarily to an update to the provisional amount recorded as of December 31, 2017. We determined that indefinite lived goodwill would provide a source of income to realize indefinite lived deferred tax assets resulting in a tax benefit of $0.9 million during the year ended December 31, 2018. Quarterly Results of Operations The following table sets forth our unaudited quarterly consolidated statements of operations data for each of the periods presented as well as the percentage of total revenue that each line item represented for each quarter. In management’s opinion, the data below have been prepared on the same basis as the audited consolidated financial statements included elsewhere in this report and reflect all necessary adjustments, consisting of normal recurring adjustments and the immaterial errors described below, necessary for a fair statement of this data. The results of historical periods are not necessarily indicative of the results to be expected for a full year or any future period. The following quarterly financial data should be read in conjunction with our audited financial statements and related notes included elsewhere in this report. (1) In preparing our 2019 annual financial statements, we discovered an immaterial error in recording deferred sales commissions for the first three quarters of 2019 impacting our previously reported quarterly financial results. We have presented the corrected quarterly consolidated statements of operations data and percentage of total revenue that each line item represented for each of the first three quarters of 2019 as presented below. The correction to sales commission expense resulted in additional sales and marketing expenses of $1.1 million, $1.1 million, and $0.9 million for each of the three-month periods ended March 31, 2019, June 30, 2019, and September 30, 2019, respectively. (2) The stock-based compensation expense included above was as follows: The amortization of acquired intangibles included above was as follows: (1) Free cash flow is a non-GAAP financial measure. For more information about free cash flow, see “Use and Reconciliation of Non-GAAP Financial Measures.” Seasonality and Quarterly Trends We have historically signed a higher percentage of agreements with new customers, as well as renewal and upgrade agreements with existing customers, in the fourth quarter of each year and usually during the last month. This can be attributed to buying patterns typical in the software industry. Since the terms of most of our customer agreements are annual, agreements initially entered into in the fourth quarter or last month of any quarter will generally come up for renewal at that same time in subsequent years. As a result, we have historically seen a higher percentage of customer agreement cancellations in the fourth quarter of each year. While this seasonality is reflected in our revenues, the impact to overall annual or quarterly revenues is minimal since we recognize subscription revenue ratably over the term of the customer contract. Additionally, this seasonality is reflected in commission expenses to our sales personnel and our partners. Our quarterly revenue has increased in each period presented primarily due to increased sales to new customers, as well as increased usage by our existing customers. Our operating expenses generally have increased sequentially in every quarter primarily due to increases in headcount and related expenses to support our growth. Increases in our sales and marketing expenses primarily reflects the impacts of personnel additions and various sales and marketing initiatives that may fluctuate from quarter to quarter. Research and development expenses have fluctuated based on the timing of personnel additions and related spending on product development. We anticipate our operating expenses will continue to increase in absolute dollars in future periods as we invest in the long-term growth of our business. We anticipate that gross profit and gross margin for professional services may also fluctuate from quarter to quarter because of variability in our professional services projects and changes in headcount. Liquidity and Capital Resources We require cash to fund our operations, including outlays for infrastructure growth, acquisitions, geographic expansion, expanding our sales and marketing activities, research and development efforts, and working capital for our growth. To date, we have financed our operations primarily through cash received from customers for our solutions, public offerings of our common stock, private placements, and bank borrowings. As of December 31, 2019, we had $467.0 million of cash and cash equivalents, most of which was held in money market accounts. Borrowings We had a loan and security agreement with Silicon Valley Bank and Ally Bank (the “Lenders”) that consisted of a $50.0 million revolving credit facility (the “Credit Facility”). On June 25, 2019, we terminated the Credit Facility. As of December 31, 2019, we had no credit facilities in place and had no borrowings outstanding. Prior to the termination of the Credit Facility, we were required to pay a quarterly fee of 0.50% per annum on the undrawn portion available under the revolving credit facility plus the sum of outstanding letters of credit. Under the Credit Facility, the interest rate on the revolving credit facility was based on the greater of either 4.25% or the current prime rate, plus 1.75%. Future Cash Requirements As of December 31, 2019, our cash and cash equivalents included proceeds from our June 2019 and our June 2018 public offerings of common stock. We intend to continue to increase our operating expenses and capital expenditures to support the growth in our business and operations. We may also use our cash and cash equivalents to acquire complementary businesses, products, services, technologies, or other assets. We believe that our existing cash and cash equivalents of $467.0 million as of December 31, 2019, together with cash generated from operations, will be sufficient to meet our anticipated cash needs for at least the next 12 months. Our financial position and liquidity are, and will be, influenced by a variety of factors, including our growth rate, the timing and extent of spending to support research and development efforts, the continued expansion of sales and marketing spending, the introduction of new and enhanced solutions, the cash paid for any acquisitions, and the continued market acceptance of our solutions. The following table shows our cash flows from operating activities, investing activities, and financing activities for the stated periods: Operating Activities Our largest source of operating cash is cash collections from our customers for subscriptions and returns services. Our primary uses of cash from operating activities are for employee-related expenditures, commissions paid to our partners, marketing expenses, and facilities expenses. Cash provided by (used in) operating activities is comprised of our net loss adjusted for certain non-cash items, including stock-based compensation, depreciation and amortization, goodwill impairment, operating lease costs, and other non-cash income and expense items. For the year ended December 31, 2019, cash provided by operating activities was $22.4 million compared to cash used of $3.1 million for the year ended December 31, 2018. The improvement in cash from operations of $25.5 million was due primarily to an increase in cash collected from customers and, to a lesser extent, earning interest income in 2019 while incurring interest expense in 2018, resulting in a net improvement of $6.8 million. The increase in cash collected from customers is due to growing demand for our subscription and returns services, which is partially offset by increasing costs to support this growth. In 2019, we earned and received interest income on a portion of the cash proceeds included in cash and cash equivalents from our June 2018 and June 2019 public offerings of our common stock, while in 2018 we accrued and paid interest expense on our outstanding borrowings. See “Results of Operations” for further discussion. For the year ended December 31, 2018, cash used in operating activities was $3.1 million compared to $3.5 million for the year ended December 31, 2017, a decrease in cash used of $0.4 million. During 2017, we received reimbursements for tenant improvements of $10.5 million compared to $1.7 million in 2018. Under the lease for our new corporate headquarters, we were granted approximately $12.3 million of tenant improvements to be paid by the landlord. We initially funded these improvements, which were recorded in investing activities as capital expenditures, and record the reimbursement of these expenditures to deferred rent, which increased cash from operating activities. Excluding reimbursements for tenant improvements, cash used in operating activities decreased by $9.1 million. This improvement in cash flows was due primarily to higher sales and improved cash collection in 2018, but was partially offset by higher operating expenses, primarily employee-related costs. Investing Activities Our investing activities primarily include cash outflows related to purchases of property and equipment, changes in customer fund assets, and, from time-to-time, the cash paid for asset and business acquisitions. For the year ended December 31, 2019, cash used in investing activities was $52.1 million, compared to cash used of $20.4 million for the year ended December 31, 2018. The increase in cash used of $31.7 million was due primarily to cash paid for acquisitions of $30.3 million, and an increase in customer fund assets of $11.6 million, partially offset by lower cash paid for purchases of intangible assets of $4.9 million and lower capital expenditures of $5.3 million. In 2019, we acquired substantially all the assets of Compli, Indix, and Portway for total cash consideration of $30.3 million. In 2018, we acquired developed technology to facilitate cross-border transactions (e.g. duties and tariffs). Capital expenditures decreased due primarily to spending related to our new corporate headquarters in Seattle, Washington and expansion of our Durham, North Carolina office during 2018. Our Seattle headquarters opened in the first quarter of 2018. For the year ended December 31, 2018, cash used in investing activities was $20.4 million, compared to cash used of $16.3 million for the year ended December 31, 2017. The increase in cash used of $4.1 million was due primarily to cash paid for acquisition of intangible assets of $5.0 million and higher capital expenditures of $1.5 million, partially offset by a decrease in customer fund assets of $2.4 million. In 2018, we acquired a customer list for $0.4 million and developed technology to facilitate cross-border transactions (e.g., tariffs and duties) for total consideration of $7.1 million, which included total cash payments of $4.6 million. Capital expenditures increased $1.5 million from the prior year due primarily to expansion and related tenant improvements for our Durham, North Carolina office. Financing Activities Our financing activities primarily include cash inflows and outflows from issuance and repurchases of capital stock, our employee stock purchase plan, our Credit Facility, and changes in customer fund obligations. For the year ended December 31, 2019, cash provided by financing activities was $354.4 million compared to cash provided of $151.4 million for the year ended December 31, 2018. This increase in cash provided of $203.0 million was due primarily to increased cash proceeds from offerings of our common stock of $82.2 million, a $51.0 million increase in cash proceeds from exercise of stock options, $12.3 million of cash proceeds from common stock purchased under our employee stock purchase plan, and a $11.6 million increase in customer fund obligations in 2019. We also had net repayments on our Credit Facility of $40.0 million in 2018 with no comparable activity in 2019. For 2018, cash provided by financing activities was $151.4 million compared to cash provided by financing activities of $13.7 million for the year ended December 31, 2017. This increase in cash provided of $137.7 million was due primarily to cash received from our IPO net of underwriting discounts of $192.5 million and an increase of $6.1 million in cash proceeds from exercise of stock options and stock warrants, partially offset by the repayment of outstanding borrowings under our Credit Facility of $63.0 million. Prior to repayment of our revolving credit line in June 2018 and our term loan in August 2018, we borrowed $23.0 million during the first half of 2018. Funds Held from Customers and Customer Funds Obligations We maintain trust accounts with financial institutions, which allows our customers to outsource their tax remittance functions to us. We have legal ownership over the accounts utilized for this purpose. Funds held from customers represents cash and cash equivalents that, based upon our intent, are restricted solely for satisfying the obligations to remit funds relating to our tax remittance services. Funds held from customers are not commingled with our operating funds, but typically are deposited with funds also held on behalf of our other customers. Customer funds obligations represent our contractual obligations to remit collected funds to satisfy customer tax payments. Customer funds obligations are reported as a current liability on the consolidated balance sheets, as the obligations are expected to be settled within one year. Cash flows related to the cash received from and paid on behalf of customers are reported as follows: 1) changes in customer funds obligations liability are presented as cash flows from financing activities; 2) changes in customer fund assets (e.g., customer funds held in cash and cash equivalents and receivable from customers and taxing authorities) are presented as net cash flows from investing activities; and 3) changes in customer fund asset account that relate to paying for the trust operations, such as banking fees, are presented as cash flows from operating activities. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2019: (1) Purchase obligations are comprised primarily of long-term software licenses, subscriptions, and software hosting services. (2) We maintain trust accounts with financial institution that are solely for satisfying the obligations to remit funds relating to our tax remittance services. Customer funds obligations represent our contractual obligations to remit collected funds to satisfy customer tax payments. At December 31, 2019, we had $24.4 million of funds held from (collected from) customers. Because of in-transit payments and changes in the amounts owed to us or to the taxing authority, the asset and liability amounts presented for any period will generally not offset. (3) Other liabilities include the cash portion of earnout liabilities owed to Tradestream Technologies Inc. for the measurement period ended December 31, 2019 and the fair value of cash earnout liabilities owed to Compli and Indix estimated as of December 31, 2019. Other liabilities also include holdback liabilities owed to Portway, Indix and Compli. Off-Balance Sheet Arrangements We did not have any off-balance sheet arrangements in the years ended December 31, 2019 or 2018. Use and Reconciliation of Non-GAAP Financial Measures In addition to our results determined in accordance with GAAP, we have calculated non-GAAP cost of revenue, non-GAAP gross profit, non-GAAP gross margin, non-GAAP research and development expense, non-GAAP sales and marketing expense, non-GAAP general and administrative expense, non-GAAP operating loss, non-GAAP net loss, free cash flow, and calculated billings, which are non-GAAP financial measures. We have provided tabular reconciliations of each of these non-GAAP financial measures to its most directly comparable GAAP financial measure. • We calculate non-GAAP cost of revenue, non-GAAP research and development expense, non-GAAP sales and marketing expense, and non-GAAP general and administrative expense as GAAP cost of revenue, GAAP research and development expense, GAAP sales and marketing expense, and GAAP general and administrative expense before stock-based compensation expense and the amortization of acquired intangible assets included in each of the expense categories. • We calculate non-GAAP gross profit as GAAP gross profit before the stock-based compensation expense and amortization of acquired intangibles included in cost of revenue. We calculate non-GAAP gross margin as GAAP gross margin before the impact of stock-based compensation expense and the amortization of acquired intangibles included in cost of revenue as a percentage of revenue. • We calculate non-GAAP operating loss as GAAP operating loss before stock-based compensation expense, amortization of acquired intangibles, and goodwill impairments. We calculate non-GAAP net loss as GAAP net loss before stock-based compensation expense, amortization of acquired intangibles, and goodwill impairments. • We define free cash flow as net cash (used in) provided by operating activities less cash used for the purchases of property and equipment. • We define calculated billings as total revenue plus the changes in deferred revenue and contract liabilities in the period. Management uses these non-GAAP financial measures to understand and compare operating results across accounting periods, for internal budgeting and forecasting purposes, and to evaluate financial performance and liquidity. In addition, because we recognize subscription revenue ratably over the subscription term, management uses calculated billings to measure our subscription sales activity for a particular period, to compare subscription sales activity across particular periods, and as a potential indicator of future subscription revenue, the actual timing of which will be affected by several factors, including subscription start date and duration. We believe that non-GAAP financial measures provide useful information to investors and others in understanding and evaluating our results, prospects, and liquidity period-over-period without the impact of certain items that do not directly correlate to our performance and that may vary significantly from period to period for reasons unrelated to our operating performance, as well as comparing our financial results to those of other companies. Our definitions of these non-GAAP financial measures may differ from the definitions used by other companies and therefore comparability may be limited. In addition, other companies may not publish these or similar metrics. Thus, our non-GAAP financial measures should be considered in addition to, not as a substitute for, or in isolation from, measures prepared in accordance with GAAP. We encourage investors and others to review our financial information in its entirety, not to rely on any single financial measure, and to view non-GAAP cost of revenue, non-GAAP gross profit, non-GAAP gross margin, non-GAAP research and development expense, non-GAAP sales and marketing expense, non-GAAP general and administrative expense, non-GAAP operating loss, non-GAAP net loss, free cash flow, and calculated billings in conjunction with the related GAAP financial measure. As a result of adoption of ASC 606 effective January 1, 2019, non-GAAP financial measures for the twelve months ended December 31, 2019, as computed in accordance with ASC 606, are not as comparable to non-GAAP financial measures for the twelve months ended December 31, 2018 and 2017, which are computed in accordance with ASC 605. Except for calculated billings, the reconciliation of non-GAAP measures provided below includes additional information to reconcile the impacts of the adoption of ASC 606 on the non-GAAP financial measures for the twelve months ended December 31, 2019, including presentation of the non-GAAP measures for 2019 under ASC 605 for comparison to the prior years. The following schedule reflects our non-GAAP financial measures and reconciles our non-GAAP financial measures to the related GAAP financial measures: The following table reflects calculated billings and reconciles to GAAP revenues. In addition to the defined reconciling items for calculated billings, the first quarter of 2019 also includes one-time reconciling adjustments related to the impact of adoption of ASC 606 as of January 1, 2019. Critical Accounting Policies Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements. The preparation of these financial statements in accordance 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, as well as the revenue and expenses during the reporting periods. These estimates, assumptions, and judgments are necessary because future events and their effects on our consolidated financial statements cannot be determined with certainty and are made based on our historical experience and on other assumptions that we believe to be reasonable under the circumstances. These estimates may change as new events occur or additional information is obtained, and we may periodically be faced with uncertainties, the outcomes of which are not within our control and may not be known for a prolonged period of time. Because the use of estimates is inherent in the financial reporting process, actual results could materially differ from those estimates. We believe the following critical accounting policies affect our most significant judgments and estimates used in preparation of our consolidated financial statements: • Revenue Recognition; • Assets Recognized from the Costs to Obtain a Contract with a Customer • Stock-based Compensation; • Common Stock Valuations; and • Business Combinations, including Intangible Assets, Contingent Consideration and Goodwill. Revenue Recognition We primarily generate revenue from fees paid for subscriptions to tax compliance solutions and fees paid for services performed in preparing and filing tax returns on behalf of our customers. Amounts that have been invoiced are recorded in trade accounts receivable and deferred revenue, contract liabilities, or revenue, depending upon whether the revenue recognition criteria have been met. Revenue is recognized once the customer is provisioned and services are provided. Beginning in 2019, our revenue recognition policy follows guidance from ASC 606, Revenue from Contracts with Customers. We determine revenue recognition through the following five-step framework: • Identification of the contract, or contracts, with a customer; • Identification of the performance obligations in the contract; • Determination of the transaction price; • Allocation of the transaction price to the performance obligations in the contract; and • Recognition of revenue when, or as, we satisfy a performance obligation. We identify performance obligations in our contracts with customers, which primarily include subscription services and professional services. The transaction price is determined based on the amount we expect to be entitled to in exchange for providing the promised services to the customer. The transaction price in the contract is allocated to each distinct performance obligation on a relative standalone selling price basis. Revenue is recognized when performance obligations are satisfied. Contract payment terms are typically net 30 days. Collectability is assessed based on a number of factors including collection history and creditworthiness of the customer, and we may mitigate exposure to credit risk by requiring payments in advance. If collectability of substantially all consideration to which we are entitled under the contract is determined to be not probable, revenue is not recorded until collectability becomes probable at a later date. Subscription and Returns Revenue Subscription and returns revenue primarily consist of contractually agreed upon fees paid for using our cloud-based solutions, which include tax determination and compliance management services, and fees paid for preparing and filing transaction tax returns on behalf of customers. Under our subscription agreements, customers select a price plan that includes an allotted maximum number of transactions over the subscription term. Unused transactions are not carried over to the customer’s next subscription term, and customers are not entitled to refunds of fees paid or relief from fees due in the event they do not use the allotted number of transactions. If customers exceed the maximum transaction level within their price plan, we will generally upgrade the customer to a higher transaction price plan or, in some cases, charge overage fees on a per transaction basis. Our subscription arrangements do not provide the customer with the right to take possession of the software supporting the cloud-based application services. Our standard subscription contracts are non-cancelable except where contract terms provide rights to cancel in the first 60 days of the contract term. Cancellations under our standard subscription contracts are not material, and do not have a significant impact on revenue recognized. Tax returns processing services include collection of tax data and amounts, preparation of compliance forms, and submission to taxing authorities. Returns processing services are primarily charged on a subscription basis for an allotted number of returns to process within a given time period. Revenue is recognized ratably over the contractual term of the arrangement, beginning on the date that the service is made available to the customer. We invoice our subscription customers for the initial term at contract signing and at each subscription renewal. Initial terms generally range from 12 to 18 months, and renewal periods are typically one year. Amounts that are contractually billable and have been invoiced, or which have been collected as cash, are initially recorded as deferred revenue or contract liabilities. While most of our customers are invoiced once at the beginning of the term, a portion of customers are invoiced semi-annually, quarterly, or monthly. Included in the total subscription fee for cloud-based solutions are non-refundable upfront fees that are typically charged to new customers. These fees are associated with work performed to set up a customer with our services, and do not represent a distinct good or service. Instead, the fees are included within the transaction price and are allocated to the remaining performance obligations in the contract. We recognize revenue for these fees in accordance with the revenue recognition for those performance obligations. Professional Services Revenue We invoice for professional service arrangements on a fixed fee, milestone, or time and materials basis. Professional services revenue includes fees from providing tax analysis, configurations, registrations, data migrations, integration, training, and other support services. The transaction price allocated to professional services performance obligations is recognized as revenue as services are performed or upon completion of work. Judgments and Estimates Our contracts with customers often include obligations to provide multiple services to a customer. Determining whether services are considered distinct performance obligations that should be accounted for separately from one another requires judgment. Subscription services and professional services are both distinct performance obligations that are accounted for separately. Judgment is required to determine the standalone selling price (“SSP”) for each distinct performance obligation. We allocate revenue to each performance obligation based on the relative SSP. We determine SSP for performance obligations based on overall pricing objectives, which take into consideration observable prices, market conditions and entity-specific factors. This includes a review of historical data related to the services being sold and customer demographics. We use a range of amounts to estimate SSP for performance obligations. There is typically more than one SSP for individual services due to the stratification of those services by information, such as size and type of customer. The revenue recognition critical accounting policy under ASC 605 is included in the Annual Report on Form 10-K for the year ended December 31, 2018, which was filed with the SEC on February 28, 2019. Assets Recognized from the Costs to Obtain a Contract with a Customer We recognize an asset for the incremental costs of obtaining a contract with a customer if we expect the benefit of those costs to be longer than one year. We have determined that certain costs related to employee sales incentive programs (sales commissions) and partner commission programs represent incremental costs of obtaining a contract and, therefore, should be capitalized. Capitalized costs are included in deferred commissions on the consolidated balance sheets. Deferred commissions are amortized over an estimated period of benefit, generally six years. We determine the period of benefit by taking into consideration past experience with customers, the expected life of acquired technology that generates revenue, industry peers, and other available information. The period of benefit is generally longer than the term of the initial contract because of anticipated renewals. We elected to apply the practical expedient to recognize the incremental costs of obtaining a contract as an expense if the amortization period of the asset would have been one year or less. For 2019, amortization of deferred commissions was $7.3 million. If the estimated period of benefit was changed from 6 years to 5 years, amortization of deferred commissions would have increased by $0.4 million. If the estimated period of benefit was changed from 6 years to 7 years, amortization of deferred commissions would have decreased by $0.6 million. Stock-Based Compensation Stock-based compensation expense is measured and recognized in our consolidated financial statements based on the fair value of our common stock underlying the stock-based awards. These awards include stock options, restricted stock units (“RSUs”), and purchase rights issued under our 2018 Employee Stock Purchase Plan (“ESPP”). The fair value of each award, excluding RSUs, is estimated on the grant date using the Black-Scholes option-pricing model. The fair value of each RSU is determined using the fair value of the underlying common stock on the date of the grant. Stock-based compensation expense is recognized on a straight-line basis in the consolidated statements of operations over the period during which the participant is required to perform services in exchange for the award, which is generally four years for stock options and RSUs and generally six months for purchase rights issued under the ESPP. Forfeitures are accounted for upon occurrence. The determination of the grant date fair value of stock-based awards using the Black-Scholes option-pricing model is affected by our estimated common stock fair value as well as other highly subjective assumptions, including the expected term of the awards, our expected volatility over the expected term of the awards, expected dividend yield, and risk-free interest rates. The assumptions used in our option-pricing model require significant judgment and represent management’s best estimates. These assumptions and estimates are as follows: • Fair Value of Common Stock. Prior to our initial public offering, we estimated the fair value of common stock as discussed in “Common Stock Valuations” below. • Expected Term. The expected term of employee stock-based awards represents the weighted average period that the stock awards are expected to remain outstanding. To determine the expected term for stock options, we apply the simplified approach in which the expected term of an award is presumed to be the mid-point between the vesting date and the expiration date of the award. • Expected Volatility. As we have limited trading history for our common stock, the selected volatility used is representative of expected future volatility. We based expected future volatility on the historical and implied volatility of comparable publicly traded companies over a similar expected term. • Expected Dividend Yield. We have never declared or paid cash dividends and do not presently intend to pay cash dividends in the foreseeable future. As a result, we used an expected dividend yield of zero. • Risk-Free Interest Rates. We based the risk-free interest rate on the rate for a U.S. Treasury zero-coupon issue with a term that closely approximates the expected life of the stock award grant at the date nearest the stock award grant date. If any assumptions used in the Black-Scholes option-pricing model change significantly, stock-based compensation for future awards may differ materially compared with the awards granted previously. For 2019, 2018, and 2017, stock-based compensation expense was $34.4 million, $15.9 million, and $11.8 million, respectively. As of December 31, 2019, we had approximately $30.3 million of total unrecognized stock-based compensation expense related to stock options, $66.6 million of unrecognized stock-based compensation expense related to RSUs, and $0.3 million of unrecognized stock-based compensation expense related to the ESPP, which we expect to recognize over a period of approximately 2.5 years, 3.3 years, and one month, respectively. Common Stock Valuations Following the closing of our IPO, the fair value per share of our common stock for purposes of determining stock-based compensation is the closing price of our common stock as reported on the applicable grant date. Prior to our IPO in June 2018, the fair value of the common stock underlying our stock options and common stock warrants was estimated by our Board of Directors, with input from management. Because stock-based compensation is recognized over the requisite service period (generally four years), our 2019 stock-based compensation expense includes a significant portion attributable to the common stock valuations described below. The estimated fair value of our common stock was determined at each valuation date in accordance with the guidelines outlined in the American Institute of Certified Public Accountants Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. Each valuation of our common stock was done using significant judgment and considering a variety of factors, including the following: • contemporaneous valuations performed at periodic intervals by unrelated third-party valuation firms; • the prices, rights, preferences and privileges of our preferred stock relative to our common stock; • the lack of marketability of our common stock; • our actual operating and financial performance; • current business conditions and projections; • hiring of key personnel and the experience of our management; • our stage of development; • the likelihood of achieving a liquidity event, such as an initial public offering, a merger, or an acquisition of our business; • the market performance of comparable publicly traded companies; and • macroeconomic conditions, including U.S. and global capital market conditions. The enterprise value utilized in determining the fair value of common stock for financial reporting purposes was estimated using the market approach and the income approach. Under the market approach, we used the guideline public company method, which estimates the fair value of the business enterprise based on market prices of stock of guideline public companies and an option pricing method (“OPM”) that considered our September 12, 2016 Series D-2 preferred stock financing. Indications of value were estimated by utilizing revenue multiples to measure enterprise value. The guideline merged and acquired company method was not utilized in our valuation, as we regarded the method as less reliable as we believe it did not directly reflect our future prospects. The income approach estimates the enterprise value based on the present value of our future estimated cash flows and our residual value beyond the forecast period. The residual value was based on an exit (or terminal) multiple observed in the comparable company method analysis. The future cash flows and residual value are discounted to present value to reflect the risks inherent in us achieving these estimated cash flows. The discount rate was based on venture capital rates of return for companies nearing an initial public offering. The discount rate was applied using the mid-year convention. The mid-year convention assumes that cash flows are generated evenly throughout the year, as opposed to in a lump sum at the end of the year. Our indicated enterprise value at each valuation date was allocated to the shares of our convertible preferred stock, common stock, warrants, and options using either an OPM or a probability-weighted expected return method, or PWERM. An OPM treats common stock and convertible preferred stock as call options on a business, with exercise prices based on the liquidation preference of the convertible preferred stock. Therefore, the common stock has value only if the funds available for distribution to shareholders exceed the value of the liquidation preference at the time of a liquidity event, such as a merger, sale, or initial public offering, assuming the business has funds available to make a liquidation preference meaningful and collectible by shareholders. The common stock is modeled as a call option with a claim on the business at an exercise price equal to the remaining value immediately after the convertible preferred stock is liquidated. The OPM uses the Black-Scholes option-pricing model to price the call option. Under a PWERM approach, the value ascribed to each share is based upon the probability-weighted present value of expected future investment returns, considering each of the possible future scenarios available to the business enterprise, as well as the rights of each class of stock. Finally, because we were a privately held company, we also applied a non-marketability discount in determining the fair value of our common stock based on the protective put model, which we deemed appropriate because it typically results in a low discount, to derive a fair value of our common stock on a non-marketable basis. Business Combinations, including Intangible Assets, Contingent Consideration, and Goodwill The results of a business acquired in a business combination are included in our consolidated financial statements from the date of the acquisition. Purchase accounting results in assets and liabilities of an acquired business being recorded at their estimated fair values on the acquisition date. Any excess consideration over the fair value of assets acquired and liabilities assumed is recognized as goodwill. We perform valuations of assets acquired and liabilities assumed and allocate the purchase price to the respective assets and liabilities. Determining the fair value of assets acquired and liabilities assumed requires significant judgment and estimates, including the selection of valuation methodologies, estimates of future revenue, costs and cash flows, discount rates, and selection of comparable companies. We engage the assistance of third-party valuation specialists in concluding on fair value measurements in connection with determining fair values of assets acquired and liabilities assumed in a business combination. These estimates are inherently uncertain and unpredictable, and if different estimates were used the purchase price for the acquisition could be allocated to the acquired assets and liabilities differently from the allocation that we have made. In addition, unanticipated events and circumstances may occur which may affect the accuracy or validity of such estimates, and if such events occur, we may be required to record a charge against the value ascribed to an acquired asset or an increase in the amounts recorded for assumed liabilities. Under the current accounting guidance, we are allowed a one-year measurement period from the date of the acquisition to finalize our preliminary valuation of the tangible and intangibles assets and liabilities acquired and make necessary adjustments to goodwill. Intangible Assets. We evaluate our intangible assets for indications of impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Our intangible assets consist primarily of developed technology and customer relationships arising from business acquisitions. Factors that could trigger an impairment analysis include significant under-performance relative to historical or projected future operating results, significant changes in the manner of our use of the acquired assets or the strategy for our overall business or significant negative industry or economic trends. If this evaluation indicates that the value of the intangible asset may be impaired, we assess the likelihood of recoverability of the net carrying value of the asset over its remaining useful life. If this assessment indicates that the intangible asset is not recoverable, based on the estimated undiscounted future cash flows of the technology over the remaining useful life, we reduce the net carrying value of the related intangible asset to fair value. Contingent Consideration (Earnout Liability). Contingent consideration arising from business combinations may be payable in cash or the company’s common stock and is recorded as a liability upon acquisition and measured at fair value each subsequent reporting period. Changes in fair value are recorded in Other (income) expense, net in the consolidated statements of operations. As of December 31, 2019, our total liability related to contingent consideration for business combinations was $13.8 million. For 2019, 2018, and 2017, other income for subsequent period fair value measurements was $1.0 million, $0.4 million, and $0.7 million, respectively. Determining the fair value of contingent consideration requires us to make assumptions and judgments. We estimate the fair value of contingent consideration using the probability-weighted discounted cash flow and Monte Carlo simulations. These estimates involve inherent uncertainties and if different assumptions had been used, the fair value of contingent consideration could have been materially different from the amounts recorded. Goodwill. Goodwill is assessed for impairment at the reporting unit level at least annually on October 31, or in the event of certain occurrences. We have three reporting units for purposes of analyzing goodwill, consisting of our U.S., European, and Brazilian operations. Our impairment assessment involves comparing the fair value of each reporting unit to its carrying value, including goodwill. If the fair value exceeds the carrying value, we conclude that no goodwill impairment has occurred. In assessing goodwill for impairment, we first assess the qualitative factors to determine whether events or circumstances indicate that it is more likely than not that the fair value of a reporting unit is less than its carrying value. The next step in our assessment is to perform a quantitative analysis, if necessary, which involves determining the fair value of the reporting unit. We estimate the fair value of the reporting unit using both an income approach and a market approach, which are Level 3 measurements under the fair value hierarchy. The income approach uses discounted future cash flows derived from current internal forecasts, which include assumptions for long-term growth rates and a residual value (the hypothetical terminal value) for the reporting unit. Cash flows are discounted using the weighted average cost of capital, which is risk-adjusted to reflect the specific risk profile of the reporting unit. The market approach identifies similar publicly traded companies to the reporting unit and develops a correlation, referred to as a multiple, to apply to the operating results of the reporting unit. The primary market multiple we compare to is revenue. The market approach also reflects a reasonable control premium to compute the fair value. These estimates involve inherent uncertainties and if different assumptions are used, the fair value of a reporting unit could be materially different from the amount we computed. As part of our annual impairment test, a qualitative impairment test was performed for the Company’s U.S. reporting unit. We concluded it is more likely than not that the fair value of the reporting unit exceeds its carrying value. A quantitative test was performed for the European reporting unit. The European reporting unit had goodwill with a carrying value of $10.6 million as of October 31, 2019. From our quantitative assessment, we determined that the fair value of the European reporting unit was substantially in excess of its carrying value. Our internal cash flow forecast includes significant revenue growth attributable to a single customer. While this single customer is not currently significant to our consolidated results, it is expected to be significant to the European reporting unit representing assumed future revenues contributed in the near-term and long-term of approximately 45% of the total reporting unit revenue. If our revenue growth assumptions are not realized or our expectations with respect to future revenue growth are reduced, the fair value of the European reporting unit would be adversely impacted. Significant estimates and assumptions used in the income approach for the European reporting unit included using a discount rate of 25% and a hypothetical terminal value of 1.65 times revenue. For the market approach, significant estimates and assumptions included our selection of an appropriate peer group, consisting of publicly traded U.S. and European companies, which allowed us to derive revenue multiples (e.g., trailing twelve months and next fiscal year) averaging approximately 3.0 times revenue and a selected control premium of 10%. JOBS Act Accounting Election Prior to December 31, 2019, the Company qualified as an emerging growth company, or “EGC” as defined in the Jump-start Our Business Start-ups Act (“JOBS Act”), which allowed the Company to delay adoption of new or revised accounting pronouncements applicable to public companies until such pronouncements are made applicable to private companies. Effective December 31, 2019, the Company is no longer an EGC and has transitioned to a large accelerated filer status as a result of the market value of the common stock held by the Company’s non-affiliates as of June 30, 2019. As a result, the Company will adopt new or revised accounting pronouncements at dates applicable to public companies. Additionally, as a result of losing EGC status, the Company is required to have an independent registered public accounting firm issue an opinion on the effectiveness of internal control over financial reporting on an annual basis. Recent Accounting Pronouncements For further information on recent accounting pronouncements, refer to Note 2 in the accompanying notes to the consolidated financial statements contained within this Annual Report on Form 10-K.

<s>[INST] Overview We provide a leading suite of cloudbased solutions that help businesses of all types and sizes comply with transaction tax requirements worldwide. Our Avalara Compliance Cloud offers a broad and growing suite of compliance solutions that enable businesses to address the complexity of transaction tax compliance, process transactions in real time, produce detailed records of transaction tax determinations, and reduce errors, audit exposure and total transaction tax compliance costs. We sell our solutions primarily through our sales force, which focuses on selling to qualified leads provided by our marketing efforts and by partner referrals. Our marketing investments and related activities generate awareness from many businesses, both large and small, and enhance communications with our existing customers. We focus on maintaining and expanding our partner network, which has been an essential part of our growth. We continue to increase the available number of partner integrations, which are designed to link our tax compliance solutions to a wide variety of business applications, including accounting, ERP, ecommerce, POS, recurring billing, and CRM systems. Partners also improve our sales efficiency by bringing us qualified leads and provide for a better onboarding process and customer experience. During 2019, we continued to benefit from the adoption of economic nexus legislation by many U.S. states following the June 2018 U.S. Supreme Court decision in South Dakota v. Wayfair, Inc., which requires certain outofstate retailers to collect and remit sales taxes on sales into South Dakota. Since that decision, many U.S. states have adopted similar economic nexus legislation. These developments have increased awareness of transaction tax issues and increased the sense of urgency among many businesses to comply with new laws. We believe we are wellpositioned to continue to benefit from these changes in 2020 and beyond. During 2019, we continued our acquisition strategy to provide new solutions and expand our market opportunity. We acquired a provider of U.S. compliance services, technology, and software to the beverage alcohol industry, an artificial intelligence company to expand and maintain our tax content database, and a provider of Harmonized System classifications and outsourced customs brokerage support services to expand our crossborder solutions. In addition to acquisitions, we continued to invest organically by devoting significant resources to continuous improvement of our existing solutions, by adding new features and functionalities, building technology to support new content, and improving our customers’ experience with our products. We expect to continue to make significant investments, both organically and through acquisitions, to gain new and relevant content, technology, and expertise that best serve the transaction tax needs of our customers. We also will continue making significant investments to improve our existing solutions and customer experience. Total revenue for 2019 was $382.4 million, an increase of 41% from $272.1 million in 2018. Most of our revenue comes from subscriptions and returns, with approximately 93% in both 2019 and 2018. Our revenue growth was attributable to adding new customers and expanding service offerings to existing customers. While only 6% of total revenue for 2019 was generated outside the U.S., we are aggressively targeting and investing internationally, including in Europe and Latin America. We added approximately 2,890 core customers during 2019 and delivered a net revenue retention rate of 111% on average over the past four quarters. We use core customers, which represent more than 80% of our total revenue, as a metric to focus our customer count reporting on the midmarket segment, which is our primary market. We use net revenue retention rate to reflect the stability of our revenue base and to provide insight into our ability to grow existing customer revenues. Despite improved revenue during 2019, our gross margin declined to 70% compared to 71% in 2018. The decline in gross margin was due primarily to higher software hosting costs and, to a lesser extent, higher costs to support our international products and operations. Operating expenses increased to $323.0 million in 2019 from $269.5 million in 2018, as we continued to make significant investments in our future growth. Sales and marketing expenses were $168.6 million in 2019, or [/INST] Negative. </s>

California BanCorp

2020-04-14

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 together with our Consolidated Financial Statements and accompanying notes presented elsewhere in this report. 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 many factors, including those set forth under Item 1A “Risk Factors” and elsewhere in this Report. Please see the “Forward Looking Information” immediately preceding Part I of this Report. Overview California BanCorp is a California corporation that was organized to serve as the holding company for California Bank of Commerce. On June 30, 2017, we completed a reorganization in which California BanCorp became the Bank’s holding company. As a registered bank holding company under the Bank Holding Company Act, the Company is subject supervision and regulation by the Federal Reserve. California Bank of Commerce, which was incorporated in 2007, is a California -chartered commercial bank headquartered in Lafayette, California. The Bank is regulated by the FDIC and the DBO and is not a member of the Federal Reserve. The Bank has seven offices, six of which are in the San Francisco Bay Area and all of which are in Northern California. These offices include three banking offices in Lafayette (the Bank’s headquarters), Fremont and San Jose, where the Bank offers loan, deposit and treasury management products. The Bank also has four loan production offices in Oakland, Walnut Creek, San Jose and Sacramento, California. As with most community banks, the Bank derives a significant portion of its income from interest received on loans and investments. The Bank’s primary source of funding is deposits, both interest-bearing and noninterest-bearing. In order to maximize the Bank’s net interest income, or the difference between the income on interest-earning assets and the expense of interest-bearing liabilities, the Bank must not only manage the volume of these balance sheet items, but also the yields earned on interest-earning assets and the rates paid on interest-bearing liabilities. To account for credit risk inherent in all loans, the Bank maintains an allowance for loan losses to absorb possible losses on existing loans that may become uncollectible. The Bank establishes and maintains this allowance by charging a provision for loan losses against operating earnings. Beyond its net interest income, the Bank further receives income through the net gain on sale of loans held for sale as well as servicing income which is retained on those sold loans. In order to maintain its operations and bank locations, the Bank incurs various operating expenses which are further described within the “Results of Operations” later in this section. As of December 31, 2019, the Company had total consolidated assets of $1.2 billion, total gross loans of $949.7 million, total deposits of $988.2 million and total shareholders’ equity of $130.3 million. The Company employs approximately 133 full-time equivalent employees and has an assets-to-FTE ratio of approximately $9.0 million. Critical Accounting Policies and Estimates Our accounting and reporting policies conform to accounting principles generally accepted in the United States of America (“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 following is a discussion of the critical accounting policies and significant estimates that require us to make complex and subjective judgments. Additional information about these policies can be found in Note 1 of our consolidated financial statements as of December 31, 2019, included elsewhere in this report. 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 uncollectibility 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. The allowance for loan losses is maintained at a level that management believes is appropriate to provide for known and inherent incurred loan losses as of the date of the consolidated balance sheet and we have established methodologies for the determination of its adequacy. The methodologies are set forth in a formal policy and take into consideration the need for an overall general valuation allowance as well as specific allowances that are determined on an individual loan basis. The evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available. While management uses available information to recognize losses on loans, changes in economic or other conditions may necessitate revision of the estimate in future periods. Summary of Performance Our net income was $7.0 million for the year ended December 31, 2019, compared to $8.7 million for the year ended December 31, 2018. The decrease in net income of $1.7 million, or 19.6% was primarily driven by increases in noninterest expense and provision for loan losses, which offset increases in net interest income and noninterest income. • Our net interest income increased by $5.1 million, or 14.2%. The increase in net interest income was the result of growth in average earning assets of $116.4 million, or 13.3%, and expansion of our net interest margin to 4.12% in the year ended December 31, 2019 from 4.09% in the same period of 2018. • Our loan loss provision increased by $891 thousand, or 62.1%, during 2019 compared to the same period of 2018. • Noninterest income grew by $532 thousand or 14.3% during the year ended December 31, 2019 compared to the same period in 2018. • Noninterest expense grew by $6.9 million or 26.0% during 2019 compared to 2018. Summary of Performance-Financial Condition December 31, 2019 relative to December 31, 2018 • Total assets were $1.2 billion at December 31, 2019, an increase of $146.4 million or 14.6% compared to $1.0 billion at December 31, 2018. • Total gross loans grew by $104.9 million or 12.4% to $949.7 million at December 31, 2109 from $844.7 million at December 31, 2018. • Total deposits grew by $114.0 million or 13.0% to $988.2 million at December 31, 2019 compared to $874.2 million at December 31, 2018. Noninterest bearing deposits grew by $34.9 million or 9.9%. • Total shareholders’ equity increased by $9.2 million or 7.6%. As of December 31, 2019, the Company’s total risk-based capital ratio was 11.99% and its Tier 1 leverage ratio was 10.64%. Results of Operations Net Interest Income and Net Interest Margin Our net interest income increased to $40.9 million in 2019 from $35.8 million in 2018. The increase of $5.1 million or 14.2% in 2019 was primarily the result of higher average earning assets, a $116.4 million increase or 13.3% compared to 2018, as well as an increase in our net interest margin to 4.12% from 4.09%. The increase in net interest margin for the period was primarily due to an increase in the percentage of average earning assets represented by loans, which has grown to 91.1% in December 31, 2019 from 86.2% in 2018. The following table shows the annual average balance for each principal balance sheet category, and the amount of interest income or expense associated with that category for the years ended December 31, 2019 and 2018. The table also shows the yields earned on each major component of our investment and loan portfolio, the average rates paid on each key segment of our interest bearing liabilities, and the net interest margin. Distribution, Yield and Rate Analysis of Net Interest Income and Net Interest Margin For the Year Ended December 31, 2019 For the Year Ended December 31, 2018 Average Balance Interest Income/ Expense Average Yield/ Rate(1) Average Balance Interest Income/ Expense Average Yield/ Rate(1) Assets: Loans, gross(1) $903,921,555 $46,914,858 5.19% $755,659,225 $38,443,340 5.09% Securities 37,866,932 1,164,519 3.08% 23,377,672 635,410 2.72% Interest bearing deposits and fed funds sold 50,890,463 999,015 1.96% 97,250,623 1,859,592 1.91% Total interest earning assets 992,678,950 49,078,392 4.94% 876,287,520 40,938,342 4.67% Cash and due from banks 19,663,364 18,497,543 Premises and equipment, net 1,893,369 2,426,713 Goodwill and other intangible assets 7,623,509 7,768,128 Other assets 42,593,087 25,376,764 Total assets $1,064,452,279 $930,356,668 Liabilities and shareholders’ equity: Deposits: Demand, noninterest-bearing $342,720,451 $331,809,172 Demand, interest-bearing 24,450,491 23,834 0.10% 26,199,672 21,697 0.08% Savings and Money market 411,744,974 4,805,575 1.17% 363,232,025 3,004,131 0.83% Time deposits-under $100,000 7,480,742 99,632 1.33% 6,584,456 61,347 0.93% Time deposits-$100,000 and over 107,496,662 2,279,822 2.12% 85,839,772 1,374,270 1.60% Total interest-bearing deposits 551,172,869 7,208,863 1.31% 481,855,925 4,461,445 0.93% Total deposits 893,893,320 7,208,863 0.80% 813,665,097 4,461,445 0.55% Borrowings 29,717,185 931,442 3.13% 11,908,315 644,221 5.41% Total interest-bearing liabilities 580,890,054 8,140,305 1.40% 493,764,240 5,105,666 1.03% Other liabilities 14,124,694 4,072,444 937,735,198 829,645,856 Total liabilities Shareholders’ equity 126,717,081 100,710,812 Total liabilities and shareholders’ equity $1,064,452,279 $930,356,668 Net interest income / margin(3) 4.12% 4.09% Net interest income $40,938,087 $35,832,676 (1) Amortization of loan fees net of origination costs have been included in the calculation of interest income. The amortization resulted in net costs of approximately $1,062,483 and $1,246,548 for the years ended December 31, 2019 and 2018, respectively. (2) Net interest margin is net interest income divided by total interest earning assets. The following table 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 average balance multiplied by prior period rates, and rate variances are equal to the increase or decrease in rate times prior period average balances. Variances attributable to both rate and volume changes are calculated by multiplying the change in rate by the change in average balance, and are allocated to the volume variance. Years Ended December 30, 2019 vs. 2018 Increase (Decrease) Due to Change In: Average Volume Average Rate Net Change Income from interest earning assets: Loans, gross $7,631,354 $840,164 $8,471,518 Securities 478,239 50,870 529,109 Cash and due from banks (909,949) 49,372 (860,577) Total interest income from interest earnings assets 7,199,644 940,406 8,140,050 Expense on interest-bearing liabilities: Demand, interest-bearing (1,705) 3,842 2,137 Savings and Money market 566,206 1,235,238 1,801,444 Time deposits-under $100,000 11,937 26,348 38,285 Time deposits-$100,000 and over 459,306 446,246 905,552 Total interest expense on interest-bearing deposits 1,035,744 1,711,674 2,747,418 Borrowings 202,613 84,608 287,221 Net interest income $5,961,287 $(855,876) $5,105,411 Interest Income Interest income increased by $8.1 million in 2019 compared to 2018, primarily due to volume growth in average earning assets, and in particular an increase in loans. The increase in interest earned on our loan portfolio of $8.4 million in 2019 compared to the 2018 was comprised of $7.6 million attributable to an approximate $148.3 million increase in average loans outstanding and $840 thousand attributable to an increase in the yield earned on loans to 5.19% from 5.09%. In addition to the increase from greater loan volume and yields in 2019 compared to 2018, interest income also increased by $529 thousand primarily as a result of a higher volume of investment securities. For the year ended December 31, 2019 average investment securities increased approximately $14.5 million, or 62%, to $37.9 million. In addition, the average yield earned on investment securities during 2019 increased to 3.07% compared to 2.72% in 2018, which was largely the effect of generally higher medium and long term interest rates and slightly higher duration in the portfolio. Partially offsetting these increases was a decrease of $861 thousand in interest earned on interest-bearing deposits and fed funds sold. Average interest-bearing deposits and fed funds sold decreased $46.4 million to $50.9 million in 2019 from $97.3 million in 2018. Interest Expense Our interest expense increased by $3.0 million or 59.4% in 2019 primarily due to the effect of increased rates paid on interest-bearing deposits and the overall growth in the volume of average interest-bearing deposits and borrowings to fund earning asset growth. The average rate paid on interest-bearing liabilities in 2019 increased 37 basis points to 1.40% from 1.03% in 2018, which accounted for $1.8 million of the total increase in interest expense. An additional increase in interest expense of $1.2 million was attributable to an increase in average interest-bearing liabilities of $87.1 million. Our overall cost of funds was 0.82% in 2019 compared to 0.58% in 2018 as growth in average noninterest bearing demand deposits offset, in part, the cost of average interest-bearing deposits. Average noninterest bearing demand deposits of $342.7 million in the 2019 represented 38.3% of total deposits compared to $331.8 million and 40.8% in 2018. Our ability to manage the cost of our deposit funding is partially dependent on our ability to continue to attract noninterest-bearing demand deposits as part of a business banking relationship with our customers. Provision for Loan Losses We made provisions for loan losses of $2.3 million and $1.4 million for the years ended December 31, 2019 and 2018, respectively. We recorded net loan charge-offs of $2.1 million in 2019 compared to net recoveries of $65,000 during 2018. The increase in our provision reflects the impact of loan growth and higher charge-off activity. The allowance for loan loss as a percent of outstanding loans declined to 1.17% at December 31, 2019 from 1.28% at December 31, 2018. The decrease in the reserve percentage reflects the impact enhancements to our qualitative methodology and higher charge-off activity in 2019. See further discussion in “Financial Condition - Allowance for Loan Losses” Noninterest Income The following table sets forth the various components of noninterest income for the periods indicated: Year Ended December 31, Increase (Decrease) 2019 versus 2018 Amount Percent Service charges and other fees $3,003,057 $2,451,405 $551,652 23% Earnings on BOLI 528,489 251,726 276,763 110% Net gain on sales of investment securities - 96,568 (96,568) N/M Net gains on sales of loans 252,668 417,520 (164,852) -39% Other 463,306 498,693 (35,387) -7% Total noninterest income $4,247,520 $3,715,912 $531,608 14% Noninterest income grew by $532 thousand or 14% in 2019, compared to 2018. The increase was primarily attributable to growth in service charges and other fees related to growth in noninterest-bearing deposits and loans as well as an increase in earnings from bank-owned life insurance. Partially offsetting increases in those categories were decreases in nonrecurring revenues from gains on sales of loans and investment securities. Noninterest Expense The following table sets forth our noninterest expenses for the periods indicated: Year Ended December 31, Increase (Decrease) 2019 versus 2018 Amount Percent Salaries and employee benefits $20,674,248 $15,572,646 $5,101,602 33% Occupancy and equipment 3,501,701 2,917,875 583,825 20% Professional fees 2,585,317 1,761,108 824,209 47% Data processing 1,882,976 1,539,842 343,134 22% Advertising and marketing 1,290,640 781,370 509,270 65% Directors’ stock-based and other compensation 790,390 978,347 (187,957) -19% Regulatory assessments and insurance 353,374 525,354 (171,980) -33% Loan processing 551,511 523,726 27,785 5% Other 1,592,605 1,771,258 (178,653) -13% Total noninterest expense $33,222,761 $26,371,526 $6,851,235 26% Noninterest expense grew $6.8 million or 26% to $33.2 million in 2019 compared to $26.4 million in 2018. Noninterest expense as a percentage of average earnings assets increased from the prior year, growing to 3.4% in 2019 from 3.0% in 2018. The largest component of noninterest expense is salaries and benefits expense, which increased by approximately $5.1 million or 33% in 2019 compared to 2018. The increase in salary and benefits expense was primarily the result of hiring of key executive, lending and operational staff positions to support the Company’s continued growth. The number of full-time equivalent staff grew to 133 as of December 31, 2019 from 111 on December 31, 2018. Occupancy and equipment increased $583.8 thousand, or 20%, in 2019 to $3.5 million from $2.9 million in 2018. The increase in occupancy was related to expansion activities in our Oakland and San Jose facilities to accommodate growth. Professional fees of $2.6 million for the year ended December 31, 2019 increased $824.2 thousand, or 47%, over $1.8 million for the same period in 2018. The increase in professional fees related to work in connection with FDICIA implementation, public registration of our shares on Nasdaq and remediation of material weaknesses in financial reporting controls identified in the external audits for 2018. Advertising and marketing costs increased $509.3 thousand, or 65%, to $1.3 million in 2019 compared to $781.4 thousand in 2018. The increase in 2019 was primarily related to an initiative to refresh branding and advertising campaigns. Provision for Income Taxes Income tax expense was $2.6 million in 2019 which compared to a $3.0 million for the same period in 2018. Our effective tax rate increased slightly to 27.4% in 2019 from 25.8% in 2018. Financial Condition Summary Total assets grew by $146.4 million or 14.6% to $1.2 billion during the year ended December 31, 2019 compared to $1.0 billion at December 31, 2018. The increase in assets was primarily due to loan growth, which was $104.9 million, or 12.4% in 2019. Growth in assets was primarily funded by growth in deposits and borrowing as well as a reduction in cash and due from banks and investment securities. Substantially all of our funding comes from deposits maintained by core business customer relationships. In 2019, deposits grew by $114.0 million or 13.0%, of which $34.9 million was noninterest-bearing demand accounts and $79.1 million was interest-bearing deposits. Loan Portfolio Our loan portfolio consists almost entirely of loans to customers who have a full banking relationship with us. Gross loan balances increased by $104.9 million or 12.4% from December 31, 2018 to December 31, 2019. The loan portfolio at December 31, 2019 was comprised of approximately 41.0% of commercial and industrial loans compared to 39.8% at December 31, 2018. In addition, commercial real estate loans comprised 57.5% of our loans at December 31, 2019 compared to 58.7% at December 31, 2018. A substantial percentage of the commercial real estate loans are considered owner-occupied loans. Our loans are generated by our relationship managers and executives. Our senior management is actively involved in the lending, underwriting, and collateral valuation processes. Higher dollar loans or loan commitments are also approved through a bank loan committee comprised of executives and outside board members. The following tables set forth the composition of our loan portfolio as of the dates indicated: Loan Portfolio Composition December 31, December 31, Loans: Commercial & Industrial $389,745,758 $336,234,467 Real estate-Construction & Land 42,518,666 42,294,500 Real estate-Other 502,929,381 451,850,943 Real estate-HELOC 981,897 2,064,056 Installment and other 13,476,383 12,284,106 Loans 949,652,085 844,728,072 Deferred loan (fees) costs, net 2,554,746 2,203,164 Allowance for loan losses (11,074,947) (10,800,000) Loans, net $941,131,884 $836,131,236 The following table shows the maturity distribution for total loans outstanding as of December 31, 2019. The maturity distribution is grouped by remaining scheduled principal payments that are due within one year, after one but within five years, or after five years. The principal balances of loans are indicated by both fixed and floating rate categories. Loan Maturities and Re-pricing Schedule Due in One Year Or Less Over One Year But Less than Five Years Over Five Years Total Loans with Fixed Rates(1) Loans with Variable Rates (Dollars in thousands) Commercial & Industrial $137,935,732 $ 88,697,977 $163,112,049 $389,745,758 $226,279,871 $163,465,888 Real estate-Construction & Land 18,737,870 14,119,256 9,661,540 42,518,666 7,546,659 34,972,007 Real estate-Other 21,857,376 88,436,351 392,635,654 502,929,381 205,182,812 297,746,478 Real estate-HELOC - 525,000 456,897 981, 987 - 981,987 Installment and other 843,058 1,620,961 11,012,364 13,476,383 308,888 13,167,495 Loans $179,374,036 $193,399,545 $576,878,504 $949,652,085 $439,318,230 $510,333,855 (1) Excludes variable rate loans on floors. In the normal course of business, we make commitments to extend credit to our customers as long as there are no violations of any conditions established in contractual arrangements. Total unused commitments to extend credit were $374.0 million at December 31, 2019 compared to $325.5 million as of December 31, 2018. Unused commitments represented 33.4% and 38.5% of gross loans outstanding at December 31, 2019 and December 31, 2018, respectively. We also had $7.7 million and $7.5 million in standby letters of credit and commercial letters of credit at December 31, 2019 and December 31, 2018. These commitments are obligations that represent a potential credit risk to us, and a $185 thousand reserve for unfunded commitments is reflected as a liability in the our balance sheet at December 30, 2019. The effect on our revenues, expenses, cash flows and liquidity from the unused portion of the commitments to provide credit cannot be reasonably predicted, because there is no certainty that lines of credit will ever be fully utilized. Nonperforming Assets Nonperforming assets are comprised of loans on nonaccrual status, loans 90 days or more past due and still accruing interest, and other real estate owned. We had no loans 90 days or more past due and still accruing interest and no other real estate owned at December 31, 2019. A loan is placed on nonaccrual status if there is concern that principal and interest may not be fully collected or if the loan has been past due for a period of 90 days or more, unless the obligation is both well secured and in process of legal collection. When loans are placed on nonaccrual status, all interest previously accrued but not collected is reversed against current period interest income. Income on nonaccrual loans is subsequently recognized only to the extent that cash is received and the loan’s principal balance is deemed collectible. Loans are returned to accrual status when they are brought current with respect to principal and interest payments and future payments are reasonably assured. Loans in which the borrower is encountering financial difficulties and we have modified the terms of the original loan are evaluated for impairment and classified as TDR loans. The following table presents information concerning our nonperforming and restructured loans as of the dates indicated: Nonperforming and Restructured Loans December 31, December 31, Nonaccrual loans $2,752,910 $4,463,232 Loans over 90 days past due and still accruing - - Total nonperforming loans 2,752,910 4,463,232 Foreclosed assets - - Total nonperforming assets 2,752,910 4,463,232 Performing TDRs $646,177 $930,123 Allowance for Loan Losses We maintain an allowance for loan losses at a level that management believes is adequate to provide for loan losses based on currently available information. A comprehensive discussion concerning our allowance for loan losses is included in Note 3 of the accompanying interim Financial Statements. Our allowance for loan losses was $11.1 million at December 31, 2019, compared to $10.8 million at December 31, 2018. The increase resulted from a provision for loan losses of $2.3 million and $2.1 million in net charge-offs. Charge-off activity was primarily attributed to one commercial loan for $1.6 million during the third quarter of 2019. The $2.3 million in provisions for loan losses during 2019 was generally attributable to recognition of the change in inherent risk represented in the mix of loan growth and to absorbing charge-off activity. The allowance for loan loss as a percent of outstanding loans decreased to 1.17% at December 31, 2019 from 1.28% at December 31, 2018. During 2019, we made enhancements to our methodology for applying qualitative factors in determining our reserve. Generally, we sought to establish additional drivers of specific risks through segments of the portfolio that were quantifiable and updated measures to reflect recent trends in the drivers for application of qualitative assessments. This enabled us to apply judgements to specific segments of the portfolio, where previously we applied them to a broad portfolio and to reflect more recent experience in individual segments. A detailed discussion of the changes in elements of the reserve appears below following the “Allocation of the Allowance for Loan Losses.” A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due (principal and interest) according to the original contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and probability of collecting scheduled principal and interest payments. Measurement of impairment is based on the present value of expected future cash flows of the impaired loan, which are discounted at the loan’s effective interest rate. For collateral-dependent loans, we use the fair value of the collateral for the impaired loan to measure impairment. An impairment allowance is established to record the difference between the carrying amount of the loan and the present value, or in the case of a collateral-dependent loan, the fair value of the collateral. As of December 31, 2019, we identified loans totaling $5.6 million as impaired, requiring reserves of $650 thousand, compared to $6.4 million, requiring reserves of $205 thousand, at December 31, 2018. The following table summarizes the activity in the allowance for loan losses for the periods indicated: Allowance for Loan Losses December 31, Balance, beginning of year $10,800,000 $9,300,000 Charge-offs: Commercial & Industrial 1,951,652 - Real estate-Construction & Land - - Real estate-Other - - Real estate-HELOC - - Installment and other 136,541 - Total charge-offs 2,088,193 - Recoveries: Commercial & Industrial 37,000 64,600 Real estate-Construction & Land - - Real estate-Other - - Installment and other - - Total recoveries 37,000 64,600 Net (charge-offs) recoveries (2,051,193) 64,600 Provision for loan losses 2,326,140 1,435,400 Balance, end of year $11,074,947 $10,800,000 Ratios: Annualized net (charge-offs) recoveries to average loans (0.23)% 0.01% Allowance for loan losses to total loans 1.17% 1.28% Allowance for loan losses to nonperforming loans 402% 242% Allocation of Allowance for Loan Losses Provided below is a summary of the allocation of the allowance for loan and lease losses for specific loan categories at the dates indicated. The allocation presented should not be viewed as an indication that charges to the allowance will be incurred in these amounts or proportions, or that the portion of the allowance allocated to each loan category represents the total amounts available for charge-offs that may occur within these categories. Allocation of Allowance for Loan Losses December 31, 2019 December 31, 2018 Allowance Percent of Loans in each category to total loans Allowance Percent of Loans in each category to total loans Commercial & Industrial $6,757,431 1.73% $5,577,564 1.66% Real estate-Construction & Land 1,022,128 2.40% 1,493,045 3.52% Real estate-Other 3,281,216 0.65% 3,703,298 0.82% Real estate-HELOC 6,263 0.64% 15,762 0.76% Installment and other 7,909 0.06% 10,331 0.08% Total allowance for loan losses $11,074,947 1.17% $10,800,000 1.28% At December 31, 2019 the reserve of $11.1 million represented an increase of $275 thousand compared to $10.8 million at December 31, 2018. The increase in the aggregate reserve reflects the charge-off activity in 2019 and the result of assessing the qualitative reserve by trends in each segment of the portfolio. Generally, these factors shifted the allocation of the reserve toward the commercial loan segment from the commercial real estate segment. Specifically, the decrease in the overall reserve was primarily comprised of an increase of $1.2 million in the segment of the reserve allocated to commercial and industrial loans offset by a decrease of $471 thousand in the segment allocated to construction and land, and a decrease of $422 thousand in the segment allocated to other commercial real estate. The following table shows the changes in and allocation of the allowance for loan losses for the period ended December 31, 2019 by portfolio segment, as well as the balances of the allowance for loan losses and loans by portfolio segment and impairment methodology: Commercial & Industrial Real Estate Construction & Land Real Estate - Other Real Estate HELOC Installment & Other Total Allowance for Loan Losses December 31, 2019 Balance at beginning of year $5,577,564 $1,493,045 $3,703,298 $15,762 $10,331 $10,800,000 Provision for loan losses 3,044,519 ( 470,917) (422,082) ( 9,499) 184,119 2,326,140 Loans charged-off 1,951,652 - - - 136,541 2,088,193 Recoveries of loans previously charged-off 37,000 - - - - 37,000 Ending balance allocated to portfolio segments $6,707,431 $1,022,128 $3,281,216 $6,263 $57,909 $11,074,947 Ending balance: individually evaluated for impairment $ 600,245 $- $- $- $50,000 $650,254 Ending balance: collectively evaluated for impairment $6,107,186 $1,022,128 $3,281,216 $6,263 $7,909 $10,424,702 Commercial & Industrial Real Estate Construction & Land Real Estate - Other Real Estate HELOC Installment & Other Total Loans-December 31, 2019 Ending balance $389,745,758 $42,518,666 $502,929,381 $981,897 $13,476,383 $949,652,085 Ending balance: individually evaluated for impairment $ 4,915,721 $- $686,614 $- $- $5,602,335 Ending balance: collectively evaluated for impairment $384,830,037 $42,518,666 $502,242,767 $981,897 $13,476,383 $944,049,750 For additional information on our allowance for loan losses see footnote 3 in our December 31, 2019 financial statements included in this filing. At December 31, 2019, the portion of our reserve allocated to the Commercial and Industrial loan segment was $6.1 million and represents 1.73% of loan balances in this segment. This represented an increase of $1.2 million over $5.6 million and 1.66% at December 31, 2018. The provision of $3.1 million includes $2.0 million to absorb net charge-off activity, $445 thousand increase in specific impairment reserves, $508 thousand increase in our quantitative reserve to accommodate growth in the segment and an increase in our qualitative reserve of $227 thousand. The increase in quantitative reserve is primarily attributed to our growth rate, industry concentrations and recent migration trends in this segment. The increase in our qualitative reserve in 2019 reflects recent trends of growth rate and concentration. We believe our reserves in this segment are adequate to provide for loan losses based on currently available information. At December 31, 2019, the portion of our reserve allocated to the Real Estate-Construction and Land loan segment was $1.0 million, representing 2.40% of loan balances in this segment. This represented a decrease of $471 thousand from $1.5 million and 3.50% at December 31, 2018. The decrease in this segment includes a $224 thousand decrease in our quantitative reserve and a decrease in our qualitative reserve of $246 thousand. The decreases in both the quantitative and qualitative reserves are primarily attributed to seasoning of our business line, which was acquired in 2015, and the performance of loans and migration trends in this segment. We believe our reserves in this segment are adequate to provide for loan losses based on currently available information. At December 31, 2019, the portion of our reserve allocated to the Real Estate - Other loan segment was $3.3 million and represents 0.65% of loan balances in this segment. This represented a decrease of $422 thousand from $3.7 million and 0.81% at December 31, 2018. The decrease resulted from a decrease of $542 thousand in our qualitative reserve, partially offset by an increase of $120 thousand in our quantitative reserve. This portfolio is comprised primarily of loans categorized as Non-farm, Nonresidential in Federal Reserve statistics. The decrease in qualitative reserve is primarily attributed to our low historical loss rate, underwriting conservatism in recent growth production, continuity in credit administration’s oversight of the segment and recent migration trends in this segment. Loan migration trends since 2017 are centered in one loan relationship underwritten under the Small Business Administration’s 504 program. This loan was downgraded in 2017, at which time our exposure was approximately $2.6 million, and has increased to $4.7 million at December 31, 2019 as the project funding progressed to completion. The two loans under this relationship are performing and they have been included in our quantitative reserve calculation. The improvement in this relationship is a favorable development and a significant consideration in our qualitative assessment of trends in this segment. We believe our reserves in this segment are adequate to provide for loan losses based on currently available information. Investment Portfolio Our investment portfolio is comprised of debt securities. We use two classifications for our investment portfolio: available-for-sale (AFS) and held-to-maturity (HTM). Securities that we have the positive intent and ability to hold to maturity are classified as “held-to-maturity securities” and reported at amortized cost. Securities not classified as held-to-maturity securities are classified as “investment securities available-for-sale” and reported at fair value. At December 31, 2019, we had no held-to-maturity investments, compares to $6.0 million at December 31, 2018. Available-for-sale securities had a total fair value of $28.6 million as of December 31, 2019. Available-for-sale securities declined through security maturities and principal repayments during the year ended December 31, 2019. December 31, 2019, available-for-sale securities decreased by $8.9 million or 24% and from December 31, 2018. The decline in AFS securities was associated with the sale and principal repayment of investment securities over the period and the objective to reduce overall portfolio duration. Our investments provide a source of liquidity as they can be pledged to support borrowed funds or can be liquidated to generate cash proceeds. The investment portfolio is also a significant resource to us in managing interest rate risk, as the maturity and interest rate characteristics of this asset class can be readily changed to match changes in the loan and deposit portfolios. The majority of our available-for-sale investment portfolio is comprised of mortgage-backed securities (MBSs) that are either issued or guaranteed by U.S. government agencies or government-sponsored enterprises (GSEs). The following table reflects the amortized cost and fair market values for the total portfolio for each of the categories of investments in our securities portfolio for the indicated periods: December 31, 2019 December 31, 2018 Amortized Cost Fair Value Amortized Cost Fair Value Available-for-sale: Mortgage-backed securities-residential $20,290,259 $20,721,716 $25,404,324 $25,402,933 Government agency 7,823,664 7,832,952 9,508,335 9,510,489 Corporate bonds - - 2,501,004 2,501,460 Total available-for-sale $28,113,923 $28,554,668 $37,413,663 $37,414,882 Held-to-maturity: Government agency $- $- $6,000,000 $5,995,700 Total held-to-maturity $- $- $6,000,000 $5,995,700 The investment maturities table below summarizes contractual maturities for our investment securities and their weighted average yields at December 31, 2019. The actual timing of principal payments may differ from remaining contractual maturities, because obligors may have the right to repay certain obligations with or without penalties. Contractual Maturity Within One Year or Less After One and Within Five Years Over Five Years Securities Not Due at a Single Maturity Date Total Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield Available-for-sale: Mortgage-backed securities-residential $- - % $- - % $- - % $20,721,716 2.22% $20,721,716 2.22% Government agency - - % - - % - - % 7,832,952 2.18% 7,832,952 2.18% Corporate bonds - - % - - % - - % - - % - - % Total available- for-sale $- - % $- - % $- - % $28,554,668 2.21% $28,554,668 2.21% Deposits Our deposits are generated through core customer relationships, related predominantly to business relationships. Many of our business customers maintain high levels of liquid balances in their demand deposit accounts and use the Bank’s treasury management services extensively. At December 31, 2019, approximately 39% of our deposits were in noninterest-bearing demand deposits. The balance of our deposits at December 31, 2019 were held in interest-bearing demand, savings and money market accounts and time deposits. More than 49% of total deposits were held in interest-bearing demand, savings and money market deposit accounts at December 31, 2019, which provide our customers with interest and liquidity. Time deposits comprised the remaining 12% of our deposits at December 31, 2019. Included in time deposits are approximately $49.5 million of reciprocal CDARS balances and $10.0 million of brokered certificates of deposit. Information concerning average balances and rates paid on deposits by deposit type for the past two fiscal years is contained in the Distribution, Yield and Rate Analysis of Net Income table located in the previous section titled “Results of Operations-Net Interest Income and Net Interest Margin”. The following table provides a comparative distribution of our deposits by outstanding balance as well as by percentage of total deposits at the dates indicated: Deposit Distribution December 31, 2019 December 31, 2018 Balance % of Total Balance % of Total Demand, noninterest-bearing $387,266,777 39.2% $352,402,295 40.3% Demand, interest-bearing 25,178,320 2.5% 32,649,941 3.7% Money market 384,696,659 38.9% 339,889,794 38.9% Savings 70,739,101 7.2% 52,399,522 6.0% Time deposits-under $100,000 8,672,419 0.9% 6,057,208 0.7% Time deposits-$100,000 and over 52,169,917 5.3% 64,673,649 7.4% Other deposits-CDARS, etc. 59,512,636 6.0% 26,181,208 3.0% Total deposits $988,235,829 100% $874,253,617 100% Liquidity and Market Risk Management Liquidity Our primary source of funding is deposits from our core banking relationships. The majority of the Bank’s deposits are transaction accounts or money market accounts that are payable on demand. A small number of customers represent a large portion of the Bank’s deposits, as evidenced by the fact that 20.0% of deposits were represented by the 10 largest depositors as of December 31, 2019. We strive to manage our liquidity in a manner that enables us to meet expected and unexpected liquidity needs under both normal and adverse conditions. The Bank maintains significant on-balance sheet and off-balance liquidity sources, including a relatively large marketable securities portfolio and borrowing capacity through various secured and unsecured sources. We maintain secured borrowing lines with available capacity of $261.1 million with the Federal Home Loan Bank and the Federal Reserve and Fed funds borrowing lines with correspondent banks of $61 million, in each case as of December 31, 2019. Our board reviews liquidity position and key liquidity measurements on a quarterly basis. As of December 31, 2019, our primary liquidity ratio was 10.7% and our overall liquidity ratio was 43.8%. Interest Rate Risk Management We measure our interest rate sensitivity through the use of a simulation model. The model incorporates the contractual cash flows and re-pricing characteristics from each financial instrument, as well as certain management assumptions. The model also captures the estimated impacts of optionality and duration and their expected change due to changes in interest rates and the shape of the yield curve. We manage our interest rate risk through established policies and procedures. We measure both the potential short term change in earnings and the long term change in market value of equity on a quarterly basis. Both measurements use immediate rate shocks that assume parallel shifts in interest rates up and down the yield curve in 100 basis point increments. There are eight scenarios comprised of rate changes up or down to 400 basis points. We have established policy thresholds for each of these eight scenarios. In the current interest rate environment, however, we do not consider a decrease in interest rates that is greater than 25 basis points. The impact on earnings for one year and the change in market value of equity are limited to a change of no more than (7.5)% for rate changes of 100 basis points, no more than (15)% for changes of 200 basis points, no more than (20)% for rate changes of 300 basis points, and no more than (25)% for rate change of 400 basis points. The objective of these various simulation scenarios is to optimize the risk/reward equation for our future earnings and capital. Based upon the results of these various simulations and evaluations, we are positioned to be moderately asset sensitive, with earnings increasing in a rising rate environment. If interest rates were to increase by 100 basis points on an immediate, parallel and sustained basis, our net interest income would increase by approximately $1.1 million or 4.3% over the next 12 months. The following reflects our estimated net interest income sensitivity as of December 31, 2019: Increase/ (Decrease) in Estimated Net Interest Income Amount Percent Change in Interest Rates (basis points) +400 $57,495,000 15.5% +300 $55,895,000 12.3% +200 $54,045,000 8.6% +100 $51,889,000 4.3% $49,773,000 - % ($47,995,000) (3.6)% In an effort to measure the long-term impact of interest rate risk, we use a technique called the market value of equity (MVE), which calculates the net present value of our assets and liabilities, based on a discount rate derived from current replacement rates. The market value of equity is obtained by subtracting the market value of liabilities from the market value of assets. The change in market value of equity will differ based on the characteristics of each financial instrument and type of deposit. The longer the duration of a financial instrument, the greater the impact a rate change will have on its market value. Because we have minimal deposits with contractual maturities, the decay rate assumptions used for non-maturity deposits can have a significant impact on the market value of equity. The following reflects estimated changes in MVE as of December 31, 2019: Increase/(Decrease) in Estimated Market Value of Equity Amount Percent Change in Interest Rates (basis points) +400 $163,295,000 16.8% +300 $161,361,000 15.4% +200 $156,581,000 12.0% +100 $148,860,000 6.5% $139,832,000 - % $147,406,000 5.4% Capital Resources As of December 31, 2019, California Bancorp had total shareholders’ equity of $130.3 million, compared to $121.1 million at December 31, 2018. We use a variety of measures to evaluate capital adequacy. Our management reviews various capital measurements on a quarterly basis and takes appropriate action to ensure that such measurements are within established internal and external guidelines. The external guidelines, which are issued by the federal bank regulatory agencies, establish a risk-adjusted ratio relating capital to different categories of assets and off balance sheet exposures. There are three categories of capital under the FDIC guidelines: Common Equity Tier 1, Tier 1 and Tier 2 Capital. Common Equity Tier 1 Capital consists of total common shareholders’ equity (excluding accumulated other comprehensive income or loss), less intangible assets and disallowed deferred tax assets. Tier 1 Capital includes common shareholders’ equity less goodwill and certain other deductions, notably the unrealized net gains or losses (after tax adjustments) on securities available for sale, which are carried at fair market value. Tier 2 Capital includes the allowance for loan losses, subject to certain limitations. California Bancorp and the Bank’s respective capital positions exceed all current guidelines established by the federal banking regulators that are applicable to us. By the current regulatory definitions, the regulatory capital ratios of each California Bancorp and the Bank exceeded the minimums necessary to be considered “well capitalized,” the highest rating of the five capital categories defined under FDIC regulations, at December 31, 2019. At December 31, 2019, the Bank had a Common Equity Tier 1 capital ratio of 10.38%, Tier 1 risk based capital ratio of 10.38%, a total capital to risk-weighted assets ratio of 11.79%, and a leverage ratio of 10.44%. At December 31, 2018, the Bank had a Common Equity Tier 1 capital ratio of 10.94%, Tier 1 risk based capital ratio of 10.94%, a total capital to risk-weighted assets ratio of 12.52%, and a leverage ratio of 11.31%. At December 31, 2019, the Company had a Common Equity Tier 1 capital ratio of 10.58%, Tier 1 risk based capital ratio of 10.58%, a total capital to risk-weighted assets ratio of 11.99%, and a leverage ratio of 10.64%. At December 31, 2018, the Company had a Common Equity Tier 1 capital ratio of 11.18%, Tier 1 risk based capital ratio of 11.18%, a total capital to risk-weighted assets ratio of 12.76%, and a leverage ratio of 11.57%.

<s>[INST] The following discussion and analysis of our financial condition and results of operations should be read together with our Consolidated Financial Statements and accompanying notes presented elsewhere in this report. 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 many factors, including those set forth under Item 1A “Risk Factors” and elsewhere in this Report. Please see the “Forward Looking Information” immediately preceding Part I of this Report. Overview California BanCorp is a California corporation that was organized to serve as the holding company for California Bank of Commerce. On June 30, 2017, we completed a reorganization in which California BanCorp became the Bank’s holding company. As a registered bank holding company under the Bank Holding Company Act, the Company is subject supervision and regulation by the Federal Reserve. California Bank of Commerce, which was incorporated in 2007, is a California chartered commercial bank headquartered in Lafayette, California. The Bank is regulated by the FDIC and the DBO and is not a member of the Federal Reserve. The Bank has seven offices, six of which are in the San Francisco Bay Area and all of which are in Northern California. These offices include three banking offices in Lafayette (the Bank’s headquarters), Fremont and San Jose, where the Bank offers loan, deposit and treasury management products. The Bank also has four loan production offices in Oakland, Walnut Creek, San Jose and Sacramento, California. As with most community banks, the Bank derives a significant portion of its income from interest received on loans and investments. The Bank’s primary source of funding is deposits, both interestbearing and noninterestbearing. In order to maximize the Bank’s net interest income, or the difference between the income on interestearning assets and the expense of interestbearing liabilities, the Bank must not only manage the volume of these balance sheet items, but also the yields earned on interestearning assets and the rates paid on interestbearing liabilities. To account for credit risk inherent in all loans, the Bank maintains an allowance for loan losses to absorb possible losses on existing loans that may become uncollectible. The Bank establishes and maintains this allowance by charging a provision for loan losses against operating earnings. Beyond its net interest income, the Bank further receives income through the net gain on sale of loans held for sale as well as servicing income which is retained on those sold loans. In order to maintain its operations and bank locations, the Bank incurs various operating expenses which are further described within the “Results of Operations” later in this section. As of December 31, 2019, the Company had total consolidated assets of $1.2 billion, total gross loans of $949.7 million, total deposits of $988.2 million and total shareholders’ equity of $130.3 million. The Company employs approximately 133 fulltime equivalent employees and has an assetstoFTE ratio of approximately $9.0 million. Critical Accounting Policies and Estimates Our accounting and reporting policies conform to accounting principles generally accepted in the United States of America (“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 following is a discussion of the critical accounting policies and significant estimates that require us to make complex and subjective judgments. Additional information about these policies can be found in Note 1 of our consolidated financial statements as of December 31, 2019, included elsewhere in this report. Allowance for Loan Losses The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are [/INST] Positive. </s>

PowerFleet, Inc.

2020-04-08

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following discussion is intended to assist you in understanding our financial condition and results of operations and should be read in conjunction with the financial statements and related notes included elsewhere in this Annual Report on Form 10-K. Many of the amounts and percentages in this section have been rounded for convenience of presentation, but actual recorded amounts have been used in computations. Accordingly, some information may appear not to compute accurately. Overview PowerFleet, Inc. (together with its subsidiaries, “PowerFleet,” the “Company,” “we,” “our” or “us”) is a global leader and provider of subscription-based wireless Internet-of-Things (IoT) and machine-to-machine (M2M) solutions for securing, controlling, tracking, and managing high-value enterprise assets such as industrial trucks, trailers, containers, cargo, and light vehicles and heavy truck fleets. As described more fully in Note 3 to our consolidated financial statements included in this Annual Report on Form 10-K, on October 3, 2019, we completed the Transactions (as defined below) contemplated by (i) the Agreement and Plan of Merger, dated as of March 13, 2019 (the “Merger Agreement”), by and among I.D. Systems, Inc., a Delaware corporation (“I.D. Systems”), the Company, Pointer Telocation Ltd., a private company limited by shares formed under the laws of the State of Israel (“Pointer”), PowerFleet Israel Ltd. (f/k/a Powerfleet Israel Holding Company Ltd.), a private company limited by shares formed under the laws of the State of Israel and a wholly-owned subsidiary of the Company (“PowerFleet Israel”), and Powerfleet Israel Acquisition Company Ltd., a private company limited by shares formed under the laws of the State of Israel and a wholly-owned subsidiary of PowerFleet Israel prior to the Transactions, and (ii) the Investment and Transaction Agreement, dated as of March 13, 2019, as amended by Amendment No. 1 thereto dated as of May 16, 2019, Amendment No. 2 thereto dated as of June 27, 2019 and Amendment No. 3 thereto dated as of October 3, 2019 (the “Investment Agreement,” and together with the Merger Agreement, the “Agreements”), by and among I.D. Systems, the Company, PowerFleet US Acquisition Inc., a Delaware corporation and a wholly-owned subsidiary of the Company prior to the Transactions, and ABRY Senior Equity V, L.P., ABRY Senior Equity Co-Investment Fund V, L.P. and ABRY Investment Partnership, L.P. (the “Investors”), affiliates of ABRY Partners II, LLC. As a result of the transactions contemplated by the Agreements (the “Transactions”), I.D. Systems and PowerFleet Israel each became direct, wholly-owned subsidiaries of the Company and Pointer became an indirect, wholly-owned subsidiary of the Company. Prior to the Transactions, PowerFleet had no material assets, did not operate any business and did not conduct any activities, other than those incidental to its formation and matters contemplated by the Agreements. I.D. Systems was determined to be the accounting acquirer in the Transactions. As a result, the historical financial statements of I.D. Systems for the periods prior to the Transactions are considered to be the historical financial statements of PowerFleet and the results of Pointer have been included in our consolidated financial statements from the date of the Transactions. We are headquartered in Woodcliff Lake, New Jersey, with offices located around the globe. Our patented technologies address the needs of organizations to monitor and analyze their assets to improve safety, increase efficiency and productivity, reduce costs, and improve profitability. Our offerings are sold under the global brands PowerFleet, Pointer and Cellocator. We deliver advanced mobility solutions that connect assets to increase visibility operational efficiency and profitability. Across our vertical markets we differentiate ourselves by being OEM agnostic and helping mixed fleets view and manage their assets similarly. All of our solutions are paired with software as a service, or SaaS, analytics platforms to provide an even deeper layer of insights. These insights include a full set of operational Key Performance Indicators, or KPI’s, to drive operational and strategic decisions. These KPI’s leverage industry comparisons to show how a company is performing versus their peers. The more data the system collects, the more accurate a client’s understanding becomes. The analytics platform, which is integrated into our customers’ management systems, is designed to provide a single, integrated view of asset and operator activity across multiple locations that provides enterprise-wide benchmarks and peer-industry comparisons. We look for analytics, as well as the data contained therein, to differentiate us from our competitors, make a growing contribution to revenue, and add value to our solutions, and help keep us at the forefront of the wireless asset management markets we serve. We sell our wireless mobility solutions to both corporate-level executives, division heads and site-level management within the enterprise. We also utilize channel partners such as independent dealers and original equipment manufacturers, or OEMs, who may opt for us to white label our product. Typically, our initial system deployment serves as a basis for potential expansion across the customer’s organization. We work closely with customers to help maximize the utilization and benefits of our system and demonstrate the value of enterprise-wide deployments. Post-implementation, we consult with our customers to further extend and customize the benefits to the enterprise by delivering enhanced analytics capabilities We market and sell our solutions to a wide range of customers in the commercial and government sectors. Our customers operate in diverse markets, such as automotive manufacturing, heavy industry, retail food and grocery distribution, logistics, wholesale distribution, transportation, aviation, manufacturing, aerospace and defense, homeland security and vehicle rental. We incurred net losses of approximately, $3.9 million, $5.8 million and $12 million for the years ended December 31, 2017, 2018 and 2019, respectively, and have incurred additional net losses since inception. As of December 31, 2019, we had cash (including restricted cash), of $16.7 million, working capital of $29.3 million, and an accumulated deficit of $112.1 million. Our primary sources of cash are cash flows from operating activities, our holdings of cash, cash equivalents and investments from the sale of our capital stock and borrowings under our credit facility. To date, we have not generated sufficient cash flow solely from operating activities to fund our operations. On January 30, 2019, we completed the acquisition (“CarrierWeb US Acquisition”) of substantially all of the assets of CarrierWeb, L.L.C. (“CarrierWeb”), an Atlanta-based provider of real-time in-cab mobile communications technology, electronic logging devices, two-way refrigerated command and control, and trailer tracking. On July 30, 2019, we completed the acquisition (the “CarrierWeb Ireland Acquisition” and together with the CarrierWeb US Acquisition, the “CarrierWeb Acquisitions”) of substantially all of the assets of CarrierWeb Services Ltd. (“CarrierWeb Ireland”), an affiliate of CarrierWeb, from e*freightrac Holding B.V., the owner of the outstanding equity of CarrierWeb Ireland. The assets we acquired in the CarrierWeb Acquisitions have been integrated into our products. The CarrierWeb Acquisitions allow the Company to offer a full complement of highly-integrated logistics technology solutions to its current customers and prospects and immediately add customers and subscriber units. The results of operations from each of the CarrierWeb Acquisitions have been included in our consolidated financial statements from the date of each such acquisition. On July 31, 2017, we, together with our wholly-owned subsidiary Keytroller, LLC, a Delaware limited liability company (“Keytroller”), acquired substantially all of the assets of Keytroller, LLC, a Florida limited liability company (the “Keytroller Acquisition”). The business we acquired in the Keytroller Acquisition develops and markets electronic products for managing forklifts and construction vehicles. The Keytroller Acquisition gives us a full suite of industrial fleet management product offerings capable of covering any sized fleet and budget and provides our industrial truck business more scale, both from a product and revenue standpoint and markets its line of forklift management devices mainly through a network of lift truck dealers, offering solutions for different fleet sizes at a wide range of price points. The results of operations of Keytroller have been included in our consolidated financial statements from the date of the Keytroller Acquisition. Critical Accounting Estimates We have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States in the preparation of our financial statements. Our significant accounting policies are described in Note 2 to our consolidated financial statements included in this Annual Report on Form 10-K. Certain accounting policies involve significant judgments and assumptions by our management that can have a material impact on the carrying value of certain assets and liabilities. We consider such accounting policies to be our critical accounting policies. The judgments and assumptions used by our management in these critical accounting policies are based on historical experience and other factors that our management believes to be reasonable under the circumstances. Because of the nature of these judgments and assumptions, actual results could differ significantly from these judgments and estimates, which could have a material impact on the carrying values of our assets and liabilities and our results of operations. Our critical accounting policies are described below. Revenue Recognition We generate revenue from sales of systems and products and from customer SaaS and hosting infrastructure fees. Revenue is measured as the amount of consideration the Company expects to receive in exchange for transferring goods or providing services. Sales, value add, and other taxes the Company collects concurrently with revenue-producing activities are excluded from revenue. Incidental items that are immaterial in the context of the contract are recognized as expense. The expected costs associated with the Company’s base warranties continue to be recognized as expense when the products are sold. Revenue is recognized when performance obligations under the terms of a contract with our customer are satisfied. Product sales are recognized at a point in time when title transfers, when the products are shipped, or when control of the system is transferred to the customer, which usually is upon delivery of the system and when contractual performance obligations have been satisfied. For products which do not have stand-alone value to the customer separate from the SaaS services provided, the Company considers both hardware and SaaS services a bundled performance obligation. Under the applicable accounting guidance, all of the Company’s billings for equipment and the related cost for these systems are deferred, recorded, and classified as a current and long-term liability and a current and long-term asset, respectively. The deferred revenue and cost are recognized over the service contract life, ranging from one to five years, beginning at the time that a customer acknowledges acceptance of the equipment and service. We recognize revenue for remotely hosted SaaS agreements and post-contract maintenance and support agreements beyond our standard warranties over the life of the contract. Revenue is recognized ratably over the service periods and the cost of providing these services is expensed as incurred. Amounts invoiced to customers which are not recognized as revenue are classified as deferred revenue and classified as short-term or long-term based upon the terms of future services to be delivered. Deferred revenue also includes prepayment of extended maintenance, hosting and support contracts. We earn other service revenues from installation services, training and technical support services which are short-term in nature and revenue for these services are recognized at the time of performance or right to invoice. We recognize revenue on non-recurring engineering services over time, on an input-cost method performance basis, as determined by the relationship of actual labor and material costs incurred to date compared to the estimated total project costs. Estimates of total project costs are reviewed and revised during the term of the project. Revisions to project costs estimates, where applicable, are recorded in the period in which the facts that give rise to such changes become known. We also derive revenue from leasing arrangements. Such arrangements provide for monthly payments covering product or system sale, maintenance, support and interest. These arrangements meet the criteria to be accounted for as sales-type leases. Accordingly, an asset is established for the “sales-type lease receivable” at the present value of the expected lease payments and revenue is deferred and recognized over the service contract, as described above. Maintenance revenues and interest income are recognized monthly over the lease term. Our contracts with customers may include multiple performance obligations. For such arrangements, the Company allocates revenue to each performance obligation based on its relative standalone selling price. The Company generally determines standalone selling prices based on observable prices charged to customers or adjusted market assessment or using expected cost-plus margin when one is available. Adjusted market assessment price is determined based on overall pricing objectives taking into consideration market conditions and entity specific factors. We recognize an asset for the incremental costs of obtaining the contract arising from the sales commissions to employees because the Company expects to recover those costs through future fees from the customers. The Company amortizes the asset over one to five years because the asset relates to the services transferred to the customer during the contract term of one to five years. The Company does not disclose the value of unsatisfied performance obligations for (i) contracts with an original expected length of one year or less and (ii) contracts for which the Company recognizes revenue at the amount to which the Company has the right to invoice for services performed. Stock-Based Compensation We account for stock-based employee compensation for all share-based payments, including grants of stock options and restricted stock, as an operating expense based on their fair values on the grant date. The Company recorded stock-based compensation expense of $2,437,000, $2,163,000 and $3,794,000 for the years ended December 31, 2017, 2018 and 2019, respectively. We estimate the fair value of share-based option awards on the grant date using an option pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service period in the Company’s consolidated statement of operations. The Company estimates forfeitures at the time of grant in order to estimate the amount of share-based awards that will ultimately vest. The estimate is based on the Company’s historical rates of forfeitures. Estimated forfeitures are revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Long-lived Assets Long-lived assets, which includes definite lived intangible assets and fixed assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is assessed by a comparison of the carrying amount of the assets to the future undiscounted net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets and would be charged to earnings. Fair value is determined through various valuation techniques including discounted cash flow models, quoted market values and third-party independent appraisals, as considered necessary. Business Combinations Goodwill represents costs in excess of fair values assigned to the underlying net assets of acquired businesses. Goodwill and intangible assets deemed to have indefinite lives are not amortized and are tested for impairment on an annual basis and between annual tests whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Intangible assets other than goodwill are amortized over their useful lives unless the lives are determined to be indefinite. Intangible assets are carried at cost, less accumulated amortization. Intangible assets consist of trademarks and trade names, patents, customer relationships and other intangible assets. Goodwill is tested at the reporting unit level, which is defined as an operating segment or one level below the operating segment. The Company operates in one reportable segment which is its only reporting unit. We test for an indication of goodwill impairment annually during the fourth quarter or when an indicator of impairment exists, by comparing the fair value of the reporting unit to its carrying value. In the evaluation of goodwill for impairment, we have the option to perform a qualitative assessment to determine whether further impairment testing is necessary or to perform a quantitative assessment by comparing the fair value of a reporting unit to its carrying amount, including goodwill. Under the qualitative assessment, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount. If under the quantitative assessment the fair value of a reporting unit is less than its carrying amount, then the amount of the impairment loss, if any, must be measured under step two of the impairment analysis. In the first phase of impairment testing, goodwill attributable to the reporting units is tested for impairment by comparing the fair value of each reporting unit with its carrying value. If the carrying value of the reporting unit exceeds its fair value, the second phase is then performed. The second phase of the goodwill impairment test compares the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit’s goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. For the years ended December 31, 2017, 2018 and 2019, the Company performed a qualitative goodwill impairment test and did not incur an impairment charge. We re-measure the fair value of the contingent consideration at each reporting period and any change in the fair value from either the passage of time or events occurring after the acquisition date, is recorded in earnings in the accompanying consolidated statement of operations. Actual results could differ from such estimates in future periods based on the re-measurement of the fair value. Income taxes We use the asset and liability method of accounting for deferred income taxes. Deferred income taxes are measured by applying enacted statutory rates to net operating loss carryforwards and to the differences between the financial reporting and tax bases of assets and liabilities. Deferred tax assets are reduced, if necessary, by a valuation allowance if it is more likely than not that some portion or all of the deferred tax assets will not be realized. We recognize uncertainty in income taxes in the financial statements using a recognition threshold and measurement attribute of a tax position taken or expected to be taken in a tax return. We apply the “more-likely-than-not” recognition threshold to all tax positions, commencing at the adoption date of the applicable accounting guidance, which resulted in no unrecognized tax benefits as of such date. Additionally, there have been no unrecognized tax benefits subsequent to adoption. We have opted to classify interest and penalties that would accrue according to the provisions of relevant tax law as selling, general, and administrative expenses, in the consolidated statement of operations. For the years ended December 31, 2017, 2018 and 2019, there was no such interest or penalty. Results of Operations The following table sets forth certain items related to our statement of operations as a percentage of revenues for the periods indicated and should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K. Our results reflect the operations of (i) Pointer from October 3, 2019, the closing date of the Transactions, (ii) the assets we acquired from CarrierWeb Ireland from July 30, 2019, the closing date of the CarrierWeb Ireland Acquisition, (iii) the assets we acquired from CarrierWeb US from January 30, 2019, the closing date of the CarrierWeb US Acquisition, and (iv) Keytroller from July 31, 2017, the closing date of the Keytroller Acquisition. A detailed discussion of the material changes in our operating results is set forth below. Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 REVENUES. Revenues increased by approximately $28.9 million, or 54.3%, to $81.9 million in 2019 from $53.1 million in 2018. The increase in revenue is attributable to an increase in revenue resulting from our acquisition of Pointer, which was completed on October 3, 2019, and an increase in PowerFleet for Vehicles solutions revenue which increased to $15.9 million in 2019 compared to $9.6 million in 2018. Revenues from products increased by approximately $8.5 million, or 23.1%, to $45.4 million in 2019 from $36.9 million in 2018. The increase in product revenue is attributable to an increase in product revenue resulting from our acquisition of Pointer, and an increase in PowerFleet for Vehicles solutions product revenue which increased to $9.6 million in 2019 compared to $8.5 million in 2018 Revenues from services increased by approximately $20.3 million, or 125.8%, to $36.5 million in 2019 from $16.2 million in 2018. The increase in service revenue is attributable to an increase in service revenue resulting from our acquisition of Pointer. COST OF REVENUES. Cost of revenues increased by approximately $16.3 million, or 59.7%, to $43.6 million in 2019 from $27.3 million in 2018. Gross profit was $38.4 million in 2019 compared to $25.8 million in 2018. As a percentage of revenues, gross profit decreased to 46.8% in 2019 from 48.6% in 2018. Cost of products increased by approximately $7.3 million, or 32.4%, to $30.0 million in 2019 from $22.6 million in in 2018. Gross profit for products was $15.4 million in 2019 compared to $14.3 million in 2018. As a percentage of product revenues, gross profit decreased to 33.9% in 2019 from 38.6% in 2018. The decrease in gross profit as a percentage of product revenue was principally due to the higher product revenue from PowerFleet for Vehicles solutions which have a lower gross profit percentage. Cost of services increased by approximately $8.9 million, or 193.2%, to $13.6 million in 2019 from $4.6 million in 2018. Gross profit for services was $22.9 million in 2019 compared to $11.5 million in 2018. The increase in the service revenue gross profit was attributable to the increase in service revenue resulting from our acquisition of Pointer. As a percentage of service revenues, gross profit decreased to 62.8% in 2019 from 71.4% in 2018. The decrease in service gross profit as a percentage of service revenue was principally due to service revenue from the Pointer acquisition having a lower service gross margin than the historical service revenue. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and administrative (“SG&A”) expenses increased by approximately $10.2 million, or 41.3%, to $34.9 million in 2019 compared to $24.7 million in 2018. The increase was principally due to our acquisition of Pointer. RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses increased by approximately $1.7 million, or 24.4%, to $8.5 million in 2019 compared to $6.9 million in 2018 principally due to our acquisition of Pointer. ACQUISITION-RELATED EXPENSES. Acquisition related expenses increased to approximately $5.1 million in 2019 compared to $-0- principally due to the completion of the Transactions in 2019. INTEREST EXPENSE. Interest expense increased by $775,000, or 448.0%, to $948,000 in 2018 from $173,000 in 2018, principally due to our credit facility with Bank Hapoalim and convertible unsecured promissory notes in the aggregate principal amount of $5,000,000 (the “Notes”) that we issued to the Investors at the closing of the Transactions, which were used to partially finance our acquisition of Pointer. NET LOSS ATTRIBUTABLE TO COMMON STOCKHOLDERS. Net loss was $12.0 million, or $(0.59) per basic and diluted share, for 2019 as compared to net loss of $5.8 million, or $(0.34) per basic and diluted share, for the same period in 2018. The decrease in the net loss was due primarily to the reasons described above. Year Ended December 31, 2018 Compared to Year Ended December 31, 2017 REVENUES. Revenues increased by approximately $12.1 million, or 29.6%, to $53.1 million in 2018 from $41.0 million in 2017. The increase in revenue is attributable to an increase in PowerFleet for Industrial solutions revenue of approximately $6.3 million to $30.0 million in 2018 from $23.7 million in 2017 and PowerFleet for Vehicles solutions revenue of approximately $6.6 million to $9.6 million in 2018 from $3.0 million in 2017, partially offset by a decrease in total PowerFleet for Logistics solutions revenue of approximately $0.8 million to $13.5 million in 2018 from $14.3 million in 2017. Revenues from products increased by approximately $13.3 million, or 56.7%, to $36.9 million in 2018 from $23.6 million in 2017. PowerFleet for Industrial solutions product revenue increased by approximately $5.2 million to $22.7 million in 2018 from $17.5 million in 2017. The increase in PowerFleet for Industrial solutions product revenue resulted principally from increased product sales of approximately $4.6 million from Keytroller. PowerFleet for Vehicles solutions product revenue increased to approximately $8.5 million in 2018 for units shipped during 2018 under a statement of work we entered into with Avis Budget Car Rental, LLC (“ABCR”) in March 2017. PowerFleet for Logistics solutions product revenue decreased by approximately $0.3 million to $5.8 million in 2018 from $6.0 million in 2017. The decrease in PowerFleet for Logistics solutions product revenue resulted principally from decreased product revenue of approximately $0.4 million from Wal-Mart Stores, Inc. Revenues from services decreased by approximately $1.2 million, or 7.1%, to $16.2 million in 2018 from $17.4 million in 2017. PowerFleet for Industrial solutions service revenue increased by approximately $1.1 million to $7.3 million in 2018 from $6.2 million in 2017, principally from increased service revenue from the General Motors Company and Toyota Industries Corporation. PowerFleet for Vehicles solutions service revenue decreased by approximately $1.8 million to $1.1 million in 2018 from $2.9 million in 2017 as the prior year included revenue for development work with ABCR that was not present in the current period. PowerFleet for Logistics solutions service revenue decreased by approximately $0.5 million to $7.7 million in 2018 from $8.3 million in 2017 principally due to a decrease in revenue per active units. COST OF REVENUES. Cost of revenues increased by approximately $7.2 million, or 36.1%, to $27.3 million in 2018 from $20.0 million in 2017. Gross profit was $25.8 million in 2017 compared to $20.9 million for the same period in 2017. As a percentage of revenues, gross profit decreased to 48.6% in 2018 from 51.1% in 2017. Cost of products increased by approximately $9.2 million, or 68.3%, to $22.6 million in 2018 from $13.5 million in in 2017. Gross profit for products was $14.3 million in 2018 compared to $10.1 million in 2017. The increase in product revenue gross profit was attributable to an increase of approximately $2.6 million in the PowerFleet for Industrial solutions gross profit to $11.6 million in 2018 from $8.9 million in 2017 and an increase in the PowerFleet for Vehicles solutions gross profit to $1.7 million in 2018 from units shipped to ABCR. The PowerFleet for Logistics solutions gross profit decreased approximately $0.2 million to $1.0 million in 2018 from $1.2 in 2017. As a percentage of product revenues, gross profit decreased to 38.6% in 2018 from 42.9% in 2017. The decrease in gross profit as a percentage of product revenue was principally due to the PowerFleet for Vehicles solutions gross profit percentage of 20.3% in 2018. The PowerFleet for Logistics solutions gross profit percentage decreased to 17.1% in 2018 from 19.9% in 2017 principally due to lower hardware unit prices. The PowerFleet for Industrial solutions gross profit percentage of 51% in 2018 remained generally consistent with the 2017 gross profit percentage. Cost of services decreased by approximately $2.0 million, or 29.6%, to $4.6 million in 2018 from $6.6 million in 2017. Gross profit for services was $11.5 million in 2018 compared to $10.8 million in 2017. The increase in the service revenue gross profit was attributable to an increase in the PowerFleet for Industrial solutions gross profit of approximately $1.1 million to $5.3 million in 2018 from $4.3 million in 2017, partially offset by a decrease in the PowerFleet for Vehicles solutions gross profit of approximately $0.2 million to $0.5 million in 2018 from $0.7 million in 2017. The PowerFleet for Logistics solutions gross profit of approximately $5.8 million in 2018 remained generally consistent with the gross profit of $5.9 million in 2017. As a percentage of service revenues, gross profit increased to 71.4% in 2018 from 62.2% in 2017. The PowerFleet for Industrial solutions gross profit percentage increased to 72.3% in 2018 from 68.5% in 2017 principally due to an increase in service revenue with fixed costs remaining constant. The PowerFleet for Logistics solutions profit percentage increased to 74.5% in 2018 from 71.5% in 2017 principally due to lower communication expenses. The PowerFleet for Vehicles solutions service revenue gross profit percentage increased to 42.9% in 2018 from 22.7% in 2017 as the prior year included SOW#4 development work with ABCR that was not present in the current period. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. SG&A expenses increased by approximately $4.2 million, or 20.5%, to $24.7 million in 2018 compared to $20.5 million in 2017. The increase was principally due to approximately $1.7 million in SG&A expenses from Keytroller and increases of approximately $1.0 million in litigation and settlements costs, $0.4 million in acquisition related costs, $0.7 million in foreign currency transaction losses, and $0.5 million in sales and marketing expenses related to the introduction of new products. As a percentage of revenues, SG&A expenses decreased to 46.5% in 2018 from 50.0% in the same period in 2017, primarily due to the increase in revenues from 2017 to 2018. RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses increased by approximately $2.3 million, or 51.2%, to $6.9 million in 2018 compared to $4.5 million in 2017 principally due to the 2017 reallocation of internal product development resources to cost of services for the Avis SOW#4 project as well as continued investment in our logistics visibility products. As a percentage of revenues, research and development expenses increased 12.9% in 2018 from 11.1% in the same period in 2017, primarily due to the increase in expenses noted above. INTEREST EXPENSE. Interest expense decreased by $169,000, or 49.4%, to $173,000 in 2018 from $342,000 in the same period in 2017, principally due to a decrease in the accretion of the contingent consideration. INCOME TAX BENEFIT. Income tax benefit decreased to $-0- in 2018 from $311,000 in 2017 from the sale of the New Jersey R&D tax credits during 2017. NET LOSS ATTRIBUTABLE TO COMMON STOCKHOLDERS. Net loss was $5.8 million, or $(0.34) per basic and diluted share, for 2018 as compared to net loss of $3.9 million, or $(0.26) per basic and diluted share, for the same period in 2017. The decrease in the net loss was due primarily to the reasons described above. Liquidity and Capital Resources Historically, our capital requirements have been funded primarily from the net proceeds from the issuance of our securities, including any issuances of our common stock upon the exercise of options. As of December 31, 2019, we had cash (including restricted cash), cash equivalents and marketable securities of $16.7 million and working capital of $29.3 million, compared to cash, cash equivalents and marketable securities of $14.6 million and working capital of $15.6 million as of December 31, 2018. On October 3, 2019, in connection with the completion of the Transactions, we issued and sold 50,000 shares of the Series A Convertible Preferred Stock, par value $0.01 per share (the “Series A Preferred Stock”), to the Investors for an aggregate purchase price of $50,000,000 pursuant to the terms of the Investment Agreement. The proceeds received from such sale were used to finance a portion of the cash consideration payable in our acquisition of Pointer. Also, on October 3, 2019, we issued and sold the Notes to the Investors at the closing of the Transactions. The $5,000,000 principal amount of, and accrued interest through the maturity date on, the Notes will convert automatically into Series A Preferred Stock (at the original issuance price thereof) upon receipt of the approval by the Company’s stockholders in accordance with Nasdaq rules. The Notes will bear interest at 10% per annum, will mature on the third business day before the first anniversary of their issuance date (unless earlier converted) and may be prepaid in full subject to a prepayment premium. A portion of the proceeds from the Notes were used to pay expenses related to the Transactions and the remaining proceeds will be used for general corporate purposes. In addition, PowerFleet Israel and Pointer are party to a Credit Agreement (the “Credit Agreement”) with Bank Hapoalim B.M. (“Hapoalim”), pursuant to which Hapoalim agreed to provide PowerFleet Israel with two senior secured term loan facilities in an aggregate principal amount of $30 million (comprised of two facilities in the aggregate principal amount of $20 million and $10 million) and a five-year revolving credit facility to Pointer in an aggregate principal amount of $10 million. The proceeds of the term loan facilities were used to finance a portion of the cash consideration payable in our acquisition of Pointer. The proceeds of the revolving credit facility may be used by Pointer for general corporate purposes. We have on file a shelf registration statement on Form S-3 that was declared effective by the Securities and Exchange Commission (the “SEC”) on November 27, 2019. Pursuant to the shelf registration statement, we may offer to the public from time to time, in one or more offerings, up to $60.0 million of our common stock, preferred stock, warrants, debt securities, and units, or any combination of the foregoing, at prices and on terms to be determined at the time of any such offering. The specific terms of any future offering will be determined at the time of the offering and described in a prospectus supplement that will be filed with the SEC in connection with such offering. Because of the recent outbreak of the novel coronavirus COVID-19, there is significant uncertainty surrounding the potential impact on our results of operations and cash flows. We are proactively taking steps to increase available cash on hand including, but not limited to, targeted reductions in discretionary operating expenses and capital expenditures and borrowing under the revolving credit facility. Capital Requirements As of December 31, 2019, we had cash (including restricted cash), cash equivalents and marketable securities of $16.7 million and working capital of $29.3 million. Our primary sources of cash are cash flows from operating activities, our holdings of cash, cash equivalents and investments from the sale of our capital stock and borrowings under our credit facility. To date, we have not generated sufficient cash flow solely from operating activities to fund our operations. We believe our available working capital, anticipated level of future revenues and expected cash flows from operations will provide sufficient funds to cover capital requirements through at least April 7, 2021. Our capital requirements depend on a variety of factors, including, but not limited to, the length of the sales cycle, the rate of increase or decrease in our existing business base, the success, timing, and amount of investment required to bring new products to market, revenue growth or decline and potential acquisitions. Failure to generate positive cash flow from operations will have a material adverse effect on our business, financial condition and results of operations. Operating Activities Net cash used in operating activities was $7.3 million for the year ended December 31, 2019, compared to net cash used in operating activities of $1.7 million for the same period in 2018. The net cash provided by operating activities for the year ended December 31, 2019 reflects a net loss of $11.0 million and includes non-cash charges of $3.8 million for stock-based compensation, $3.3 million for depreciation and amortization expense and $1.0 million for right of use asset amortization. Changes in working capital items included: ● an increase in accounts receivable of $1.1 million; ● an increase in inventories of $3.3 million; and ● a decrease in lease liabilities of $1.1 million. Net cash used in operating activities was $1.7 million for the year ended December 31, 2018, compared to net cash provided by operating activities of $3.9 million for the same period in 2017. The net cash provided by operating activities for the year ended December 31, 2018 reflects a net loss of $5.8 million and includes non-cash charges of $2.2 million for stock-based compensation and $1.6 million for depreciation and amortization expense. Changes in working capital items included: ● an increase in accounts receivable of $0.6 million; ● an increase in deferred costs of $0.5 million; and ● an increase in accounts payable and accrued expenses of $0.6 million. Investing Activities Net cash used in investing activities was $65.5 million for the year ended December 31, 2019, compared to net cash provided by investing activities of $6.6 million for the same period in 2018. The change from the same period in 2018 was primarily due to $69.0 million used for our acquisitions of Pointer and CarrierWeb, $1.0 million used for the purchase of fixed assets in 2019 compared to $251,000 used for the purchase of fixed assets in 2018 and $4.6 million provided by the proceeds from the sale and maturities of investments in 2019 compared to $10.0 million in 2018. Net cash provided by investing activities was $6.6 million for the year ended December 31, 2018, compared to net cash used in investing activities of $17.7 million for the same period in 2017. The change from the same period in 2017 was primarily due to approximately $7.4 million used for the Keytroller Acquisition in 2017 and net proceeds from the sale of investment of approximately $6.8 million in 2018 versus net investment purchases of approximately $10.0 million in 2017. Financing Activities Net cash provided by financing activities was $78.6 million for the year ended December 31, 2019, compared to net cash provided by financing activities of $69,000 for the same period in 2018. The change from the same period in 2018 was primarily due to net proceeds from our sale of Series A Preferred Stock to the Investors of $46.3 million, $35.0 million for the proceeds of long-term debt and the Notes, partially offset by $2.0 million due to the repayment of long-term debt. Net cash provided by financing activities was $69,000 for the year ended December 31, 2018, compared to net cash provided by financing activities of $14.3 million for the same period in 2017. The change from the same period in 2017 was primarily due to net proceeds from a public offering of approximately $16.1 million in 2017 and net repayments of $3.0 million of the revolving credit facility in 2017. Contractual Obligations and Commitments The following table summarizes our significant contractual obligations and commitments as of December 31, 2019: Purchase orders or contracts for the purchase of raw materials and other goods and services are not included in the table above. We are not able to determine the aggregate amount of such purchase orders that represent contractual obligations, as purchase orders may represent authorizations to purchase rather than binding agreements. Although we have entered into contracts for services, the obligations under these contracts were not significant and the contracts generally contain clauses allowing for cancellation without significant penalty. The expected timing or payment of obligations discussed above is estimated based on current information. Timing of payments and actual amounts paid may be different depending on changes to agreed-upon amounts for some obligations. Inflation We operate in several emerging market economies that are particularly vulnerable to the impact of inflationary pressures that could materially and adversely impact our operations in the foreseeable future. Business Acquisitions In addition to focusing on our core applications, we adapt our systems to meet our customers’ broader asset management needs and seek opportunities to expand our solution offerings through strategic acquisitions. For example, in 2009 we acquired Didbox Ltd., a privately held, United Kingdom-based manufacturer and marketer of vehicle operator identification systems, which provides us with a wider range of industrial vehicle management solutions and expands our base of operations in Europe. In 2010, we entered into a purchase agreement with General Electric Capital Corporation and GE Asset Intelligence, LLC (“GEAI”), pursuant to which we acquired GEAI’s telematics business through the purchase of Asset Intelligence, LLC (“AI”). AI combines web-based software technologies with satellite and cellular communications to deliver data-driven telematics solutions for supply chain asset management. These solutions help secure and optimize the performance of trailers, railcars, containers, and the freight they carry, enabling shippers and carriers to maximize security and efficiency throughout their supply chains. On July 31, 2017, we completed the Keytroller Acquisition. The business we acquired in the Keytroller Acquisition develops and markets electronic products for managing forklifts and construction vehicles. The Keytroller Acquisition gives us a full suite of industrial fleet management product offerings capable of covering any sized fleet and budget and provides our industrial truck business more scale, both from a product and revenue standpoint and markets its line of forklift management devices mainly through a network of lift truck dealers, offering solutions for different fleet sizes at a wide range of price points. On January 30, 2019, we completed the CarrierWeb Acquisition. The assets we acquired in the CarrierWeb Acquisition have been integrated into our products. The CarrierWeb Acquisition allows us to offer a full complement of highly-integrated logistics technology solutions to its current customers and prospects and immediately adds more than 70 customers and 9,000 subscriber units. On October 3, 2019, we completed the Transactions, as a result of which I.D. Systems and PowerFleet Israel each became direct, wholly-owned subsidiaries of the Company and Pointer became an indirect, wholly-owned subsidiary of the Company. For further discussion on the Transactions and related transactions, please see Note 3 to our consolidated financial statements included in this Annual Report on 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. Recently Issued Accounting Pronouncements In December 2019, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2019-12, Simplifying the Accounting for Income Taxes which removes certain exceptions related to the approach for intraperiod tax allocation, the methodology for calculating income taxes in an interim period, the recognition of deferred tax liabilities for outside basis differences and clarifies the accounting for transactions that result in a step-up in the tax basis of goodwill. The guidance is generally effective as of January 1, 2021, with early adoption permitted. The Company has not early adopted the new standard for 2019 and is evaluating the impact of the new guidance on our financial statements. In August 2018, the FASB issued ASU No. 2018-15, “Intangibles-Goodwill and Other-Internal-Use Software (Topic 350): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract”, which aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal use software license). ASU 2018-15 is effective for fiscal years beginning after December 15, 2019, with early adoption permitted. The Company is currently evaluating the impact of this ASU on the consolidated financial statements In February 2018, the FASB issued ASU No. 2018-02 Income Statement-Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. The amendments in this update allow a reclassification from accumulated other comprehensive income (“AOCI”) to retained earnings for adjustments to the tax effect of items in AOCI, that were originally recognized in other comprehensive income, related to the new statutory rate prescribed in the Tax Cuts and Jobs Act (“TCJA”) enacted on December 22, 2017, which reduced the US federal corporate tax rate from 35% to 21%. The amendments in this update should be applied either in the period of adoption or retrospectively to each period (or periods) in which the effect of the change in the US federal corporate income tax rate in the TCJA is recognized. The adoption of this standard on January 1, 2019 had no impact to our financial statements. In June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments - Credit Losses (Topic 326) Measurement of Credit Losses on Financial Instruments,” which amends the guidance on measuring credit losses on financial assets held at amortized cost. The amendment is intended to address the issue that the previous “incurred loss” methodology was restrictive for an entity’s ability to record credit losses based on not yet meeting the “probable” threshold. The new language will require these assets to be valued at amortized cost presented at the net amount expected to be collected with a valuation provision. This ASU is effective for fiscal years beginning after December 15, 2021. The Company is currently evaluating the impact of this ASU on the consolidated financial statements. In January 2017, the FASB issued ASU 2017-04, “Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment,” which simplifies how an entity is required to test goodwill for impairment by eliminating Step 2 from the goodwill impairment test. Step 2 measures a goodwill impairment loss by comparing the implied fair value of a reporting unit’s goodwill with the carrying amount of that goodwill. Under the amendments in ASU 2017-04, an entity should recognize an impairment charge for the amount by which the carrying amount of a reporting unit exceeds its fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. The updated guidance requires a prospective adoption. The guidance is effective beginning fiscal year 2020. Early adoption is permitted. The Company is currently evaluating the impact of this ASU on the consolidated financial statements. In February 2016, the FASB issued ASU No. 2016-02, “Leases” (Topic 842), which requires lessees to recognize the following for all leases (with the exception of short-term leases) at the commencement date: a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. For leases with a term of 12 months or less, the lessee is permitted to make an accounting policy election by class of underlying asset not to recognize lease assets and lease liabilities. Also, in July 2018, the FASB issued ASU 2018-11, Leases (Topic 842): “Targeted Improvements,” which provides an optional transition method to allow entities, on adoption of ASU 2016-02, to report prior periods under previous lease accounting guidance. The revised guidance must be applied on 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. The revised guidance is effective for the Company beginning after December 15, 2018, including interim periods within those fiscal years. The Company adopted Topic 842; refer to Note 14 - Leases for more information. In November 2016, the FASB issued ASU No. 2016-18, “Statement of Cash Flows (Topic 230): Restricted Cash,” which requires the inclusion of restricted cash with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. This ASU was effective for public business entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The adoption of this guidance did not have a material impact on the Company’s financial results.

<s>[INST] Overview PowerFleet, Inc. (together with its subsidiaries, “PowerFleet,” the “Company,” “we,” “our” or “us”) is a global leader and provider of subscriptionbased wireless InternetofThings (IoT) and machinetomachine (M2M) solutions for securing, controlling, tracking, and managing highvalue enterprise assets such as industrial trucks, trailers, containers, cargo, and light vehicles and heavy truck fleets. As described more fully in Note 3 to our consolidated financial statements included in this Annual Report on Form 10K, on October 3, 2019, we completed the Transactions (as defined below) contemplated by (i) the Agreement and Plan of Merger, dated as of March 13, 2019 (the “Merger Agreement”), by and among I.D. Systems, Inc., a Delaware corporation (“I.D. Systems”), the Company, Pointer Telocation Ltd., a private company limited by shares formed under the laws of the State of Israel (“Pointer”), PowerFleet Israel Ltd. (f/k/a Powerfleet Israel Holding Company Ltd.), a private company limited by shares formed under the laws of the State of Israel and a whollyowned subsidiary of the Company (“PowerFleet Israel”), and Powerfleet Israel Acquisition Company Ltd., a private company limited by shares formed under the laws of the State of Israel and a whollyowned subsidiary of PowerFleet Israel prior to the Transactions, and (ii) the Investment and Transaction Agreement, dated as of March 13, 2019, as amended by Amendment No. 1 thereto dated as of May 16, 2019, Amendment No. 2 thereto dated as of June 27, 2019 and Amendment No. 3 thereto dated as of October 3, 2019 (the “Investment Agreement,” and together with the Merger Agreement, the “Agreements”), by and among I.D. Systems, the Company, PowerFleet US Acquisition Inc., a Delaware corporation and a whollyowned subsidiary of the Company prior to the Transactions, and ABRY Senior Equity V, L.P., ABRY Senior Equity CoInvestment Fund V, L.P. and ABRY Investment Partnership, L.P. (the “Investors”), affiliates of ABRY Partners II, LLC. As a result of the transactions contemplated by the Agreements (the “Transactions”), I.D. Systems and PowerFleet Israel each became direct, whollyowned subsidiaries of the Company and Pointer became an indirect, whollyowned subsidiary of the Company. Prior to the Transactions, PowerFleet had no material assets, did not operate any business and did not conduct any activities, other than those incidental to its formation and matters contemplated by the Agreements. I.D. Systems was determined to be the accounting acquirer in the Transactions. As a result, the historical financial statements of I.D. Systems for the periods prior to the Transactions are considered to be the historical financial statements of PowerFleet and the results of Pointer have been included in our consolidated financial statements from the date of the Transactions. We are headquartered in Woodcliff Lake, New Jersey, with offices located around the globe. Our patented technologies address the needs of organizations to monitor and analyze their assets to improve safety, increase efficiency and productivity, reduce costs, and improve profitability. Our offerings are sold under the global brands PowerFleet, Pointer and Cellocator. We deliver advanced mobility solutions that connect assets to increase visibility operational efficiency and profitability. Across our vertical markets we differentiate ourselves by being OEM agnostic and helping mixed fleets view and manage their assets similarly. All of our solutions are paired with software as a service, or SaaS, analytics platforms to provide an even deeper layer of insights. These insights include a full set of operational Key Performance Indicators, or KPI’s, to drive operational and strategic decisions. These KPI’s leverage industry comparisons to show how a company is performing versus their peers. The more data the system collects, the more accurate a client’ [/INST] Positive. </s>

NXP Semiconductors N.V.

2020-02-27

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 (MD&A) should be read in conjunction with the financial statements and the related notes that appear elsewhere in this document. This section of this Form 10-K generally discusses 2019 and 2018 items and year-to-year comparisons between 2019 and 2018. Discussions of 2017 items and year-to-year comparisons between 2018 and 2017 that are not included in this Form 10-K can be found in Part I, Item 5.A. "Operating Results" of our Form 20-F for the fiscal year ended December 31, 2018 as filed with the SEC on March 1, 2019. Our MD&A is provided in addition to the accompanying consolidated financial statements and notes to assist readers in understanding our results of operations, financial condition and cash flows. MD&A is organized as follows: • Overview - Overall analysis of financial and other highlights to provide context for the MD&A • Results of Operations - An analysis of our financial results • Financial Condition, Liquidity and Capital Resources - An analysis of changes in our balance sheets and cash flows and a discussion of our financial condition and potential sources of liquidity • Critical Accounting Estimates - Accounting estimates that management believes are the most important to understanding the assumptions and judgments incorporated in our financial results and forecasts • Use of Certain Non-GAAP Financial Measures - A discussion of the non-GAAP measures used Effective January 1, 2019, NXP removed the reference to HPMS in its organizational structure in acknowledgment of the one reportable segment representing the entity as a whole. Our segment represents groups of similar products that are combined on the basis of similar design and development requirements, product characteristics, manufacturing processes and distribution channels, and how management allocates resources and measures results. See Note 1 to the financial statements for more information regarding our segment. Overview Revenue for 2019 was down 5.6% from 2018 against a very challenging semiconductor industry backdrop. Revenues decreased by 7% in our largest end market, Automotive, and 12% in our Industrial and IOT end market which were slightly offset by an increase of 5% in the Communications & Infrastructure end market and a 2% increase in the Mobile end market. When aggregating all end markets, the decrease in revenue was mostly related to lower sales to distributors due to lower end customer demand, in particular in Greater China (including Asia Pacific). Notwithstanding the challenging operating environment, we continue to successfully execute our strategy within our target markets and focus on driving profitability. Our gross profit percentage for 2019 increased from 51.6% to 52.0%, due to a slightly more favorable end-market and customer mix and also due to the benefit of certain manufacturing cost controls. NXP’s fourth quarter revenue of $2,301 million increased 1.6% sequentially from the third quarter of 2019. This was driven primarily by an increase of 5% in the Automotive end-market and a 3% increase in the mobile end-market, these increases were offset by a 3% decline in each of the other two end markets. We continue to believe that the demand trends within our end markets are beginning to improve. Over the course of 2019, we significantly enhanced our product portfolio. At the end of the year, we announced the completion of the acquisition of the Marvell wireless connectivity assets and with that introduced new product solutions. Our customers have already begun to adopt many of the new solutions which we anticipate will help to underpin NXP's long-term growth. We continue to generate strong operating cash flows, with $2,373 million in cash flows from operations for 2019. We returned $1,762 million to our shareholders during the year in dividends and repurchases of common stock. On August 29, 2019, we announced an increase in our quarterly dividend by $0.125, or 50%, to $0.375 per common share. Our cash position at the end of 2019 was $1,045 million. On November 19, 2019, the NXP Board of Directors approved a cash dividend of $0.375 per common share for the fourth quarter of 2019. Results of Operations The following table presents the composition of operating income for the years ended December 31, 2019 and December 31, 2018. Revenue Revenue for the year-ended December 31, 2019 was $8,877 million compared to $9,407 million for the year-ended December 31, 2018, a decrease of $530 million or 5.6%. As of January 1, 2019, income and expenses derived from manufacturing service arrangements (“MSA”) and transitional service arrangements (“TSA”) that are put into place when we divest a business or activity, are included in other income (expense). In 2018, revenue related to these divested activities was $136 million The remaining decrease is essentially related to lower sales in our Automotive and in our Industrial & IOT end markets, which were in particular impacted by the trade tensions between the United States and China. Revenue by end-market was as follows: Revenue by sales channel was as follows: Revenue by geographic region, which is based on the customer’s shipped-to location (except for intellectual property license revenue which is attributable to the Netherlands) was as follows: The decrease in revenue in the Automotive end market of $295 million is the result of a decline in volumes in all of the related product groups. The weakness was primarily driven by Greater China (including Asia Pacific), through lower demand from both our distributors and OEM customers as a result of lower vehicle production and lower vehicle sales, but weakness was also seen in EMEA and the Americas. The decrease in revenue in the Industrial & IoT end market of $214 million was essentially associated with our Microcontrollers product group with a decrease in distributor sales, primarily in Greater China (including Asia Pacific). The net increase in revenue of $27 million in the Mobile end market was mostly driven by the strong adoption of our secure mobile wallet solutions with key OEMs, offset by declines in our semi-custom mobile analog interface products through our distribution channel and both within the Greater China (including Asia Pacific) region. The increase of $88 million in the Communication Infrastructure & Other end market was related to robust growth in RF products in Greater China (including Asia Pacific) due to the adoption of the company’s massive-MIMO (“mMIMO”) solutions for the cellular basestation market, as mobile carriers began to increase network densification efforts ahead of future 5G cellular deployments but partly offset by a reduction in the company’s secure bank card and e-government product groups in Greater China (including Asia Pacific) as well as in Europe. Gross Profit Gross profit for the year-ended December 31, 2019 was $4,618 million, or 52.0% of revenue, compared to $4,851 million, or 51.6% of revenue, for the year-ended December 31, 2018. The decrease of $233 million was primarily driven by lower revenue resulting from lower demand. The gross margin percentage increased from 51.6% to 52.0%, due to a slightly more favorable end-market and customer mix and also due to the benefit of certain manufacturing cost controls. Operating Expenses Operating expenses for the year-ended December 31, 2019 totaled $4,002 million, or 45.1% of revenue, compared to $4,142 million, or 44% of revenue, for the year-ended December 31, 2018. The following table below presents the composition of operating expenses by line item in the statement of operations. The decrease in operating expenses was a result of the following items: Research and development (R&D) costs primarily consist of engineer salaries and wages (including share based compensation and other variable compensation), engineering related costs (including outside services, fixed-asset, IP and other licenses related costs), shared service center costs and other pre-production related expenses. •R&D costs for the year-ended December 31, 2019 decreased by $57 million, or 3.4%, when compared to last year driven by: - lower variable compensation costs; - lower costs associated with the Qualcomm transaction; + higher restructuring costs; and + share-based compensation expenses. Selling, general and administrative (SG&A) costs primarily consist of personnel salaries and wages (including share based compensation and other variable compensation), communication and IT related costs, fixed-asset related costs and sales and marketing costs (including travel expenses). •SG&A costs for the year-ended December 31, 2019 decreased by $69 million, or 6.9%, when compared to last year mainly due to: - lower salaries; - lower variable compensation costs; - lower costs associated with the Qualcomm transaction; - reductions in information technology expenditures as well as in professional services; and + higher share-based compensation expenses driven by the equity reboot grant to executives in 2018. •Amortization of acquisition-related intangible assets slightly decreased by $14 million, or 1.0%, when compared to last year driven by: - certain intangibles became fully amortized during 2019; and + the start of amortization of intangible assets related to the Wifi Marvell acquisition. Other Income (Expense) As of January 1, 2019, income and expenses derived from manufacturing service arrangements (“MSA”) and transitional service arrangements (“TSA”) that are put into place when we divest a business or activity, are included in other income (expense). These arrangements are short-term in nature and are expected to decrease as the divested business or activity becomes more established. The following table presents the split of other income (expense) for the years ended December 31, 2019 and 2018: Other income (expense) reflects income of $25 million for 2019, compared to $2,001 million of income in 2018. Included in 2019 is $20 million relating to the sale of assets, whereas the 2018 amount included the $2 billion termination compensation received from Qualcomm. Financial Income (Expense) Financial income (expense) was an expense of $350 million in 2019, compared to an expense of $335 million in 2018. The change in financial income (expense) is primarily attributable to an increase in interest expenses, net of $88 million, as a result of higher debt levels throughout 2019, partially offset by lower debt extinguishment costs in 2019 versus 2018 of $15 million and the absence of the one time charge ($60 million) on certain financial instruments for compensation related to an adjustment event required by the termination of the Qualcomm transaction in 2018. Benefit (Provision) for Income Taxes We recorded an income tax expense of $20 million for the year-ended December 31, 2019, which reflects an effective tax rate of 6.9% compared to an expense of $176 million (7.4%) for the year-ended December 31, 2018. The effective tax rate reflects the impact of tax incentives, a portion of our earnings being taxed in foreign jurisdictions at rates different than the Netherlands statutory tax rate, adjustments of prior years' income taxes, change in valuation allowance and non-deductible expenses. The impact of these items results in offsetting factors that attribute to the change in the effective tax rate between the two periods, with the significant drivers outlined below: • The Company benefits from certain tax incentives, which reduce the effective tax rate in a relative location. The dollar amount of the incentive in any given year is commensurate with the taxable income in that same period. For 2019, the Netherlands tax incentives was lower than 2018, mainly due to the fact that NXP had received a break-up fee from Qualcomm of $2 billion in 2018 which drove a higher income before tax in 2018. • The adjustments to prior years’ income taxes was higher in 2018 as a result of the agreement NXP reached with the Dutch tax authorities relative to the application of the Dutch innovation box regime to the taxable income attributable to the Netherlands. This agreement is effective from January 1, 2017. As such, the Company was able to refine its estimate of the Dutch tax liability, recognizing an additional income tax benefit of $67 million in 2018. • The increase in the valuation allowance is mainly due to new Dutch corporate income tax law applicable as from 2019. A portion of the interest expenses is non-deductible in the year it is recorded but can be carried forward without expiration. • The higher other differences in 2018 relate primarily to a tax benefit on the liquidation of a former investment of $45 million. On a go-forward basis, cash payments for corporate income taxes that are relative to our on-going operations are expected at $45 - $50 million per quarter during 2020. Our future cash payments for income taxes will also be impacted by non-recurring events, resulting in additional payments of $125 million in total, which will be paid in 2020. Results Relating to Equity-accounted Investees Results relating to equity-accounted investees amounted to a gain of $1 million in 2019, whereas in 2018, results relating to equity-accounted investees amounted to a gain of $59 million, which includes a net gain realized of $51 million resulting from the sale of ASEN in July 2018. Non-controlling Interests Non-controlling interests are related to the third-party share in the results of consolidated companies, predominantly SSMC. Their share of non-controlling interests amounted to a profit of $29 million for the year-ended December 31, 2019, compared to a profit of $50 million for the year-ended December 31, 2018. Financial Condition, Liquidity and Capital Resources We derive our liquidity and capital resources primarily from our cash flows from operations. We continue to generate strong positive operating cash flows. As of December 31, 2019, our cash balance was $1,045 million, a decrease of $1,744 million compared to December 31, 2018 ($2,789 million). Taking into account the available undrawn amount of the Unsecured Revolving Credit Facility (the “RCF Agreement”) of $1,500 million, we had access to $2,545 million of liquidity as of December 31, 2019. We currently use cash to fund operations, meet working capital requirements, for capital expenditures and for potential common stock repurchases, dividends and strategic investments. Based on past performance and current expectations, we believe that our current available sources of funds (including cash and cash equivalents, RCF Agreement, plus anticipated cash generated from operations) will be adequate to finance our operations, working capital requirements, capital expenditures and potential dividends for at least the next year. Our capital expenditures were $526 million in 2019, compared to $611 million in 2018. The common stock repurchase activity was as follows: Effective July 26, 2018, the board of directors of NXP, as authorized by its annual general meeting of shareholders (the “AGM”), authorized the repurchase of $5 billion of the Company’s stock period of 18 months. In October 2018, the board of directors of NXP authorized the additional repurchase of shares up to a maximum of 20% (approximately 69 million shares) of the number of shares issued. As of year-end 2018, NXP repurchased 54.4 million shares, for a total of approximately $5 billion, of which a number of 17,300,143 shares had been cancelled. Effective June 17, 2019, the board of directors of NXP, as authorized by its annual general meeting of shareholders (the “AGM”), renewed and revised this authorization for a period of 18 months to repurchase ordinary shares up to the statutory limit. During the fiscal year-ended December 31, 2019 NXP repurchased 15.9 million shares, for a total of approximately $1.4 billion, of which a number of 13.2 million shares had been cancelled. Under Dutch tax law, the repurchase of a company’s shares by an entity domiciled in the Netherlands results in a taxable event. The tax on the repurchased shares is attributed to the shareholders, with NXP making the payment on the shareholders’ behalf. As such, the tax on the repurchased shares is accounted for within stockholders’ equity. On November 27, 2019, the Company, as authorized by the June 2019 AGM, canceled approximately 4% (representing 13,183,081 shares) of the issued number of NXP shares. As a result, the number of issued NXP shares as per November 27, 2019 is 315,519,638 shares. On September 10, 2018, NXP announced the initiation of a Quarterly Dividend Program under which the Company intends to pay a regular quarterly cash dividend. Accordingly, interim dividends of $0.25 per ordinary share were paid on March 15, 2019 and June 13, 2019, and dividends of $0.375 per ordinary share were paid on October 4, 2019 and January 6, 2020. Our total debt amounted to $7,365 million as of December 31, 2019, an increase of $11 million compared to December 31, 2018 ($7,354 million). On December 2, 2019, NXP retired the $1.15 billion outstanding principal amount of the 1.0% Cash Convertible Senior Notes at maturity. At December 31, 2019, our cash balance was $1,045 million, of which $188 million was held by SSMC, our consolidated joint venture company with TSMC. Under the terms of our joint venture agreement with TSMC, a portion of this cash can be distributed by way of a dividend to us, but 38.8% of the dividend will be paid to our joint venture partner. There was no dividend declared in 2019 (in 2018, a dividend of $139 million has been paid by SSMC). From time to time, we engage in discussions with third parties regarding potential acquisitions of, or investments in, businesses, technologies and product lines. Any such transaction could require significant use of our cash and cash equivalents, or require us to arrange for new debt and equity financing to fund the transaction. Our ability to make scheduled payments or to refinance our debt obligations depends on our financial and operating performance, which is subject to prevailing economic and competitive conditions. In the future, we may not be able to maintain a level of cash flows from operating activities sufficient to permit us to pay principal, premium, if any, and interest on our indebtedness. Our business may not generate sufficient cash flow from operations, or we may not have enough capacity under the RCF Agreement, or from other sources in an amount sufficient to enable us to repay our indebtedness, including the RCF Agreement, the unsecured notes or to fund our other liquidity needs, including working capital and capital expenditure requirements. In any such case, we may be forced to reduce or delay capital expenditures, sell assets or operations, seek additional capital or restructure or refinance our indebtedness. See Part I, Item 1A. Risk Factors. Cash Flow from Operating Activities For the year-ended December 31, 2019 our operating activities provided $2,373 million in cash. This was primarily the result of net income of $272 million, adjustments to reconcile the net income of $2,261 million and changes in operating assets and liabilities of ($160) million. Adjustments to net income includes offsetting non-cash items, such as depreciation and amortization of $2,047 million, share-based compensation of $346 million, amortization of the discount on debt and debt issuance costs of $53 million, a gain on sale of assets of ($20) million, a loss on extinguishment of debt of $11 million, results relating to equity-accounted investees of ($1) million and changes in deferred taxes of ($175) million. The change in operating assets and liabilities (working capital accounts) was attributable to the following: The $116 million decrease in receivables and other current assets was primarily due to the decrease in accounts receivable, net, which was driven by the linearity in revenue and the related timing of cash collections in the fourth quarter of 2019 compared with the same period in 2018. The $128 million decrease in inventories was primarily related to management's efforts to align inventory on hand with the current demand forecasts in the fourth quarter of 2019 compared with the same period in 2018 along with the reclassification of $8 million of inventory related to Voice and Audio Solutions as held for sale, offset by $50 million of inventory that was acquired as part of the acquisition of assets from Marvell. The $460 million decrease in accounts payable and other liabilities was primarily related to a decrease in other liabilities resulting from the $197 million payment of an income tax payable related to the Qualcomm break-up fee received in 2018, a decrease of $90 million related to the accrual for variable compensation, a decrease of $76 million related to the accrual for litigation matters, coupled with a decrease of $55 million in accounts payable due to timing in the fourth quarter of 2019 compared with the same period in 2018. The $43 million decrease in other non-current assets was primarily related to the decrease of $44 million for insurance claims in relation to litigation matters as a result of settlement activity. For the year-ended December 31, 2018 our operating activities provided $4,369 million in cash. This was primarily the result of net income of $2,258 million, adjustments to reconcile the net income of $2,114 million and changes in operating assets and liabilities of ($3) million. Net income includes offsetting non-cash items, such as depreciation and amortization of $1,987 million, share-based compensation of $314 million, amortization of the discount on debt and debt issuance costs of $52 million, a loss on extinguishment of debt of $26 million, results relating to equity-accounted investees of ($54) million and changes in deferred taxes of ($211) million. Cash Flow from Investing Activities Net cash used for investing activities amounted to $2,284 million for the year-ended December 31, 2019 and principally consisted of the cash outflows for purchases of interests in businesses (net of cash) of $1,698 million, relating to the acquisition of the Wifi assets of Marvell, capital expenditures of $526 million and $102 million for the purchase of identified intangible assets, partly offset by proceeds of $37 million from the sale of businesses (net of cash) and $23 million from the disposal of property, plant and equipment. Net cash used for investing activities amounted to $522 million for the year-ended December 31, 2018 and principally consisted of the cash outflows for capital expenditures of $611 million and $50 million for the purchase of identified intangible assets, partly offset by proceeds of $159 million from the sale of businesses (net of cash). Cash Flow from Financing Activities Net cash used for financing activities was $1,831 million for the year-ended December 31, 2019 compared to $4,597 million for the year-ended December 31, 2018. The cash flows related to financing transactions in 2019 and 2018 are primarily related to the financing activities described below under the captions 2019 Financing Activities and 2018 Financing Activities. In addition to the financing activities described below, net cash used for financing activities by year included: 2019 Financing Activities 2024 Revolving Credit Facility On June 11, 2019, NXP B.V. together with NXP Funding LLC, entered into a $1.5 billion unsecured revolving credit facility agreement, replacing the $600 million secured revolving credit facility, entered into on December 7, 2015. 2020 Senior Notes On June 11, 2019, NXP B.V. together with NXP Funding LLC, commenced a cash tender offer for any and all of their $600 million outstanding aggregate principal amount of the 4.125% Senior Notes due 2020 (“4.125% 2020 Notes”). An amount of $553 million aggregate principal amount of the 4.125% 2020 Notes were tendered in this offer and retired on June 18, 2019. The remaining $47 million were redeemed under the terms of the indenture governing these notes on July 3, 2019. 2026 and 2029 Senior Unsecured Notes On June 18, 2019, NXP B.V., together with NXP USA Inc. and NXP Funding LLC, issued $750 million of 3.875% Senior Unsecured Notes due 2026 and $1 billion of 4.3% Senior Unsecured Notes due 2029. NXP used a portion of the net proceeds of the offering of these notes to repay in full, the 2020 Senior Notes, as described above. The remaining proceeds were used to refinance the $1,150 million aggregate principal amount of Cash Convertible Notes due 2019 issued by NXP Semiconductors N.V. on December 1, 2014 upon the maturity of these notes on December 1, 2019. 2019 Cash Convertible Senior Notes On December 2, 2019, NXP repaid the Cash Convertible Notes upon their maturity through a combination of available cash and payments made by the counterparties under privately negotiated convertible note hedge transactions (the “Cash Convertible Notes Hedges”), as further described in Note 14 of the notes to consolidated financial statements in this report. 2018 Financing Activities 2024, 2026 and 2028 Senior Unsecured Notes On December 6, 2018, NXP B.V., together with NXP Funding LLC, issued $1 billion of 4.875% Senior Unsecured Notes due March 1, 2024, $500 million of 5.35% Senior Unsecured Notes due March 1, 2026 and $500 million of 5.55% Senior Unsecured Notes due 2028. NXP used a portion of the net proceeds of the offering of these notes to repay in full the Bridge Loan, as described below. The remaining proceeds will be used for general corporate purposes, which may include the repurchase of additional shares of NXP’s common stock. 2019 Bridge Loan On September 19, 2018, NXP B.V., together with NXP Funding LLC, entered into a $1 billion senior unsecured bridge term credit facility agreement under which an aggregate principal amount of $1 billion of term loans (the “Bridge Loan”) was borrowed. The Bridge Loan was to mature on September 18, 2019 and the interest at a LIBOR rate plus an applicable margin of 1.5 percent. NXP used the net proceeds of the Bridge Loan for general corporate purposes as well as to finance parts of the announced equity buy-back program. On December 6, 2018, the Bridge Loan was repaid in full, as described above. 2018 Senior Notes On March 8, 2018, NXP B.V., together with NXP Funding LLC, delivered notice that it would repay to holders of its 3.75% Senior Notes due 2018 (the “2018 Notes”) $750 million of the outstanding aggregate principal amount of the 2018 Notes, which represented all of the outstanding aggregate principal amount of the 2018 Notes. The repayment occurred in April 2018 using available surplus cash. 2023 Senior Notes On March 2, 2018, NXP B.V., together with NXP Funding LLC, delivered notice that it would repay to holders of its 5.75% Senior Notes due 2023 (the “2023 Notes”) $500 million of the outstanding aggregate principal amount of the 2023 Notes, which represented all of the outstanding aggregate principal amount of the 2023 Notes. The repayment occurred in April 2018 using available surplus cash. Debt Position Short-term Debt As of December 31, 2019, there was no short-term debt outstanding. As of December 31, 2018, our short-term debt amounted to $1,107 million. Long-term Debt As of December 31, 2019, we had outstanding debt of: (1) On June 9, 2015, we issued $600 million aggregate principal amount of 4.125% Senior Unsecured Notes due 2020. On June 11, 2019, an amount of $553 million aggregate principal amount were tendered and on June 18, 2019, retired. The remaining $47 million were redeemed under the terms of the indenture governing these notes on July 3, 2019. (2) On May 23, 2016, and August 1, 2016, we issued $850 million and $500 million, respectively, aggregate principal amount of 4.125% Senior Unsecured Notes due 2021. (3) On June 9, 2015, we issued $400 million aggregate principal amount of 4.625% Senior Unsecured Notes due 2022. (4) On August 11, 2016, we issued $1,000 million aggregate principal amount of 3.875% Senior Unsecured Notes due 2022. (5) On May 23, 2016, we issued $900 million aggregate principal amount of 4.625% Senior Unsecured Notes due 2023. (6) On December 6, 2018, we issued $1,000 million aggregate principal amount of 4.875% Senior Unsecured Notes due 2024, $500 million aggregate principal amount of 5.35% Senior Unsecured Notes due 2026 and $500 million aggregate principal amount of 5.55% Senior Unsecured Notes due 2028. (7) On June 18, 2019, we issued $750 million of 3.875% Senior Unsecured Notes due 2026 and $1 billion of 4.3% Senior Unsecured Notes due 2029. (8) On June 11, 2019, we entered into a $1.5 billion unsecured revolving credit facility agreement, replacing the $600 million secured revolving credit facility, entered into on December 7, 2015. (9) Other long-term debt consists primarily of capital lease obligations. (10) Other mainly relates to the reclassification of capital lease obligations to current and non-current other liabilities due to the adoption of the new lease standard in 2019. We may from time to time continue to seek to retire or purchase our outstanding debt through cash purchases and/or exchanges, in open market purchases, privately negotiated transactions or otherwise. See the discussion in Part II, Item 7. Financial Condition, Liquidity and Capital Resources above. 2019 Cash Convertible Senior Notes We repaid the Cash Convertible Notes upon their maturity on December 1, 2019 through a combination of available cash and payments made by the counterparties under privately negotiated convertible note hedge transactions (the “Cash Convertible Notes Hedges”), as further described in Note 14 of the notes to consolidated financial statements in this report. For a detailed description of the Warrants underlying the Cash Convertible Notes Hedge, refer to Note 14 of the notes to consolidated financial statements included in this report. Off-Balance Sheet Arrangements As of December 31, 2019, we had no material off-balance sheet arrangements Contractual Obligations Presented below is a summary of our contractual obligations as of December 31, 2019. (1) As of December 31, 2019, we had reserves of $170 million recorded for uncertain tax positions, including interest and penalties. We are not including this amount in the long-term contractual obligations table presented because of the difficulty in making reasonably reliable estimates of the timing of cash settlements, if any, with the respective taxing authorities. (2) Certain of these obligations are denominated in currencies other than U.S. dollars, and have been translated from foreign currencies into U.S. dollars based on an aggregate average rate of $1.1209 per €1.00, in effect at December 31, 2019. As a result, the actual payments will vary based on any change in exchange rate. In addition to the above obligations, we enter into a variety of agreements in the normal course of business, containing provisions that certain penalties may be charged if we do not fulfill our commitments. It is not possible to predict with certainty the maximum potential amount of future payments under these or similar provisions due to the conditional nature of our obligations and the unique facts and circumstances involved in each particular case. Historically, payments pursuant to such provisions have not been material and we believe that any future payments required pursuant to such provisions would not have a material adverse effect on our consolidated financial condition. However, such payments may be material to our Consolidated Statement of Operations for a specific period. We sponsor pension plans in many countries in accordance with legal requirements, customs and the local situation in the countries involved. These are defined-benefit pension plans, defined contribution pension plans and multi-employer plans. Contributions to funded pension plans are made as necessary, to provide sufficient assets to meet future benefits payable to plan participants. These contributions are determined by various factors, including funded status, legal and tax considerations and local customs. The expected cash outflows in 2020 and subsequent years are uncertain and may change as a consequence of statutory funding requirements as well as changes in actual versus currently assumed discount rates, estimations of compensation increases and returns on pension plan assets. Critical Accounting Estimates The preparation of financial statements and related disclosures in accordance with U.S. GAAP requires our management to make judgments, assumptions and estimates that affect the amounts reported in our Consolidated Financial Statements and the accompanying notes. Our management bases its estimates and judgments on historical experience, current economic and industry conditions and on various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. The methods, estimates, and judgments that we use in applying our accounting policies have a significant impact on the results that we report in our Consolidated Financial Statements. Some of our accounting policies require us to make difficult and subjective judgments, often as a result of the need to make estimates regarding matters that are inherently uncertain. Our most critical accounting estimates include: • the valuation of inventory, which impacts gross margin; • the assessment of recoverability of goodwill, identified intangible assets and tangible fixed assets, which impacts gross margin or operating expenses when we record asset impairments or accelerate their depreciation or amortization; • revenue recognition, which impacts our results of operations; • the recognition of current and deferred income taxes (including the measurement of uncertain tax positions), which impacts our provision for income taxes; • the assumptions used in the determination of postretirement benefit obligations, which impacts operating expenses; • the assumptions used in the determination of share based compensation, which impacts gross margin and operating expenses; and • the recognition and measurement of loss contingencies, which impacts gross margin or operating expenses when we recognize a loss contingency or revise the estimates for a loss contingency. In the following section, we discuss these policies further, as well as the estimates and judgments involved. Inventories Inventories are valued at the lower of cost or market. We regularly review our inventories and write down our inventories for estimated losses due to obsolescence. This allowance is determined for groups of products based on sales of our products in the recent past and/or expected future demand. Future demand is affected by market conditions, technological obsolescence, new products and strategic plans, each of which is subject to change with little or no forewarning. In estimating obsolescence, we utilize information that includes projecting future demand. The need for strategic inventory levels to ensure competitive delivery performance to our customers are balanced against the risk of inventory obsolescence due to rapidly changing technology and customer requirements. The change in our reserves for inventories was primarily due to the normal review and accrual of obsolete or excess inventory. If actual future demand or market conditions are less favorable than those projected by our management, additional inventory write-downs may be required. Goodwill Goodwill is required to be tested for impairment at least annually or sooner whenever events or changes in circumstances indicate that the assets may be impaired. Such events or changes in circumstances can be significant changes in business climate, operating performance or competition, or upon the disposition of a significant portion of a reporting unit. A significant amount of judgment is involved in determining if an indicator of impairment has occurred between annual test dates. This impairment review compares the fair value for each reporting unit containing goodwill to its carrying value. Determining the fair value of a reporting unit involves the use of significant estimates and assumptions, including projected future cash flows, discount rates based on weighted average cost of capital and future economic and market conditions. We base our fair-value estimates on assumptions we believe to be reasonable. Actual cash flow amounts for future periods may differ from estimates used in impairment testing. For the annual impairment assessment for the year-ended December 31, 2019, we determined that for our reporting unit,the fair value exceeded the carrying value. During the third and fourth quarter of each of the prior two fiscal years, respectively, we have completed our annual impairment assessments and concluded that goodwill was not impaired in any of these years. Impairment or disposal of identified intangible assets and tangible fixed assets We perform reviews of property, plant and equipment, and certain identifiable intangibles, excluding goodwill, to determine if facts and circumstances indicate that the useful life is shorter than what we had originally estimated or that the carrying amount of assets may not be recoverable. If such facts and circumstances exist, we assess the recoverability of the long-lived assets by comparing the projected undiscounted net cash flows associated with the related asset or group of assets over their remaining lives against their respective carrying amounts. In the event such cash flows are not expected to be sufficient to recover the recorded value of the assets, the assets are written down to their estimated fair values based on the expected discounted future cash flows attributable to the assets or based on appraisals. Impairment losses, if any, are based on the excess of the carrying amount over the fair value of those assets. The assumptions and estimates used to determine future values and remaining useful lives of our intangible and other long-lived assets are complex and subjective. They can be affected by various factors, including external factors such as industry and economic trends, and internal factors such as changes in our business strategy and our forecasts for specific product lines. In 2019 and 2018, we had no impairments. In 2017, we recognized impairment charges of $23 million, of which $16 million relative to IPR&D that was acquired from Freescale. Revenue recognition The Company recognizes revenue under the core principle to depict the transfer of control to customers in an amount reflecting the consideration the Company expects to be entitled. In order to achieve that core principle, the Company applies the following five step approach: (1) identify the contract with a customer, (2) identify the performance obligations in the contract, (3) determine the transaction price, (4) allocate the transaction price to the performance obligations in the contract, and (5) recognize revenue when a performance obligation is satisfied. The vast majority of the Company’s revenue is derived from the sale of semiconductor products to distributors, Original Equipment Manufacturers (“OEMs”) and similar customers. In determining the transaction price, the Company evaluates whether the price is subject to refund or adjustment to determine the consideration to which the Company expects to be entitled. Variable consideration is estimated and includes the impact of discounts, price protection, product returns and distributor incentive programs. The estimate of variable consideration is dependent on a variety of factors, including contractual terms, analysis of historical data, current economic conditions, industry demand and both the current and forecasted pricing environments. The estimate of variable consideration is not constrained because the Company has extensive experience with these contracts. Revenue is recognized when control of the product is transferred to the customer (i.e., when the Company’s performance obligation is satisfied), which typically occurs at shipment. In determining whether control has transferred, the Company considers if there is a present right to payment and legal title, and whether risks and rewards of ownership having transferred to the customer. For sales to distributors, revenue is recognized upon transfer of control to the distributor. For some distributors, contractual arrangements are in place which allow these distributors to return products if certain conditions are met. These conditions generally relate to the time period during which a return is allowed and reflect customary conditions in the particular geographic market. Other return conditions relate to circumstances arising at the end of a product life cycle, when certain distributors are permitted to return products purchased during a pre-defined period after the Company has announced a product’s pending discontinuance. These return rights are a form of variable consideration and are estimated using the most likely method based on historical return rates in order to reduce revenues recognized. However, long notice periods associated with these announcements prevent significant amounts of product from being returned. For sales where return rights exist, the Company has determined, based on historical data, that only a very small percentage of the sales of this type to distributors is actually returned. Repurchase agreements with OEMs or distributors are not entered into by the Company. Sales to most distributors are made under programs common in the semiconductor industry whereby distributors receive certain price adjustments to meet individual competitive opportunities. These programs may include credits granted to distributors, or allow distributors to return or scrap a limited amount of product in accordance with contractual terms agreed upon with the distributor, or receive price protection credits when our standard published prices are lowered from the price the distributor paid for product still in its inventory. In determining the transaction price, the Company considers the price adjustments from these programs to be variable consideration that reduce the amount of revenue recognized. The Company’s policy is to estimate such price adjustments using the most likely method based on rolling historical experience rates, as well as a prospective view of products and pricing in the distribution channel for distributors who participate in our volume rebate incentive program. We continually monitor the actual claimed allowances against our estimates, and we adjust our estimates as appropriate to reflect trends in pricing environments and inventory levels. The estimates are also adjusted when recent historical data does not represent anticipated future activity. Historically, actual price adjustments for these programs relative to those estimated have not materially differed. Income taxes Deferred tax assets and liabilities are recognized for the expected tax consequences of temporary differences between the tax basis of assets and liabilities and their reported amounts. Measurement of deferred tax assets and liabilities is based upon 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. Deferred tax liabilities for withholding taxes on dividends from subsidiaries are recognized in situations where the company does not consider the earnings indefinitely reinvested and to the extent that these withholding taxes are not expected to be refundable. Deferred tax assets, including assets arising from loss carryforwards, are recognized, net of a valuation allowance, if based upon the available evidence it is more likely than not that the asset will be realized. The income tax benefit from an uncertain tax position is recognized only if it is more likely than not that the tax position will be sustained upon examination by the relevant taxing authorities. The income tax benefit recognized is measured based on the largest benefit that is more than 50% likely to be realized upon resolution of the uncertainty. Unrecognized tax benefits are presented as a reduction to the deferred tax asset for related net operating loss carryforwards, unless these would not be available, in which case the uncertain tax benefits are presented together with the related interest and penalties as a liability, under accrued liabilities and other non-current liabilities based on the timing of the expected payment. Penalties are recorded as income tax expense, whereas interest is reported as financial expense in the statement of operations. Postretirement benefits The Company’s employees participate in pension and other postretirement benefit plans in many countries. The costs of pension and other postretirement benefits and related assets and liabilities with respect to the Company’s employees participating in defined-benefit plans are based upon actuarial valuations. The projected defined-benefit obligation is calculated annually by qualified actuaries using the projected unit credit method. For the Company’s major plans, the discount rate is derived from market yields on high quality corporate bonds. Plans in countries without a deep corporate bond market use a discount rate based on the local government bond rates. In calculating obligation and expense, the Company is required to select actuarial assumptions. These assumptions include discount rate, expected long-term rate of return on plan assets and rates of increase in compensation costs determined based on current market conditions, historical information and consultation with and input from our actuaries. Changes in the key assumptions can have a significant impact to the projected benefit obligations, funding requirements and periodic pension cost incurred. The Company determines the fair value of plan assets based on quoted prices or comparable prices for non-quoted assets. For a defined-benefit pension plan, the benefit obligation is the projected benefit obligation; for any other postretirement defined benefit plan it is the accumulated postretirement benefit obligation. Share-based compensation We recognize compensation expense for all share-based awards based on the grant-date estimated fair values, net of an estimated forfeiture rate. We use the Black-Scholes option pricing model to determine the estimated fair value for certain awards. Share-based compensation cost for restricted share units (“RSUs”) with time-based vesting is measured based on the closing fair market value of our common stock on the date of the grant, reduced by the present value of the estimated expected future dividends, and then multiplied by the number of RSUs granted. Share-based compensation cost for performance-based share units (“PSUs”) granted with performance or market conditions is measured using a Monte Carlo simulation model on the date of grant. Our valuation models and generally accepted valuation techniques require us to make assumptions and to apply judgment to determine the fair value of our awards. These assumptions and judgments include estimating the volatility of our stock price, expected dividend yield, employee turnover rates and employee stock option exercise behaviors. When establishing the expected life assumption, we used the ‘simplified’ method prescribed in ASC Topic 718 for companies that do not have adequate historical data. The risk-free interest rate is measured as the prevailing yield for a U.S. Treasury security with a maturity similar to the expected life assumption. We also estimate a forfeiture rate at the time of grant and revise this rate in subsequent periods if actual forfeitures or vesting differ from the original estimates. We evaluate the assumptions used to value our awards on a quarterly basis. If factors change and we employ different assumptions, share-based compensation expense may differ significantly from what we have recorded in the past. If there are any modifications or cancellation of the underlying unvested securities, we may be required to accelerate, increase or cancel any remaining unearned share-based compensation expense. Litigation and claims We are regularly involved as plaintiffs or defendants in claims and litigation related to our past and current business operations. The claims can cover a broad range of topics, including intellectual property, reflecting the Company’s identity as a global manufacturing and technology business. The Company vigorously defends itself against improper claims, including those asserted in litigation. Due to the unpredictable nature of litigation, there can be no assurance that the Company’s accruals will be sufficient to cover the extent of its potential exposure to losses but, historically, legal actions have not had a material adverse effect on the Company’s business, results of operations or financial condition. The estimated aggregate range of reasonably possible losses is based on currently available information in relation to the claims that have arisen and on the Company’s best estimate of such losses for those cases for which such estimate can be made. For certain claims, the Company believes that an estimate cannot currently be made. The estimated aggregate range requires significant judgment, given the varying stages of the proceedings (including the fact that many of them are currently in preliminary stages), the existence of multiple defendants (including the Company) in such claims whose share of liability has yet to be determined, the numerous yet-unresolved issues in many of the claims, and the attendant uncertainty of the various potential outcomes of such claims. Accordingly, the Company’s estimate will change from time to time, and actual losses may be more than the current estimate. Use of Certain Non-GAAP Financial Measures Net debt is a non-GAAP financial measure and represents total debt (short-term and long-term) after deduction of cash and cash equivalents. Management believes this measure is appropriate to calculate our net leverage. We understand that, although net debt is used by investors and securities analysts in their evaluation of companies, this concept has limitations as an analytical tool and it should not be used as an alternative to any other measure in accordance with U.S. GAAP.

<s>[INST] Our MD&A is provided in addition to the accompanying consolidated financial statements and notes to assist readers in understanding our results of operations, financial condition and cash flows. MD&A is organized as follows: Overview Overall analysis of financial and other highlights to provide context for the MD&A Results of Operations An analysis of our financial results Financial Condition, Liquidity and Capital Resources An analysis of changes in our balance sheets and cash flows and a discussion of our financial condition and potential sources of liquidity Critical Accounting Estimates Accounting estimates that management believes are the most important to understanding the assumptions and judgments incorporated in our financial results and forecasts Use of Certain NonGAAP Financial Measures A discussion of the nonGAAP measures used Effective January 1, 2019, NXP removed the reference to HPMS in its organizational structure in acknowledgment of the one reportable segment representing the entity as a whole. Our segment represents groups of similar products that are combined on the basis of similar design and development requirements, product characteristics, manufacturing processes and distribution channels, and how management allocates resources and measures results. See Note 1 to the financial statements for more information regarding our segment. Overview Revenue for 2019 was down 5.6% from 2018 against a very challenging semiconductor industry backdrop. Revenues decreased by 7% in our largest end market, Automotive, and 12% in our Industrial and IOT end market which were slightly offset by an increase of 5% in the Communications & Infrastructure end market and a 2% increase in the Mobile end market. When aggregating all end markets, the decrease in revenue was mostly related to lower sales to distributors due to lower end customer demand, in particular in Greater China (including Asia Pacific). Notwithstanding the challenging operating environment, we continue to successfully execute our strategy within our target markets and focus on driving profitability. Our gross profit percentage for 2019 increased from 51.6% to 52.0%, due to a slightly more favorable endmarket and customer mix and also due to the benefit of certain manufacturing cost controls. NXP’s fourth quarter revenue of $2,301 million increased 1.6% sequentially from the third quarter of 2019. This was driven primarily by an increase of 5% in the Automotive endmarket and a 3% increase in the mobile endmarket, these increases were offset by a 3% decline in each of the other two end markets. We continue to believe that the demand trends within our end markets are beginning to improve. Over the course of 2019, we significantly enhanced our product portfolio. At the end of the year, we announced the completion of the acquisition of the Marvell wireless connectivity assets and with that introduced new product solutions. Our customers have already begun to adopt many of the new solutions which we anticipate will help to underpin NXP's longterm growth. We continue to generate strong operating cash flows, with $2,373 million in cash flows from operations for 2019. We returned $1,762 million to our shareholders during the year in dividends and repurchases of common stock. On August 29, 2019, we announced an increase in our quarterly dividend by $0.125, or 50%, to $0.375 per common share. Our cash position at the end of 2019 was $1,045 million. On November 19, 2019, the NXP Board of Directors approved a cash dividend of $0.375 per common share for the fourth quarter of 2019. Results of Operations The following table presents the composition of operating income for the years ended December 31, 2019 and December 31, 2018. Revenue Revenue for the yearended December 31, 2019 was $8,877 million compared to $9,407 million for the yearended December 31, 2018, a decrease of $530 million or 5.6%. As of January 1, 2019, income and expenses derived from manufacturing service arrangements (“MSA”) and transitional service arrangements (“ [/INST] Positive. </s>

Grocery Outlet Holding Corp.

2020-03-25

2019-12-28

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION You should read the following discussion of our financial condition and results of operations in conjunction with the consolidated financial statements and related notes thereto included in “Item 8. Financial Statements and Supplementary Data.” This discussion may contain 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 described in “Item 1A. Risk Factors” or in other sections of this report. We operate on a fiscal year that ends on the Saturday closest to December 31st each year. References to fiscal 2019, fiscal 2018, and fiscal 2017 refer to the fiscal years ended December 28, 2019, December 29, 2018, and December 30, 2017, respectively. OVERVIEW We are a high-growth, extreme value retailer of quality, name-brand consumables and fresh products sold through a network of independently operated stores. Our flexible buying model allows us to offer quality, name-brand opportunistic products at prices generally 40% to 70% below those of conventional retailers. Entrepreneurial independent operators (“IOs”) run our stores and create a neighborhood feel through personalized customer service and a localized product offering. This differentiated approach has driven 16 consecutive years of positive comparable store sales growth. As of December 28, 2019, we had 347 stores in California, Washington, Oregon, Pennsylvania, Idaho and Nevada. Initial Public Offering On June 24, 2019, we completed our initial public offering (“IPO”) of 19,765,625 shares of our common stock at a public offering price of $22.00 per share for net proceeds of $407.7 million, after deducting underwriting discounts and commissions of $27.1 million. We also incurred offering costs payable by us of $7.2 million which we recognized as a charge to additional paid-in-capital. The shares of common stock sold in the IPO and the net proceeds from the IPO included the full exercise of the underwriters’ option to purchase additional shares. In connection with the closing of our IPO, we repaid in full the $150.0 million outstanding principal amount and $3.6 million accrued interest on our second lien term loan and terminated the related loan agreement. Additionally, using the remainder of the net proceeds, together with excess cash on hand, we prepaid a portion of the term loan outstanding under our first lien credit agreement, dated as of October 22, 2018 (as amended, the “First Lien Credit Agreement”) totaling $248.0 million and $3.8 million of accrued interest. On October 23, 2019, we prepaid an additional $15.0 million of principal on the term loan outstanding under our First Lien Credit Agreement. See “-Liquidity and Capital Resources” for additional information. In addition, in fiscal 2019, we recognized $24.3 million for share-based compensation expense related to time-based stock options granted prior to our IPO, for which vesting became probable upon completion of our IPO, as well as $3.0 million for share-based compensation expense related to time-based stock options and RSUs granted as part of and subsequent to our IPO. See NOTE 7-Share-based Awards to our Consolidated Financial Statements for additional information. Secondary Public Offerings On October 8, 2019, certain of our selling stockholders completed a secondary public offering of shares of our common stock. We did not receive any of the proceeds from the sale of these shares by the selling stockholders. We incurred related offering costs of $1.1 million which are included in selling, general and administrative expenses for fiscal 2019. We received $3.2 million in cash (excluding withholding taxes) in connection with the exercise of 451,470 options by certain stockholders participating in this secondary public offering. On February 3, 2020, certain of our selling stockholders completed another secondary public offering of shares of our common stock. We did not receive any of the proceeds from the sale of these shares by the selling stockholders. We incurred offering costs payable by us of $1.1 million. We received $1.4 million in cash (excluding withholding taxes) in connection with the exercise of 191,470 options by certain stockholders participating in this secondary public offering. COVID-19 On March 11, 2020, the World Health Organization declared the novel strain of coronavirus, COVID-19, a global pandemic and recommended containment and mitigation measures worldwide. As a result, many states, including California, Washington and Oregon, where we have a significant number of stores, have declared a state of emergency, closed schools and non-essential businesses and enacted limitations on the number of people allowed to gather at one time in the same space. As of the date of this filing, grocery stores are considered essential businesses in states and counties that have enacted requirements that residents leave their homes only for essential business (“shelter in place”) and are able to continue operating. However, we expect that our IOs may face staffing challenges so long as school closures and COVID-19-related concerns exist. In addition, certain inventory items such as water, beans and bread as well as key cleaning supplies and protective equipment have been, and may continue to be, in short supply. These factors could impact the ability of stores to operate normal hours of operation or have sufficient inventory at all times which may disrupt our business and negatively impact our financial results. Further, planned construction and opening of new stores may be negatively impacted due to shelter in place requirements and the closure of government offices in certain areas. In the event that an employee, IO, or IO employee tests positive for COVID-19, we may have to temporarily close a store, office or distribution center for cleaning and/or quarantine one or more employees which could negatively impact our financial results. We cannot reasonably estimate the length or severity of this pandemic, but it could have a material adverse impact on our consolidated financial position, consolidated results of operations, and consolidated cash flows in fiscal 2020. See “Item 1A. Risk Factors-Major health epidemics, such as the outbreak caused by a coronavirus (COVID-19), and other outbreaks could disrupt and adversely affect our operations, financial condition and business” for additional information. Key Factors and Measures We Use to Evaluate Our Business We consider a variety of financial and operating measures in assessing the performance of our business. The key GAAP measures we use are net sales, gross profit and gross margin, selling, general and administrative expenses (“SG&A”) and operating income. The key operational metrics and non-GAAP measures we use are number of new stores, comparable store sales, EBITDA, adjusted EBITDA and non-GAAP adjusted net income. Fiscal 2019 Overview Key financial and operating performance results for our fiscal 2019 compared to our fiscal 2018 are as follows: •Net sales increased by 11.9% to approximately $2.56 billion for fiscal 2019 from approximately $2.29 billion for fiscal 2018; comparable store sales increased by 5.2% in fiscal 2019 compared to a 3.9% increase in fiscal 2018. •We opened 34 new stores and closed 3, ending fiscal 2019 with 347 stores in six states. •Net income decreased 2.8% to $15.4 million, or $0.19 per diluted share for fiscal 2019, compared to net income of $15.9 million, or $0.23 per diluted share, for fiscal 2018. •Adjusted EBITDA(1) increased 10.6% to $169.8 million for fiscal 2019 compared to $153.6 million for fiscal 2018. •Non-GAAP adjusted net income(1) increased 31.7% to $65.0 million, or $0.79 per non-GAAP diluted share, for fiscal 2019 compared to $49.3 million, or $0.72 per non-GAAP diluted share, for fiscal 2018. _______________________ (1)Adjusted EBITDA, non-GAAP adjusted net income and non-GAAP adjusted diluted earnings per share are non-GAAP financial measures and should be considered as a supplement to, and not as a substitute for, or superior to, financial measures calculated in accordance with GAAP. See GAAP to non-GAAP reconciliations in the “Operating Metrics and Non-GAAP Financial Measures” section below for additional information. Key Components of Results of Operations Net Sales We recognize revenues from the sale of products at the point of sale, net of any taxes or deposits collected and remitted to governmental authorities. Discounts provided to customers by us are recognized at the time of sale as a reduction in sales as the products are sold. Discounts that are funded solely by IOs are not recognized as a reduction in sales as the IO bears the incidental costs arising from the discount. We do not accept manufacturer coupons. Sales consist of sales from comparable stores and non-comparable stores, described below under “Comparable Store Sales.” Growth of our sales is primarily driven by expansion of our store base in existing and new markets as well as comparable store sales growth. Sales are impacted by product mix and availability, as well as promotional and competitive activities and the spending habits of our customers. Our ever-changing selection of offerings across diverse product categories supports growth in sales by attracting new customers and encouraging repeat visits from our existing customers. The spending habits of our customers are subject to macroeconomic conditions and changes in discretionary income. Our customers’ discretionary income is primarily impacted by wages, fuel and other cost-of-living increases including food-at-home inflation, as well as consumer trends and preferences, which fluctuate depending on the environment. Because we offer a broad selection of merchandise at extreme values, historically we have benefited from periods of economic uncertainty. Cost of Sales, Gross Profit and Gross Margin Cost of sales includes, among other things, merchandise costs, inventory markdowns, inventory losses and transportation, distribution and warehousing costs, including depreciation. Gross profit is equal to our sales less our cost of sales. Gross margin is gross profit as a percentage of our sales. Gross margin is a measure used by management to indicate whether we are selling merchandise at an appropriate gross profit. Gross margin is impacted by product mix and availability, as some products generally provide higher gross margins, and by our merchandise costs, which can vary. Gross margin is also impacted by the costs of distributing and transporting product to our stores, which can vary. Our gross profit is variable in nature and generally follows changes in sales. Our disciplined buying approach has produced consistent gross margins throughout economic cycles which we believe has helped to mitigate adverse impacts on gross profit and results of operations. The components of our cost of sales may not be comparable to the components of cost of sales or similar measures of our competitors and other retailers. As a result, our gross profit and gross margin may not be comparable to similar data made available by our competitors and other retailers. Prior to fiscal 2014, we calculated gross margin based on gross sales, not deducting for deposits collected or discounts provided, and excluding warehouse depreciation. Selling, General and Administrative Expenses SG&A expenses are comprised of both store-related expenses and corporate expenses. Store-related expenses include commissions paid to IOs, occupancy and shared maintenance costs, Company-operated store expenses, including payroll, benefits, supplies and utilities and the cost of opening new IO stores. Corporate expenses include payroll and benefits for corporate and field support, marketing and advertising, insurance and professional services and AOT recruiting and training costs. SG&A generally increases as we grow our store base and invest in our corporate infrastructure. SG&A expenses related to commissions paid to IOs are variable in nature and generally increase as gross profits rise. The remainder of our expenses are primarily fixed in nature. We continue to closely manage our expenses and monitor SG&A as a percentage of sales. The components of our SG&A may not be comparable to the components of similar measures of other retailers. We expect that our SG&A will continue to increase in future periods as we continue to grow our sales revenue. Operating Income Operating income is gross profit less SG&A, depreciation and amortization and share-based compensation. Operating income excludes interest expense, net, debt extinguishment and modification costs and income tax expense. We use operating income as an indicator of the productivity of our business and our ability to manage expenses. Results of Operations The following tables summarize key components of our results of operations for the periods presented, both in dollars and as a percentage of net sales (amounts in thousands, except for percentages): _______________________ (1)Components may not sum to totals due to rounding. Operating Metrics and Non-GAAP Financial Measures Number of New Stores The number of new stores reflects the number of stores opened during a particular reporting period. New stores require an initial capital investment in the store build-outs, fixtures and equipment which we amortize over time as well as cash required for inventory and pre-opening expenses. We expect new store growth of IO stores to be the primary driver of our sales growth. We lease substantially all of our store locations. Our initial lease terms on stores are typically ten years with options to renew for two or three successive five-year periods. Comparable Store Sales We use comparable store sales as an operating metric to measure performance of a store during the current reporting period against the performance of the same store in the corresponding period of the previous year. Comparable store sales are impacted by the same factors that impact sales. Comparable store sales consists of sales from our stores beginning on the first day of the fourteenth full fiscal month following the store’s opening, which is when we believe comparability is achieved. Included in our comparable store definition are those stores that have been remodeled, expanded, or relocated in their existing location or respective trade areas. Excluded from our comparable store definition are those stores that have been closed for an extended period as well as any planned store closures or dispositions. When applicable, we exclude the sales in the non-comparable week of a 53-week year from the same store sales calculation. Opening new stores is a primary component of our growth strategy and, as we continue to execute on our growth strategy, we expect a significant portion of our sales growth will be attributable to non-comparable store sales. Accordingly, comparable store sales is only one measure we use to assess the success of our growth strategy. Prior to fiscal 2014, we calculated comparable store sales growth based on gross sales for stores beginning on the 366th day after opening. While we believe results under this prior method do not materially differ from results under our current method, we believe that our current methodology more appropriately adjusts for higher sales volumes that typically occur in conjunction with a store’s grand opening events. EBITDA, Adjusted EBITDA and Non-GAAP Adjusted Net Income EBITDA, adjusted EBITDA and non-GAAP adjusted net income are key metrics used by management and our board of directors to assess our financial performance. EBITDA, adjusted EBITDA and non-GAAP adjusted net income are also frequently used by analysts, investors and other interested parties to evaluate companies in our industry. We use EBITDA, adjusted EBITDA and non-GAAP adjusted net income to supplement GAAP measures of performance to evaluate the effectiveness of our business strategies, to make budgeting decisions and to compare our performance against that of other peer companies using similar measures. In addition, we use EBITDA to supplement GAAP measures of performance to evaluate our performance in connection with compensation decisions. Management believes it is useful to investors and analysts to evaluate these non-GAAP measures on the same basis as management uses to evaluate our operating results. We believe that excluding items from operating income, net income and net income per diluted share that may not be indicative of, or are unrelated to, our core operating results, and that may vary in frequency or magnitude, enhances the comparability of our results and provides a better baseline for analyzing trends in our business. We define EBITDA as net income before net interest expense, income taxes and depreciation and amortization expenses. Adjusted EBITDA represents EBITDA adjusted to exclude share-based compensation expense, purchase accounting inventory adjustments, debt extinguishment and modification costs, non-cash rent, asset impairment and gain or loss on disposition, new store pre-opening expenses, dead rent for acquired leases, provision for accounts receivable reserves and certain other expenses. Non-GAAP adjusted net income represents net income adjusted for the previously mentioned EBITDA adjustments, further adjusted for costs related to amortization of purchase accounting assets and deferred financing costs and tax effect of total adjustments. EBITDA, adjusted EBITDA and non-GAAP adjusted net income are non-GAAP measures and may not be comparable to similar measures reported by other companies. EBITDA, adjusted EBITDA and non-GAAP adjusted net income have limitations as analytical tools, and you should not consider them in isolation or as a substitute for analysis of our results as reported under GAAP. We address the limitations of the non-GAAP measures through the use of various GAAP measures. In the future we may incur expenses or charges such as those added back to calculate adjusted EBITDA or non-GAAP adjusted net income. Our presentation of adjusted EBITDA and non-GAAP adjusted net income should not be construed as an inference that our future results will be unaffected by the adjustments we have used to derive our non-GAAP measures. The following table summarizes key operating metrics and non-GAAP components of our results of operations for the periods presented (amounts in thousands, except for percentages and store counts): _______________________ (1)Comparable store sales consist of sales from our stores beginning on the first day of the fourteenth full fiscal month following the store’s opening, which is when we believe comparability is achieved. (2)See “-GAAP to Non-GAAP Reconciliations” section below for a reconciliation from our net income to EBITDA and adjusted EBITDA, net income to non-GAAP adjusted net income, and GAAP to non-GAAP earnings per share for the periods presented: GAAP to Non-GAAP Reconciliations The following tables provide a reconciliation from our GAAP net income to EBITDA and adjusted EBITDA, GAAP net income to non-GAAP adjusted net income, and our GAAP to non-GAAP earnings per share for the periods presented: ___________________________ (a)Includes depreciation related to our distribution centers which is included within the cost of sales line item in our consolidated statements of operations and comprehensive income. See NOTE 1-Organization and Summary of Significant Accounting Policies to our Consolidated Financial Statements for additional information about the components of cost of sales. (b)Includes $3.6 million, $10.0 million, and $1.3 million of cash dividends paid in fiscal 2019, 2018, and 2017 respectively, in respect of vested options as a result of dividends declared in connection with our recapitalizations in fiscal 2018 and 2016. (c)Represents the write-off of debt issuance costs and debt discounts related to the repricing and/or repayment of our first and second lien credit facilities. See NOTE 6-Long-term Debt to our Consolidated Financial Statements for additional information. (d)Consists of the non-cash portion of rent expense, which represents the difference between our straight-line rent expense recognized under GAAP and cash rent payments. The adjustment can vary depending on the average age of our lease portfolio, which has been impacted by our significant growth in recent years. Non-cash rent was impacted by the adoption of ASC 842, Leases, which moved approximately $3.2 million out of amortization expense and into non-cash rent expense. (e)Represents impairment charges with respect to planned store closures and gains or losses on dispositions of assets in connection with store transitions to new IOs. (f)Includes marketing, occupancy and other expenses incurred in connection with store grand openings, including costs that will be the IO’s responsibility after store opening. (g)Represents cash occupancy costs on leases acquired from Fresh & Easy, Inc. in 2015 for the periods prior to opening new stores on such sites (commonly referred to as “dead rent”). (h)Represents non-cash changes in reserves related to our IO notes and accounts receivable. (i)Other non-recurring, non-cash or discrete items as determined by management, including transaction related costs, personnel-related costs, store closing costs, legal expenses, strategic project costs, and miscellaneous costs. (j)Represents the amortization of debt issuance costs and incremental amortization of an asset step-up resulting from purchase price accounting related to the 2014 H&F Acquisition which included trademarks, customer lists, and below-market leases. In fiscal 2019, due to the adoption of ASC 842, Leases, approximately $3.2 million in below-market lease amortization expense was moved out of this line and into non-cash rent expense. (k)Represents the tax effect of the total adjustments. Because of the increased impact of discrete items on our effective tax rate including the excess tax benefits from the exercise and vest of share-based awards, beginning in the fourth quarter of fiscal 2019, we changed our methodology in order to tax effect the total adjustments on a discrete basis excluding any non-recurring and unusual tax items. Prior to the fourth quarter of fiscal 2019, the methodology we used was to calculate the tax effect of the total adjustments using our quarterly effective tax rate. (l)On June 6, 2019, we effected a 1.403 for 1 forward stock split. All share amounts and per share disclosures for all periods presented have been adjusted retroactively for the impact of this forward stock split. Comparison of fiscal 2019 to fiscal 2018 (dollars in thousands) Net Sales The increase in net sales for fiscal 2019 compared to fiscal 2018 was due to non-comparable store sales growth attributable to the net 31 stores opened during fiscal 2019 as well as an increase in comparable store sales. Comparable store sales increased 5.2% for fiscal 2019 compared to fiscal 2018, primarily driven by strong opportunistic and every day product purchasing, continued growth of our Natural, Organic, Specialty and Healthy (“NOSH”) business and expansion and effectiveness of our corporate and IO-led marketing initiatives. Cost of Sales The increase in cost of sales for fiscal 2019 compared to fiscal 2018 was primarily the result of new store growth and an increase in comparable store sales. Costs as a percentage of sales decreased slightly due to strong purchasing and inventory management. Gross Profit and Gross Margin The increase in gross profit for fiscal 2019 compared to fiscal 2018 was primarily the result of new store growth and an increase in comparable store sales. Our gross margin increased modestly for fiscal 2019 compared to fiscal 2018 due to strong purchasing and inventory management. Selling, General and Administrative Expenses (“SG&A”) The increase in SG&A for fiscal 2019 compared to fiscal 2018 was primarily driven by increased selling expenses related to new store growth and higher sales volume. These increased expenses consisted primarily of commissions, store occupancy and shared maintenance costs, as well as investments in general and administrative infrastructure to support the continued growth in the business. SG&A was also impacted by the adoption of ASC 842, Leases, which moved approximately $3.2 million of previous amortization expense into non-cash rent. As a percentage of sales, SG&A increased modestly for fiscal 2019 compared to fiscal 2018 partially as a result of approximately $4.5 million in additional costs incurred to comply with public company requirements including incremental insurance, accounting, and legal expense as well as costs required to comply with the Sarbanes-Oxley Act. Depreciation and Amortization Expense The increase in depreciation and amortization expenses for fiscal 2019 compared to fiscal 2018 is primarily driven by new store growth and other capital investments, partially offset by the adoption of ASC 842, Leases, which moved approximately $3.2 million of previous amortization expense into SG&A expenses. Share-based Compensation Expense The increase in share-based compensation expense for fiscal 2019 compared to fiscal 2018 was primarily driven by $24.3 million for share-based compensation expense related to time-based stock options granted prior to our IPO and $3.0 million for share-based compensation expense related to time-based stock options and RSUs granted as part of and subsequent to our IPO, with the remaining difference primarily relating to payment of dividends declared in connection with our recapitalizations in fiscal 2018 and 2016 for outstanding stock options that became exercisable during fiscal 2019. We did not record compensation expense for time-based stock options grants prior to our IPO in June 2019 because such time-based options were subject to a post-termination repurchase right by us until certain contingent events occurred, and such contingent events were not deemed probable prior to our IPO. When the IPO occurred and the repurchase feature lapsed, this contingent event resulted in share-based compensation expense on these options being recorded. We recognized share-based compensation expense for prior service completed as of the IPO date and began recognizing the remaining unamortized share-based compensation expense related to these outstanding time-based options over the remaining service period. Prior to our IPO, share-based compensation expense was primarily related to the equity awards granted to our board of directors and dividends paid in connection with our recapitalizations in fiscal 2018 and 2016. See NOTE 7-Share-based Awards to our Consolidated Financial Statements for additional information. Interest Expense, net The decrease in interest expense, net for fiscal 2019 compared to fiscal 2018 was primarily driven by lower total borrowings under our First Lien Credit Agreement and the repayment in full of our Second Lien Credit Agreement. In connection with the closing of our IPO in the second quarter of fiscal 2019, we repaid in full the $150.0 million outstanding principal amount on our second lien term loan and terminated the related loan agreement. Additionally, we prepaid a portion of our term loan outstanding under the First Lien Credit Agreement totaling $263.0 million. In July 2019, we repriced and amended our existing First Lien Credit Agreement by replacing the existing term loan with a new $475.2 million senior secured term loan credit facility, The First Replacement Term Loan, discussed below under “-Liquidity and Capital Resources.” The First Replacement Term Loan reduced the applicable margin rates compared to the prior term loan. On October 23, 2019, we prepaid an additional $15.0 million of principal on the First Replacement Term Loan. See NOTE 6-Long-term Debt to our Consolidated Financial Statements for additional information. Debt Extinguishment and Modification Costs During fiscal 2019, we wrote-off $4.1 million of debt issuance costs and incurred $0.2 million of debt modification costs related to the repricing and amendment of our First Lien Credit Agreement, and repaid in full our outstanding second lien term loan and terminated the related loan agreement. During fiscal 2018, we wrote-off $3.5 million of debt issuance costs and incurred $1.8 million of debt modification costs related to the 2018 recapitalization and related repayment in full of our prior first lien credit agreement. See NOTE 6-Long-term Debt to our Consolidated Financial Statements for additional information. Income Tax Expense The decrease in income tax expense in fiscal 2019 compared to fiscal 2018 was primarily the result of lower income before taxes, which was mainly due to the share-based compensation expense of $31.4 million we recognized in connection with the IPO as discussed previously. As a result, our effective tax rate decreased to 8.1% for fiscal 2019 from 27.4% for fiscal 2018 primarily due to excess tax benefits from the exercise and vesting of share-based awards. See NOTE 9-Income Taxes to our Consolidated Financial Statements for additional information. Net Income As a result of the foregoing, net income decreased modestly in fiscal 2019 compared to fiscal 2018. Adjusted EBITDA The increase in adjusted EBITDA for fiscal 2019 compared to fiscal 2018 was primarily due to the aforementioned sales growth and gross margin expansion, partially offset by increased SG&A expenses including the impact of approximately $4.5 million in additional costs incurred to comply with public company requirements. Non-GAAP Adjusted Net Income The increase in non-GAAP adjusted net income for fiscal 2019 compared to fiscal 2018 was primarily due to our increase in sales, which was primarily driven by the increase in store count for fiscal 2019 compared to fiscal 2018 and comparable sales of 5.2% and 3.9%, respectively. Additionally, our interest expense decreased for fiscal 2019 compared to fiscal 2018 as discussed previously. Comparison of fiscal 2018 to fiscal 2017 (dollars in thousands) Net Sales The increase in net sales for fiscal 2018 compared to fiscal 2017 was due to non-comparable store sales growth attributable to the net 23 stores opened during fiscal 2018 as well as an increase in comparable store sales. Comparable store sales increased 3.9% for fiscal 2018 compared to fiscal 2017, primarily driven by increases in both the average transaction size and number of customer transactions, strong opportunistic purchasing, the expansion of our digital marketing initiatives, and the continued growth of our Natural, Organic, Specialty and Healthy (“NOSH”) business. Cost of Sales The increase in cost of sales for fiscal 2018 compared to fiscal 2017 was primarily the result of new store growth and an increase in comparable store sales. Costs as a percentage of sales remained flat at 69.6% for fiscal 2018 and fiscal 2017, respectively. Gross Profit and Gross Margin The increase in gross profit for fiscal 2018 compared to fiscal 2017 was primarily the result of new store growth and an increase in comparable store sales. Our gross margin remained flat at 30.4% for fiscal 2018 and fiscal 2017 respectively. Selling, General and Administrative Expenses (“SG&A”) The increase in SG&A for fiscal 2018 compared to fiscal 2017 was primarily driven by increased selling expenses related to new store growth and higher sales volume. These increased expenses consisted primarily of commissions, store occupancy and shared maintenance costs, as well as investments in general and administrative infrastructure to support the continued growth in the business. As a percentage of sales, SG&A improved modestly for fiscal 2018 compared to fiscal 2017. This improvement was driven partially by a decrease in the provision for IO notes and receivables due to a combination of improved store performance and operational efficiencies which helped mitigate rising costs for IOs, improving the collectability of IO notes and receivables. However, IOs manage their own finances and their financial acumen and expense management practices vary significantly. As we do not control the management decisions in the stores, and as IOs implement a variety of practices with variability in their individual and collective outcomes, we experience variability in the provision and allowance over time as we assess the ability of each IO to repay the notes. Depreciation and Amortization Expense The increase in depreciation and amortization expenses (exclusive of distribution center depreciation included in cost of sales) for fiscal 2018 compared to fiscal 2017 is primarily driven by new store growth and other capital investments. Share-based Compensation Expense The increase in share-based compensation expense for fiscal 2018 compared to fiscal 2017 was primarily driven by expense related to the payment of dividends declared in connection with our recapitalizations in fiscal 2018 and 2016 for outstanding stock options that became exercisable during fiscal 2018. Interest Expense, net The increase in interest expense, net for fiscal 2018 compared to fiscal 2017 was primarily driven by rising interest rates and an increase of $150.0 million in our total debt related to the 2018 recapitalization. Debt Extinguishment and Modification Costs The increase in debt extinguishment and modification costs for fiscal 2018 compared to fiscal 2017 was primarily driven by the write-off of debt issuance costs and non-capitalizable modification costs related to the 2018 recapitalization. Income Tax Expense The increase in income tax expense for fiscal 2018 compared to fiscal 2017 was primarily the result of an increase in our effective tax rate, which was due to a $5.4 million provisional tax benefit recorded in fiscal 2017 year pursuant to the provisions of the 2017 Tax Act (the “Tax Act”). As a result, our effective tax rate increased to 27.4% for fiscal 2018 from 20.1% for fiscal 2017. The effective tax rate increase was partially offset by a $3.9 million decrease in income before taxes. The Tax Act was enacted on December 22, 2017 and among other things, decreased the existing maximum federal corporate income tax rate from 35% to 21%. The provisional tax benefit of $5.4 million recorded in fiscal 2017 was primarily due to the net impact of the revaluation of net deferred tax liability balances at fiscal year-end. See NOTE 9-Income Taxes to our Consolidated Financial Statements for additional information. Net Income As a result of the foregoing, net income decreased modestly in fiscal 2018 compared to fiscal 2017. Adjusted EBITDA The increase in adjusted EBITDA for fiscal 2018 compared to fiscal 2017 was primarily due to our increase in sales, which was primarily driven by a 3.9% increase in comparable store sales in fiscal 2018 and an increase in fiscal year-end store count to 316 stores in fiscal 2018 as compared to 293 stores in fiscal 2017. Non-GAAP Adjusted Net Income The increase in non-GAAP adjusted net income for fiscal 2018 compared to fiscal 2017 was primarily due to our increase in sales, which was primarily driven by a 3.9% increase in comparable store sales in fiscal 2018 and an increase in fiscal year-end store count to 316 stores in fiscal 2018 as compared to 316 stores in fiscal 2017. Liquidity and Capital Resources Our primary sources of liquidity are net cash provided by operating activities and borrowings and availability under our First Lien Credit Agreement. In addition, we also have a $100.0 million revolving credit facility available under our First Lien Credit Agreement. As of December 28, 2019, we had $3.6 million of outstanding standby letters of credit and $96.4 million of remaining borrowing capacity available under the revolving credit facility. Our primary cash needs are for working capital, capital expenditures, and to meet debt service requirements. Historically, we have funded our working capital and capital expenditures requirements with internally generated cash on hand, and most recently through our initial public offering of our common stock in June 2019 as described further below. As of December 28, 2019, we had cash and cash equivalent of $28.1 million, which consisted primarily of cash held in checking and money market accounts with financial institutions. On June 24, 2019, we completed our IPO in which we sold 19,765,625 shares of our common stock, including 2,578,125 shares from the full exercise of the underwriters’ option to purchase additional shares, at a public offering price of $22.00 per share. We received net proceeds of $407.7 million after deducting underwriting discounts and commissions of $27.1 million. We also incurred offering costs payable by us of $7.2 million all of which will have been fully paid as of December 28, 2019 and were charged against the proceeds of the offering. On October 8, 2019, certain of our selling stockholders completed a secondary public offering of shares of our common stock. We did not receive any of the proceeds from the sale of these shares by the selling stockholders. We incurred offering costs payable by us of $1.1 million which are included in SG&A expenses for fiscal 2019. We received $3.2 million in cash (excluding withholding taxes) in connection with the exercise of 451,470 options by certain stockholders participating in this secondary public offering. On February 3, 2020, certain of our selling stockholders completed another secondary public offering of shares of our common stock. We did not receive any of the proceeds from the sale of these shares by the selling stockholders. We incurred offering costs payable by us of $1.1 million which will be included in SG&A expenses in fiscal 2020. We received $1.4 million in cash (excluding withholding taxes) in connection with the exercise of 191,470 options by certain stockholders participating in this secondary public offering. The terms of our First Lien Credit Agreement permit voluntarily prepayment without premium or penalty. In connection with the closing of our IPO on June 24, 2019, we used the net proceeds from the offering to repay in full the $150.0 million outstanding second lien term loan plus $3.6 million accrued and unpaid interest and terminated the related agreement. In addition, using the remainder of the net proceeds, together with excess cash on hand, we prepaid a portion of the term loan outstanding under our First Lien Credit Agreement totaling $248.0 million plus accrued interest of $3.8 million. We elected to apply the prepayment against the remaining principal installments in the direct order of maturity. No further principal payment on this term loan will be due until its maturity in October 2025. On July 23, 2019, we entered into an incremental agreement (the “Incremental Agreement”) to amend the First Lien Credit Agreement. The Incremental Agreement refinanced the term loan outstanding under the First Lien Credit Agreement with a replacement $475.2 million senior secured term loan credit facility (the “First Replacement Term Loan”) with an applicable margin of 3.50% or 3.25% for Eurodollar loans and 2.50% or 2.25% for base rate loans, in each case depending on the public corporate family rating of GOBP Holdings. The First Replacement Term Loan matured on October 22, 2025, which was the same maturity date as the prior term loan under our First Lien Credit Agreement. On October 23, 2019, we prepaid $15.0 million of principal on the First Replacement Term Loan. On January 24, 2020, we entered into a second Incremental Agreement (the “Second Incremental Agreement”) to further amend the First Lien Credit Agreement. The Second Incremental Agreement refinanced the First Replacement Term Loan with a replacement $460.0 million senior secured term loan credit facility (the “Second Replacement Term Loan”) with an applicable margin of 2.75% for Eurodollar loans and 1.75% for base rate loans, and made certain other corresponding technical changes and updates to the previously amended First Lien Credit Agreement. The Second Replacement Term Loan matures on October 22, 2025, which is the same maturity date as the First Replacement Term Loan. On March 19, 2020, GOBP Holdings together with another of our wholly owned subsidiaries borrowed $90.0 million under the revolving credit facility, the proceeds of which are to be used as reserve funding for working capital needs as a precautionary measure in light of the economic uncertainty surrounding the current COVID-19 pandemic. See NOTE 14-Subsequent Events for additional information. As of December 28, 2019, we expected to pay an additional $0.7 million related to dividends declared in our recapitalizations in 2018 and 2016 for stock options that will vest during fiscal 2020 and beyond, of which $0.3 million, $0.2 million, $0.1 million, and $0.1 million is expected to be paid in fiscal 2020, fiscal 2021, fiscal 2022, and fiscal 2023, respectively. Pursuant to our 2014 Plan, if we are unable to make those payments, we may instead elect to reduce the per share exercise price of each such option by an amount equal to the dividend amount in lieu of making the applicable dividend payment. Our primary working capital requirements are for the purchase of inventory, payroll, rent, issuance of IO notes, other store facilities costs, distribution costs and general and administrative costs. Our working capital requirements fluctuate during the year, driven primarily by the timing of opportunistic inventory purchases and new store openings. Our capital expenditures are primarily related to new store openings, ongoing store maintenance and improvements, expenditures related to our distribution centers and infrastructure-related investments, including investments related to upgrading and maintaining our information technology systems and corporate offices. We expect to fund capital expenditures through cash generated from our operations. Based on our new store growth plans, we believe our existing cash and cash equivalents position, cash generated from our operations, and availability under our revolving credit facility will be adequate to finance our working capital requirements, planned capital expenditures and debt service over the next 12 months. If cash generated from our operations and borrowings under our credit facility are not sufficient or available to meet our capital requirements, then we will be required to obtain additional equity or debt financing in the future. However, there can be no assurance equity or debt financing will be available to us when we need it or, if available, the terms will be satisfactory to us and not dilutive to our then-current stockholders. Additionally, we may seek to take advantage of market opportunities to refinance our existing debt instruments with new debt instruments at interest rates, maturities and terms we deem attractive. We may also, from time to time, in our sole discretion, purchase or retire all or a portion of our existing debt instruments through privately negotiated or open market transactions, or otherwise. Debt Covenant The First Lien Credit Agreement contains certain customary representations and warranties, subject to limitations and exceptions, and affirmative and customary covenants. The First Lien Credit Agreement has the ability to restrict us from entering into certain types of transactions and making certain types of payments including dividends and stock repurchase and other similar distributions, with certain exceptions. Additionally, the revolving credit facility under our First Lien Credit Agreement is subject to a first lien secured leverage ratio of 7:00 to 1:00, tested quarterly if, and only if, the aggregate principal amount from the revolving facility, letters of credit (to the extent not cash collateralized or backstopped or, in the aggregate, not in excess of the greater of $10.0 million and the stated face amount of letters of credit outstanding on the closing date) and swingline loans outstanding and/or issued, as applicable, exceeds 35% of the total amount of the revolving credit facility commitments. As of December 28, 2019, we were not subject to the first lien secured leverage ratio testing requirement. Additionally, we were in compliance with all applicable covenant requirements as of December 28, 2019 for our First Lien Credit Agreement. Cash Flows The following table summarizes our cash flows for the periods presented (in thousands): Cash Provided by Operating Activities Net cash provided by operating activities was $132.8 million, $105.8 million, and $84.7 million for fiscal 2019, fiscal 2018, and fiscal 2017, respectively. The improvements in net cash provided by operating activities for each fiscal year presented compared to prior fiscal years was primarily the result of increased net sales driven by new store growth and comparable store sales growth, partially offset by increased cost of sales and operating expenses, particularly commissions. Cash Used in Investing Activities Net cash used in investing activities for fiscal 2019, fiscal 2018, and fiscal 2017 was primarily for capital expenditures and cash advances to IOs. Net cash used in investing activities was $108.0 million for fiscal 2019 compared to $73.6 million for fiscal 2018. The $34.5 million increase was primarily related to capital expenditures for 34 new store openings and one relocation in fiscal 2019 compared to 26 new store openings in fiscal 2018. Net cash used in investing activities was $73.6 million for fiscal 2018 compared to $77.8 million for fiscal 2017. The $4.3 million decrease was primarily related to capital expenditures for only 26 new store openings in fiscal 2018 compared to 29 new store openings in fiscal 2017. Net cash used in investing activities for fiscal 2017 was $77.8 million, which was primarily the result of capital expenditures for 29 new stores and advances to IOs. Additional fiscal 2017 capital expenditures included investments in additional corporate office space, a new warehouse management system and upgraded point of sale technology. We expect capital expenditures of between $110.0 million and $120.0 million, net of tenant improvement allowances, in fiscal year 2020. Cash Used in Financing Activities Net cash used in financing activities was $17.8 million for fiscal 2019 compared to $17.0 million for fiscal 2018. The $0.8 million increase was primarily due to debt and interest repayments and offering cost payments related to our IPO. In June 2019, using the net proceeds from our IPO and excess cash on hand, we repaid in full the $150.0 million outstanding second lien term loan plus $3.6 million of accrued interest, and prepaid a portion of our outstanding term loan under the First Lien Credit Agreement totaling $248.0 million plus $3.8 million of accrued interest. Additionally, on October 23, 2019, we prepaid an additional $15.0 million of principal on our outstanding term loan under the First Lien Credit Agreement. These debt and interest payments were partially offset by proceeds of $407.7 million from our IPO, net of $27.1 million of underwriting discounts and commissions paid. We also incurred offering costs of $7.2 million related to our IPO. Net cash used in financing activities was $17.0 million for fiscal 2018 compared to $7.9 million for fiscal 2017. The $9.1 million increase was primarily the result of the net cash used to pay bank fees and transaction expenses related to the refinancing of our Existing Credit Facilities in connection with the 2018 recapitalization. Net cash used in financing activities for fiscal 2017 was $7.9 million, which was primarily the result of $5.3 million principal payments on term loans, $1.1 million payments of debt issuance costs, and $1.3 million payments of dividends related to our 2016 recapitalization. Off-Balance Sheet Arrangements As of December 28, 2019, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K. Contractual Obligations We enter into long-term contractual obligations and commitments in the normal course of business, primarily operating leases. The contractual commitment amounts in the table below are associated with agreements that are enforceable and legally binding. Obligations under contracts that we can cancel without a significant penalty are not included in the below table. Our contractual obligations and other commitments as of December 28, 2019 were as follows (in thousands): ______________________ (1)Represents the maturities of lease liabilities of our operating and finance leases as disclosed in NOTE 4-Leases to our Consolidated Financial Statements. (2)Represents the expected cash payments for interest on our long-term debt based on the amounts outstanding as of the end of each period and the interest rates applicable on such debt as of December 28, 2019. As described in NOTE 14-Subsequent Events to our Consolidated Financial Statements, in January 2020 we refinanced the term loan outstanding under the First Lien Credit Agreement with a replacement $460.0 million senior secured term loan facility and reduced the applicable margin rates on our borrowings to 2.75% for Eurodollar loans and 1.75% for base rate loans. The maturity date of the replacement term loan remains the same as that of the previous term loan under the First Lien Credit Agreement. (3)Represents a purchase commitment for fresh meat with our primary fresh meat vendor and a purchase commitment with our human capital management software provider. Critical Accounting Policies and Estimates Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). A summary of our significant accounting policies can be found in NOTE 1-Organization and Summary of Significant Accounting Policies to our Consolidated Financial Statements. The preparation of our consolidated financial statements requires us to make judgments and estimates that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. These judgments and estimates are based on historical and other factors believed to be reasonable under the circumstances. Management evaluated the development and selection of our critical accounting policies and estimates and believes that the following involve a higher degree of judgment or complexity and are most significant to reporting our results of operations and financial position, and are therefore discussed as critical. The following critical accounting policies reflect the significant estimates and judgments used in the preparation of our consolidated financial statements. With respect to critical accounting policies, even a relatively minor variance between actual and expected results can potentially have a materially favorable or unfavorable impact on subsequent results of operations. Critical accounting estimates are applied in the following areas: •Long-lived asset impairment; •Leases; •Share-based compensation; and •Variable interest entities. Long-lived asset impairment We evaluate long-lived assets, including property and equipment and lease right-of-use assets, for impairment when events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. For purposes of this evaluation, long-lived assets are grouped with other assets at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets. Our retail stores are evaluated for impairment at the store level. A long-lived asset or asset group may be impaired if its carrying value exceeds its estimated undiscounted future cash flows over its remaining useful life. Our estimate of future cash flows requires us to make assumptions and apply judgment, including forecasting future net sales and gross margin and estimating the useful lives of the assets. If a long-lived asset or asset group is determined to be impaired, we record an impairment loss for the amount by which the carrying value of the asset or asset group exceeds its fair value. The estimated fair value of the asset or asset group is based on the estimated discounted future cash flows of the asset or asset group using a discount rate commensurate with the related risk. Leases We determine if a long-term contractual obligation is a lease at inception. The majority of our operating leases relate to retail stores. We also lease our corporate facilities and distribution centers. Most store leases have a 10-year base period and include options that allow us to extend the lease term beyond the initial base period, subject to terms agreed upon at lease inception. We have evaluated the period in which we are reasonably certain to renew our leases, based upon our history and initial capital investment, and have concluded that our reasonably certain lease period approximates 15 years for new retail store leases. Some leases also include early termination options, which can be exercised under specific conditions. Our lease agreements do not contain any material residual value guarantees or material restrictive covenants. We record our lease liabilities at the present value of the lease payments not yet paid, discounted at the rate of interest that we would have to pay to borrow on a collateralized basis over a similar term. As our leases do not provide an implicit interest rate, we use an incremental borrowing rate based on the information available at commencement date in determining the present value of lease payments. This information is dependent upon our credit rating, market information for credit spreads, and adjustments for the impact of collateral. We recognize operating lease cost over the estimated term of the lease, which includes options to extend lease terms that are reasonably certain of being exercised, starting when possession of the property is taken from the landlord, which normally includes a construction period prior to the store opening. When a lease contains a predetermined fixed escalation of the fixed rent, we recognize the related operating lease cost on a straight-line basis over the lease term. In addition, certain of our lease agreements include variable lease payments, such as increases based on a change in the consumer price index or fair market value. These variable lease payments are excluded from minimum lease payments and are included in the determination of net lease cost when it is probable that the expense has been incurred and the amount can be reasonably estimated. If an operating lease asset is impaired, the remaining operating lease asset will be amortized on a straight-line basis over the remaining lease term. We did not elect the practical expedient to combine lease and non-lease components for each of our existing underlying asset classes. The only significant non-lease component represents common-area maintenance which was analyzed and concluded to be variable and paid at stand-alone (selling) prices based upon actual costs incurred. We do not record a lease liability and corresponding right-of-use asset for leases with terms of 12 months or less. Share-based compensation Share-based compensation cost is measured at grant date, based on the fair value of the award, and is recognized on a straight-line method over the requisite service period for awards expected to vest. We estimate the fair value of employee share-based payment awards subject to only a service condition on the date of grant using the Black-Scholes-Merton valuation model. The Black-Scholes-Merton model requires the use of highly subjective and complex assumptions, including the option’s expected term and the price volatility of the underlying stock. We estimate the fair value of employee share-based payment awards subject to both a market condition and the occurrence of a performance condition on the date of grant using a Monte Carlo simulation approach implemented in a risk-neutral framework. We recognize share-based award forfeitures as they occur rather than estimating by applying a forfeiture rate. We recognize compensation expense for awards expected to vest with only a service condition on a straight-line basis over the requisite service period, which is generally the award’s vesting period. Vesting of these awards is accelerated for certain employees in the event of a change in control. Compensation expense for employee share-based awards whose vesting is subject to the fulfillment of both a market condition and the occurrence of a performance condition is recognized on a graded-vesting basis at the time the achievement of the performance condition becomes probable. Prior to our initial public offering in June 2019, as our common stock had never been publicly traded, the expected stock price volatility for the common stock was estimated by taking the average historic price volatility for industry peers based on daily price observations over a period equivalent to the expected term of the stock option grants. Industry peers consist of several public companies in our industry which are of similar size, complexity and stage of development. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury implied yield at the date of grant. The weighted-average expected term is determined with reference to historical exercise and post-vesting cancellation experience and the vesting period and contractual term of the awards. Prior to our initial public offering in June 2019, as our common stock had never been previously publicly traded, the fair value of shares of common stock underlying the stock options had historically been determined by our board of directors, with input from management. Because prior to our initial public offering in June 2019 there was no public market for our common stock, the board of directors determined the fair value of common stock at the time of grant by considering a number of objective and subjective factors including quarterly independent third-party valuations of our common stock, operating and financial performance, the lack of liquidity of our capital stock and general and industry specific economic outlook, among other factors. The third-party valuation of our common stock used a combination of the discounted cash flow method under the income approach, the guideline public company method under the market approach and the guideline merged and acquired method under the market approach. The material assumptions used in the income approach method is the estimated future cash flows and the associated discount rate used to discount such cash flows. The material assumptions used in the market approach methods are estimated future revenue and EBITDA. While these material assumptions are subjective in nature, we have not deemed them complex. Share-based awards expected to vest We are required to make estimates and assumptions with regards to the number of share-based awards that we expect will ultimately vest, among other things. With respect to performance-based stock option awards that we grant to certain executive officers and senior management, we estimate the number of shares expected to vest based primarily on our most current reported financial results. Because past or current financial trends may not be indicative of future financial performance, our estimate of the number of shares expected to vest may differ materially from the number of shares that actually vest. The maximum number of potential performance-based shares available to vest as of December 28, 2019 totaled 5.8 million, none of which were deemed probable of vesting as of December 28, 2019 because the requisite performance conditions had not been met, and accordingly, we have not recognized any compensation expense related to these awards. Total unrecognized compensation expense for the 5.8 million outstanding performance shares was $26.2 million as of December 28, 2019, which we would be required to recognize if all of the potential performance-based stock option awards were to vest. See NOTE 7-Share-based Awards to our Consolidated Financial Statements for further discussion related to awards outstanding and expected to vest. On February 3, 2020, in conjunction with a secondary offering, certain performance criteria were achieved resulting in the vesting of 4.1 million of the above noted performance-based shares. In the first fiscal quarter of 2020, we expect to recognize the additional share-based compensation expense of approximately $18.5 million associated with the vesting of the 4.1 million performance-based shares. See NOTE 14-Subsequent Events to our Consolidated Financial Statements for additional information. Variable interest entities We assess at each reporting period whether or not we are considered the primary beneficiary of a variable interest entity (“VIE”) and therefore required to consolidate the financial results of the VIE in our consolidated financial statements. Determining whether to consolidate a VIE may require judgment in assessing (i) whether an entity is a VIE, and (ii) if a reporting entity is a VIE’s primary beneficiary. A reporting entity is determined to be a VIE’s primary beneficiary if it has the power to direct the activities that most significantly impact a VIE’s economic performance and the obligation to absorb losses or rights to receive benefits that could potentially be significant to a VIE. We had 342, 308, and 283 stores operated by independent operators as of December 28, 2019, December 29, 2018, and December 30, 2017, respectively. We have Operator Agreements in place with each IO. The IO orders its merchandise exclusively from us which is provided to the independent operator on consignment. Under the Operator Agreement, the IO may select a majority of merchandise that we consign to the IO, which the IO chooses from our merchandise order guide according to IO’s knowledge and experience with local customer purchasing trends, preferences, historical sales and similar factors. The Operator Agreement gives the IO discretion to adjust our initial prices if the overall effect of all price changes at any time comports with the reputation of our Grocery Outlet retail stores for selling quality, name-brand consumables and fresh products and other merchandise at extreme discounts. IOs are required to furnish initial working capital and to acquire certain store and safety assets. The IO is required to hire, train, and employ a properly trained workforce sufficient in number to enable the IO to fulfill its obligations under the Operator Agreement. The IO is responsible for expenses required for business operations, including all labor costs, utilities, credit card processing fees, supplies, taxes, fines, levies, and other expenses. Either party may terminate the Operator Agreement without cause upon 75 days’ notice. As consignor of all merchandise to each IO, the aggregate sales proceeds from merchandise sales belongs to us. Sales related to independent operator stores were $2.5 billion, $2.2 billion, and $2.0 billion for fiscal 2019, fiscal 2018, and fiscal 2017, respectively. We, in turn, pay IOs a commission based on a share of the gross profit of the store. Inventories and related sales proceeds are our property, and we are responsible for store rent and related occupancy costs. Independent operator commissions are expensed and included in selling, general and administrative expenses. Independent operator commissions were $382.8 million, $340.0 million and $306.6 million for fiscal 2019, fiscal 2018, and fiscal 2017. Independent operator commissions of $6.1 million and $3.9 million were included in accrued expenses as of December 28, 2019 and December 29, 2018, respectively. IOs may fund their initial store investment from existing capital, a third-party loan or most commonly through a loan from us. To ensure IO performance, the Operator Agreements grant us the security interests in the assets owned by the IO. The total investment at risk associated with each IO is not sufficient to permit each IO to finance its activities without additional subordinated financial support and, as a result, the IO are VIEs which we have variable interests in. To determine if we are the primary beneficiary of these VIEs, we evaluate whether we have (i) the power to direct the activities that most significantly impact the IO’s economic performance and (ii) the obligation to absorb losses or the right to receive benefits of the IO that could potentially be significant to the IO. Our evaluation includes identification of significant activities and an assessment of its ability to direct those activities. Activities that most significantly impact the IO economic performance relate to sales and labor. Sales activities that significantly impact the IO’s economic performance include determining what merchandise the IO will order and sell and the price of such merchandise, both of which the IO controls. The IO is also responsible for all of their own labor. Labor activities that significantly impact the IO’s economic performance include hiring, training, supervising, directing, compensating (including wages, salaries and employee benefits) and terminating all of the employees of the IO, activities which the IO controls. Accordingly, the IO has the power to direct the activities that most significantly impact the IO’s economic performance. Furthermore, the mutual termination rights associated with the Operator Agreements do not give us power over the independent operator. Our maximum exposure to the IOs is generally limited to the gross receivable due from these entities, which was $37.7 million and $27.8 million as of December 28, 2019 and December 29, 2018, respectively. Additional information can be found in NOTE 2- Independent Operator Notes and Accounts Receivable to our Consolidated Financial Statements. Recent Accounting Pronouncements Refer to NOTE 1-Organization and Summary of Significant Accounting Policies to our Consolidated Financial Statements.

<s>[INST] We operate on a fiscal year that ends on the Saturday closest to December 31st each year. References to fiscal 2019, fiscal 2018, and fiscal 2017 refer to the fiscal years ended December 28, 2019, December 29, 2018, and December 30, 2017, respectively. OVERVIEW We are a highgrowth, extreme value retailer of quality, namebrand consumables and fresh products sold through a network of independently operated stores. Our flexible buying model allows us to offer quality, namebrand opportunistic products at prices generally 40% to 70% below those of conventional retailers. Entrepreneurial independent operators (“IOs”) run our stores and create a neighborhood feel through personalized customer service and a localized product offering. This differentiated approach has driven 16 consecutive years of positive comparable store sales growth. As of December 28, 2019, we had 347 stores in California, Washington, Oregon, Pennsylvania, Idaho and Nevada. Initial Public Offering On June 24, 2019, we completed our initial public offering (“IPO”) of 19,765,625 shares of our common stock at a public offering price of $22.00 per share for net proceeds of $407.7 million, after deducting underwriting discounts and commissions of $27.1 million. We also incurred offering costs payable by us of $7.2 million which we recognized as a charge to additional paidincapital. The shares of common stock sold in the IPO and the net proceeds from the IPO included the full exercise of the underwriters’ option to purchase additional shares. In connection with the closing of our IPO, we repaid in full the $150.0 million outstanding principal amount and $3.6 million accrued interest on our second lien term loan and terminated the related loan agreement. Additionally, using the remainder of the net proceeds, together with excess cash on hand, we prepaid a portion of the term loan outstanding under our first lien credit agreement, dated as of October 22, 2018 (as amended, the “First Lien Credit Agreement”) totaling $248.0 million and $3.8 million of accrued interest. On October 23, 2019, we prepaid an additional $15.0 million of principal on the term loan outstanding under our First Lien Credit Agreement. See “Liquidity and Capital Resources” for additional information. In addition, in fiscal 2019, we recognized $24.3 million for sharebased compensation expense related to timebased stock options granted prior to our IPO, for which vesting became probable upon completion of our IPO, as well as $3.0 million for sharebased compensation expense related to timebased stock options and RSUs granted as part of and subsequent to our IPO. See NOTE 7Sharebased Awards to our Consolidated Financial Statements for additional information. Secondary Public Offerings On October 8, 2019, certain of our selling stockholders completed a secondary public offering of shares of our common stock. We did not receive any of the proceeds from the sale of these shares by the selling stockholders. We incurred related offering costs of $1.1 million which are included in selling, general and administrative expenses for fiscal 2019. We received $3.2 million in cash (excluding withholding taxes) in connection with the exercise of 451,470 options by certain stockholders participating in this secondary public offering. On February 3, 2020, certain of our selling stockholders completed another secondary public offering of shares of our common stock. We did not receive any of the proceeds from the sale of these shares by the selling stockholders. We incurred offering costs payable by us of $1.1 million. We received $1.4 million in cash (excluding withholding taxes) in connection with the exercise of 191,470 options by certain stockholders participating in this secondary public offering. COVID19 On March 11, 2020, the World Health [/INST] Negative. </s>

Replimune Group, Inc.

2019-06-28

2019-03-31

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 related notes appearing elsewhere in this Annual Report. 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 elsewhere in this report, including those set forth under Item 1A. "Risk Factors" and under "Cautionary Note Regarding Forward-Looking Statements" in this Annual Report. Overview We are a clinical-stage biotechnology company committed to applying our leading expertise in the field of oncolytic immunotherapy to transform the lives of cancer patients. We use our proprietary Immulytic platform to design and develop product candidates that are intended to maximally activate the immune system against cancer. Oncolytic immunotherapy is an emerging class of cancer treatment that exploits the ability of certain viruses to selectively replicate in and directly kill tumors, as well as induce a potent, patient-specific, anti-tumor immune response. Such oncolytic, or "cancer killing," viruses have the potential to generate an immune response targeted to an individual patient's particular set of tumor antigens, including neo-antigens that are uniquely present in tumors. Our product candidates incorporate multiple mechanisms of action into a practical "off-the-shelf" approach that is intended to maximize the immune response against a patient's cancer and to offer significant advantages over personalized vaccine approaches. We believe that the bundling of multiple approaches for the treatment of cancer into single therapies will simplify the development path of our product candidates, while also improving patient outcomes at a lower cost to the healthcare system than the use of multiple different drugs. The foundation of our Immulytic platform consists of a proprietary, engineered strain of HSV-1 that has been "armed" with a fusogenic protein intended to substantially increase anti-tumor activity. Our platform enables us to incorporate various genes whose expression is intended to augment the inherent properties of HSV-1 to both directly destroy tumor cells and induce an anti-tumor immune response. We believe RP1 will be effective at killing tumors and inducing immunogenic, or immune-stimulating, tumor cell death and that it will be highly synergistic with immune checkpoint blockade therapies. We are currently conducting a Phase 1/2 clinical trial with RP1 in approximately 150 patients. We have completed enrollment of the Phase 1 dose rising part of this clinical trial in which we are assessing the safety and tolerability of RP1 administered alone in 22 patients with mixed advanced solid tumor types, and following the review of the data by the SRC, have determined the dose regimen to be administered in the Phase 2 part of this clinical trial. We are completing enrollment of a Phase 1 expansion cohort of approximately 12 patients in which we are assessing the safety and tolerability of RP1 administered in combination with an anti-PD1 therapy at the determined Phase 2 dose level. One patient with MSI-H/dMMR remains to be enrolled in the expansion cohort. The Phase 2 part of this clinical trial is designed to assess the safety and efficacy of RP1 in combination with an anti-PD1 therapy in four cohorts of approximately 30 patients with melanoma, non-melanoma skin cancers, bladder cancer and MSI-H/dMMR. Following SRC review of the Phase 1 data to date, including data from the expansion cohort receiving RP1 with anti-PD1 therapy, we have opened enrollment in the United States and the United Kingdom of the melanoma, bladder cancer, and non-melanoma skin cancer Phase 2 cohorts, and will open enrollment of the MSI-H-dMMR Phase 2 cohort after a final evaluable MSI-H/dMMR patient has been enrolled in the Phase 1 expansion cohort without safety concerns. In the Phase 2 part of the clinical trial we are also evaluating efficacy under the clinical trial protocol, primarily on the basis of the proportion of patients who have a response within each tumor type cohort. Responses are either defined as a partial response (a 30% or greater reduction in tumor size) or a complete response (a complete eradication of the disease). We then intend to analyze each cohort's data to determine the indications that merit progressing into further clinical development. We have entered into a collaboration agreement with BMS, under which it has granted us a non-exclusive, royalty-free license to, and is supplying at no cost, its anti-PD-1 therapy, nivolumab, for use in combination with RP1 in this clinical trial. BMS has no further development-related obligations under this collaboration. We have also entered into a collaboration agreement with Regeneron under which we intend to conduct clinical development of our product candidates in combination with cemiplimab. For each clinical trial conducted under this collaboration, Regeneron will fund one-half of the clinical trial costs, supply cemiplimab at no cost, and grant us a non-exclusive, royalty-free license to cemiplimab for use in the clinical trial. The first planned clinical trial under this collaboration is a randomized, controlled Phase 2 clinical trial of RP1 in combination with cemiplimab, versus cemiplimab alone, in approximately 240 patients with CSCC. Initial study site activation is currently underway in the United States and Australia, with study initiation expected in August 2019. If compelling clinical data are generated demonstrating the benefits of the combined treatment, we believe the data from this Phase 2 clinical trial could support a filing with regulatory authorities for marketing approval. We are also developing additional product candidates, RP2 and RP3, built on our Immulytic platform, that are further engineered to enhance anti-tumor immune responses and intended to address additional tumor types. RP2 has been engineered to express an antibody-like molecule that blocks the activity of CTLA-4, a protein that inhibits the immune response to tumors. RP3 is engineered with the intent of not only blocking the activity of CTLA-4, but also to further stimulate an anti-tumor response through activation of the immune co-stimulatory pathways through expression of the ligands for CD40 and 4-1BB. We began operations as Replimune Limited, an English limited company that was incorporated in 2015. On July 5, 2017, Replimune Group, Inc., a Delaware corporation, was incorporated and, on July 10, 2017, the shareholders of Replimune Limited effected a share-for-share exchange pursuant to which they exchanged their outstanding shares in Replimune Limited for shares in Replimune Group, Inc., on a one-for-one basis. In addition, the holders of warrants to purchase shares of series seed preferred stock and stock options to acquire Replimune Limited capital stock canceled their warrants and stock options in Replimune Limited and were issued replacement warrants and stock options to acquire Replimune Group, Inc. capital stock on a one-for-one basis. We refer to these transactions collectively as the reorganization. Upon completion of the reorganization, the historical consolidated financial statements of Replimune Limited became the historical consolidated financial statements of Replimune Group, Inc. because the reorganization was accounted for similar to a reorganization of entities under common control due to the high degree of common ownership of Replimune Limited and Replimune Group, Inc. and lack of economic substance to the transaction. We concluded that the reorganization resulted in no change in the material rights and preferences of each respective class of equity interests and no change in the fair value of each respective class of equity interests before and after the reorganization. On December 8, 2017, Replimune Limited transferred all outstanding shares of its wholly owned subsidiary, Replimune, Inc., to Replimune Group, Inc., a Delaware corporation. Replimune Group, Inc. is the sole shareholder of Replimune Limited, Replimune, Inc. and Replimune Securities Corporation, a Massachusetts corporation that was incorporated in November 2017. Financial overview Since our inception, we have devoted substantially all of our resources to developing our Immulytic platform and our lead product candidate, RP1, building our intellectual property portfolio, conducting research and development of our product candidates, business planning, raising capital and providing general and administrative support for our operations. To date, we have financed our operations primarily with proceeds from the sale of equity securities. We do not have any products approved for sale and have not generated any revenue from product sales. On July 24, 2018, we completed our initial public offering ("IPO") of our common stock and issued and sold 6,700,000 shares of our common stock at a public offering price of $15.00 per share, resulting in net proceeds of approximately $93.5 million after deducting underwriting discounts and commissions but before deducting offering costs. On July 30, 2018, we issued and sold an additional 707,936 shares of our common stock at the IPO price of $15.00 per share pursuant to the underwriters' partial exercise of their option to purchase additional shares of common stock, resulting in additional net proceeds of approximately $9.9 million after deducting discounts and commissions and other offering expenses. Since our inception, we have incurred significant operating 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 our product candidates. Our net losses were $30.8 million, $19.7 million and $7.7 million for the years ended March 31, 2019, 2018 and 2017, respectively. As of March 31, 2019, we had an accumulated deficit of $59.8 million. These losses have resulted primarily from costs incurred in connection with research and development activities and general and administrative costs associated with our operations. We expect to continue to incur significant expenses and increasing operating losses for at least the next several years. We anticipate that our expenses and capital requirements will 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. We expect that our expenses and capital requirements will increase substantially if and as we: • conduct our current and future clinical trials with RP1; • progress the preclinical and clinical development of RP2 and RP3; • establish, equip, and operate our own in-house manufacturing facility; • seek to identify and develop additional product candidates; • seek marketing approvals for any of our product candidates that successfully complete clinical trials, if any; • establish a sales, marketing and distribution infrastructure to commercialize any products for which we may obtain marketing approval; • maintain, expand and protect our intellectual property portfolio; • hire and retain additional clinical, quality control, scientific and finance personnel; • acquire or in-license other drugs and technologies; and • add operational, financial and management information systems and personnel, including personnel to support our research and development programs, any future commercialization efforts and our continued transition to operating as a public company. We will not generate revenue from product sales unless and until we successfully complete clinical development and obtain regulatory approval for RP1 or our other product candidates. If we obtain regulatory approval for any of our product candidates and do not enter into a commercialization partnership in any jurisdiction (which we currently do not intend to do in the United States), we expect to incur significant expenses related to 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 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 March 31, 2019, we had cash and cash equivalents and short-term investments of $134.8 million. We believe that our existing cash and cash equivalents and short-term investments will enable us to fund our operating expenses and capital expenditure requirements through at least 12 months from the issuance of the consolidated financial statements included in this Annual Report on Form 10-K. See "-Liquidity and capital resources" and "Risk factors-Risks related to our financial position and need for additional capital." Components of our results of operations Revenue To date, we have not generated any revenue from product sales as we do not have any approved products and do not expect to generate any revenue from the sale of products in the near future. If our development efforts for RP1 or any other product candidates that we may develop in the future are successful and result in regulatory approval, or if we enter into collaboration or license agreements with third parties, we may generate revenue in the future from a combination of product sales or payments from those collaborations or license agreements. Operating expenses Our 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 RP1 and our other product candidates, and include: • expenses incurred under agreements with third parties, including clinical research organizations, or CROs, that conduct research, preclinical activities and clinical trials on our behalf as well as contract manufacturing organizations, or CMOs, that manufacture our product candidates for use in our preclinical and clinical trials; • salaries, benefits and other related costs, including stock-based compensation expense, for personnel engaged in research and development functions; • costs of outside consultants, including their fees, stock-based compensation and related travel expenses; • the costs of laboratory supplies and acquiring, developing and manufacturing preclinical study and clinical trial materials; • costs related to compliance with regulatory requirements in connection with the development of RP1 and our other product candidates; and • facility-related expenses, which include direct depreciation costs and allocated expenses for rent and maintenance of facilities and other operating costs. We expense research and development costs as incurred. 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. Payments for these activities are based on the terms of the individual agreements, which may differ from the pattern of costs incurred, and are reflected in our consolidated financial statements as prepaid or accrued research and development expenses. Our direct external research and development expenses are tracked on a program-by-program basis and consist of costs, such as fees paid to consultants, contractors, CMOs, and CROs in connection with our preclinical and clinical development activities. To date, we have not allocated expenses to our earlier-stage programs for RP2 and RP3. In addition, we do not allocate employee costs, costs associated with our discovery efforts, laboratory supplies, and facilities, including depreciation or other indirect costs, to specific product development programs because these costs are deployed across multiple product development programs and, as such, are not separately classified. The table below summarizes our research and development expenses by product candidate or development program for each of the periods presented: 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 that our research and development expenses will continue to increase for the foreseeable future as we initiate additional clinical trials of RP1, complete preclinical development and pursue initial stages of clinical development of RP2 and RP3 and continue to discover and develop additional 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 scope, rate of progress, expense and results of our ongoing clinical trials of RP1, as well as of any future clinical trials of RP2 and RP3 or other product candidates and other research and development activities that we may conduct; • 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; • uncertainties in clinical trial design and patient enrollment rates; • 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; • our success in establishing, equipping, and operating a manufacturing facility, or securing 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; • the acceptance of our product candidates, if approved, by patients, the medical community, and third-party payors; • our ability to successfully develop our product candidates for use in combination with third-party products or product candidates; • negative developments in the field of immuno-oncology; • competition with other products; and • significant and changing government regulation and regulatory guidance. 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 trial delays 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. 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 other related costs, including stock-based compensation, for personnel in our executive, finance, corporate and business development and administrative functions. General and administrative expenses also include professional fees for legal, patent, accounting, auditing, tax and consulting services; 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 general and administrative headcount to support our continued research and development and potential commercialization of our product candidates. We also expect to continue 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 exchange listing and SEC requirements; director and officer insurance costs; and investor and public relations costs. Other income (expense), net Research and development incentives Research and development incentives consists of reimbursements of research and development expenditures. We participate, through our subsidiary in the United Kingdom, in the research and development program provided by the United Kingdom tax relief program, such that a percentage of up to 14.5% of our qualifying research and development expenditures are reimbursed by the United Kingdom government, and such incentives are reflected as other income. Change in fair value of warrant liability In connection with the issuance of the series seed preferred stock, we issued to the series seed preferred stockholders warrants to purchase shares of series seed preferred stock. Prior to the completion of our IPO, we classified the warrants as a liability on our consolidated balance sheets. We remeasured the warrant liability to fair value at each reporting date and recognized changes in the fair value of the warrant liability as a component of other income (expense), net in our consolidated statements of operations. Effective upon the completion of our IPO, the warrants to purchase shares of series seed preferred stock became exercisable for shares of common stock instead of shares of preferred stock, and the warrant liability was reclassified to additional paid-in capital. As a result, effective upon the completion of our IPO, we no longer recognize changes in the fair value of the warrant liability as other income (expense), net in our consolidated statements of operations. Investment income Interest income consists of income earned on our cash and cash equivalents and short-term investments. Other income (expense), net Other income (expense), net consists primarily of realized and unrealized foreign currency transaction gains and losses. Income taxes Since our inception and through March 31, 2019, we have not recorded any income tax benefits for the net losses we incurred in each jurisdiction in which we operate, as we believe, based upon the weight of available evidence, that it is more likely than not that all of our net operating loss carryforwards will not be realized. On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as 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, 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). Under the Tax Act, our deferred tax assets and liabilities (before valuation allowance) were remeasured at the lower federal tax rate, resulting in an increase to our income tax provision with an equal and offsetting reduction in our valuation allowance. We completed our final determination of the remeasurement of our deferred tax assets and liabilities for the year ended March 31, 2019 under SEC Staff Accounting Bulletin No. 118 and we have not recorded any adjustments to the provisional amounts recorded at March 31, 2018. Results of operations Comparison of the years ended March 31, 2019 and 2018 The following table summarizes our results of operations for the years ended March 31, 2019 and 2018: Research and development expenses Research and development expenses for the year ended March 31, 2019 were $22.2 million, compared to $13.5 million for the year ended March 31, 2018. The increase of $8.7 million was due primarily to an increase of approximately $2.4 million in direct research costs associated with RP1 and an approximately $6.2 million increase in our unallocated research and development costs. The increase in RP1 costs was due primarily to an increase in clinical trial costs in the year ended March 31, 2019 associated with our ongoing Phase 1/2 clinical trial, which commenced in the United Kingdom in October 2017. The increase in unallocated research and development expenses reflected an increase of $3.4 million in personnel-related costs, including stock-based compensation, and an increase of $2.8 million in other costs. The increase in personnel-related costs largely reflected the hiring of additional personnel in our research and development functions as we began work on our planned Phase 2 clinical trial of RP1 in patients with CSCC. Personnel-related costs for the years ended March 31, 2019 and 2018 included stock-based compensation expense of $2.7 million and $0.8 million, respectively. Other costs increased primarily due to purchases of supplies used across all of our product candidates. General and administrative expenses General and administrative expenses were $8.8 million for the year ended March 31, 2019, compared to $5.7 million for the year ended March 31, 2018. The increase of $3.1 million primarily reflected increases of $2.1 million in personnel related costs and increases of $1.3 million in facility and other variable costs partially offset by decreases of $0.3 million in professional fees. The increase in personnel related costs was due to the hiring of additional personnel in our general and administrative functions as we expanded our operations in the United States. The decrease in professional fees was due primarily to reduced legal fees after the completion of our IPO. The increase in facility and other variable costs was due primarily to an increase in costs associated with our directors and officers insurance. Total other income (expense), net Other income (expense) was $0.1 million for the year ended March 31, 2019, compared to $(0.5) million for the year ended March 31, 2018. The increase of $0.6 million was primarily attributable to a $0.3 million increase in research and development incentives, a $2.3 million increase in investment income due to the reinvestment of our IPO proceeds received in July 2018 and $2.5 million increase in other income due primarily to changes in foreign currency exchange rates of Great British Pounds to United States Dollars, partially offset by a $4.5 million charge related to the change in the fair value of the warrant liability. Comparison of the years ended March 31, 2018 and 2017 The following table summarizes our results of operations for the years ended March 31, 2018 and 2017: Research and development expenses Research and development expenses for the year ended March 31, 2018 were $13.5 million, compared to $6.9 million for the year ended March 31, 2017. The increase of $6.6 million was due primarily to an increase of approximately $3.4 million in direct research costs associated with RP1 and an approximately $3.2 million increase in our unallocated research and development costs. The increase in RP1 costs was due primarily to an increase in clinical trial costs in the year ended March 31, 2018 associated with our ongoing Phase 1/2 clinical trial, which commenced in the United Kingdom in October 2017. The increase in unallocated research and development expenses reflected an increase of $2.0 million in personnel-related costs, including stock-based compensation, and an increase of $1.2 million in other costs. The increase in personnel-related costs was primarily due to the hiring of additional personnel in our research and development functions as we began work on our planned Phase 2 clinical trial of RP1 in patients with CSCC. Personnel-related costs for each of the years ended March 31, 2018 and 2017 included stock-based compensation expense of $0.8 million and $0.2 million, respectively. Other costs increased primarily due to purchases of supplies used across all of our product candidates. General and administrative expenses General and administrative expenses were $5.7 million for the year ended March 31, 2018, compared to $2.7 million for the year ended March 31, 2017. The increase of $3.0 million primarily reflected increases of $1.1 million in personnel related costs and $1.6 million in professional fees. The increase in personnel related costs was due to the hiring of additional personnel in our general and administrative functions as we expanded our operations in the United States. The increase in professional fees was due to costs associated with the preparation, audit and review of our financial statements and readiness to become a public company. Total other income (expense), net Other income (expense) was $(0.5) million for the year ended March 31, 2018, compared to $1.9 million for the year ended March 31, 2017. The decrease of $2.4 million was primarily attributable to a $2.7 million increase in the expense due to a change in foreign exchange rates and a $0.8 million increase in the expense due to a change in the fair value of the warrant liability, partially offset by a $0.8 million increase in expenditure reimbursements recognized under the research and development program provided by the United Kingdom government and a $0.3 million increase in investment income. Liquidity and capital resources Since our inception, we have not generated any revenue from product sales and have incurred significant operating losses and negative cash flows from our operations. We have not yet commercialized any of our product candidates, which are in various phases of preclinical and clinical development, and we do not expect to generate revenue from sales of any products for the foreseeable future, if at all. Sources of liquidity To date, we have financed our operations primarily with proceeds from the sale equity securities. Through March 31, 2019, we had received gross proceeds of approximately $198.0 million from our sales of common stock and preferred stock. As of March 31, 2019, we had cash and cash equivalents and short-term investments of $134.8 million. On July 24, 2018, we completed our IPO and issued and sold 6,700,000 shares of our common stock at a public offering price of $15.00 per share, resulting in net proceeds of $93.5 million after deducting underwriting discounts and commissions but before deducting offering costs. On July 30, 2018, we issued and sold an additional 707,936 shares of our common stock at the IPO price of $15.00 per share pursuant to the underwriters' partial exercise of their option to purchase additional shares of our common stock, resulting in additional net proceeds of $9.9 million after deducting discounts and commissions and other offering expenses. Cash flows The following table summarizes our cash flows for each of the periods presented: Operating activities During the year ended March 31, 2019, net cash used in operating activities was $25.4 million, primarily resulting from our net loss of $30.8 million and net cash used by changes in our operating assets and liabilities of $1.3 million, partially offset by non-cash charges of $6.7 million. Net cash used by changes in our operating assets and liabilities for the year ended March 31, 2019 consisted primarily of a $0.1 million increase in accounts payable, partially offset by a $0.8 million decrease in prepaid expenses and other current assets, a $0.3 million increase in the research and development incentives receivable from the United Kingdom government due to the timing and amount of our qualifying expenditures and a $0.3 million increase in prepaid expenses and other current assets. During the year ended March 31, 2018, net cash used in operating activities was $16.0 million, primarily resulting from our net loss of $19.7 million, partially offset by net cash provided by changes in our operating assets and liabilities of $1.9 million and non-cash charges of $1.8 million. Net cash provided by changes in our operating assets and liabilities for the year ended March 31, 2018 consisted primarily of a $1.6 million increase in accounts payable and a $1.4 million increase in accrued expenses and other current liabilities, partially offset by a $0.8 million increase in the research and development incentives receivable from the United Kingdom government due to the timing and amount of our qualifying expenditures and a $0.3 million increase in prepaid expenses and other current assets due to CRO deposits related to the ongoing Phase 1/2 clinical trial for RP1. During the year ended March 31, 2017, net cash used in operating activities was $7.1 million, primarily resulting from our net loss of $7.7 million, partially offset by non-cash charges of $0.5 million, and net cash provided by changes in our operating assets and liabilities of $0.1 million. Net cash used by changes in our operating assets and liabilities for the year ended March 31, 2017 consisted primarily of a $0.2 million increase in accounts payable and a $1.4 million increase in accrued expenses due to accrued RP1 clinical trial costs, accrued compensation costs and accrued audit fees, partially offset by a $1.2 million increase in the research and development incentives receivable from the United Kingdom government due to the timing and amount of our qualifying expenditures and a $0.3 million increase in prepaid expenses and other current assets due to value-added tax receivables and CMO deposits for RP1 clinical trial supplies. Investing activities During the year ended March 31, 2019, net cash used in investing activities was $65.9 million, consisting of $189.9 million in purchases of available for sale securities and $2.6 million in purchases of property, plant and equipment, partially offset by $126.6 million in proceeds from maturities of short-term investments. During the year ended March 31, 2018, net cash used in investing activities was $44.0 million, consisting of $52.5 million in purchases of available for sale securities and $0.1 million in purchases of property, plant and equipment, partially offset by $8.6 million in proceeds from maturities of short-term investments. During the year ended March 31, 2017, net cash used in investing activities was $0.2 million, consisting of purchases of property, plant and equipment. We expect that purchases of property, plant and equipment will increase over the next several years resulting from our intended establishment of our own in-house manufacturing facility. Financing Activities During the year ended March 31, 2019, net cash provided by financing activities was $101.4 million, consisting primarily of net cash proceeds of $103.3 million from our issuance of common stock in connection with our IPO and $0.2 million from the exercise of stock options, partially offset by $2.2 million of payments of issuance costs. During the year ended March 31, 2018, net cash provided by financing activities was $54.8 million, primarily consisting of net proceeds from our issuance of series B convertible preferred stock, or series B preferred stock. During the year ended March 31, 2017, net cash provided by financing activities was $15.0 million, primarily consisted of proceeds from our issuance of series A convertible preferred stock, or series A preferred stock. Funding requirements Our plan of operation is to continue implementing our business strategy, continue research and development of RP1 and our other product candidates and continue to expand our research pipeline and our internal research and development capabilities. 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. We expect that our expenses will increase substantially if and as we: • conduct our current and future clinical trials of RP1; • progress the preclinical and clinical development of RP2 and RP3; • seek to identify and develop additional product candidates; • seek marketing approvals for any of our product candidates that successfully complete clinical trials, if any; • establish a sales, marketing and distribution infrastructure to commercialize any products for which we may obtain marketing approval; • until our planned manufacturing facility is operational, require the manufacture by third parties of larger quantities of our product candidates for clinical development and potentially commercialization; • maintain, expand and protect our intellectual property portfolio; • acquire or in-license other drugs and technologies; and • add operational, financial and management information systems and personnel, including personnel to support our research and development programs, any future commercialization efforts and our continued transition to operating as a public company. As of March 31, 2019, we had cash and cash equivalents and short-term investments of $134.8 million. We believe that our existing cash and cash equivalents and short-term investments will enable us to fund our operating expenses and capital expenditure requirements through at least 12 months from the issuance of the consolidated financial statements included elsewhere in this Annual Report on Form 10-K. Because of the numerous risks and uncertainties associated with the development of RP1 and other product candidates and programs, and because the extent to which we may enter into collaborations with third parties for development of our product candidates is unknown, we are unable to estimate the timing and amounts of increased capital outlays and operating expenses associated with completing the research and development of our product candidates. Our future capital requirements will depend on many factors, including those described in this section and above under "-Operating expenses-Research and development expenses." In addition, we intend to establish, equip, and operate an in-house manufacturing facility to manufacture RP1 and our other product candidates. We expect that such a facility would require total capital expenditures of approximately $22.5 million to construct, net of approximately $8.9 million in tenant improvement costs. Developing novel biopharmaceutical products, including conducting preclinical studies 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 for any product candidates or generate revenue from the sale of any products for which we may obtain marketing approval. In addition, our product candidates, if approved, may not achieve commercial success. Our commercial revenues, if any, will be derived from sales of therapies that we do not expect to be commercially available for many years, if ever. Accordingly, we will need to obtain substantial additional funds to achieve our business objectives. Adequate additional funds may not be available to us on acceptable terms, or at all. We do not currently have any committed external source of funds. To the extent that we raise additional capital through the sale of our equity or convertible debt securities, our shareholders' interest may be diluted, and the terms of these securities may include liquidation or other preferences and anti-dilution protections that could adversely affect the rights of our common stockholder. Additional debt or preferred equity financing, if available, may involve agreements that include restrictive covenants that may limit our ability to take specific actions, such as incurring debt adversely impact our ability to conduct our business, and may require the issuance of warrants, which could potentially dilute our shareholders' interest. If we raise additional funds through collaborations, strategic alliances or licensing arrangements with third parties, we may have to relinquish valuable rights to our technology, 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 or collaborations, strategic alliances or licensing arrangements with third parties when needed, we may be required to delay, limit, reduce and/or terminate our 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. Contractual obligations and commitments The following table summarizes our contractual obligations as of March 31, 2019 and the effects that such obligations are expected to have on our liquidity and cash flows in future periods: (1)Amounts in the table reflect commitments for costs associated with our external CMO, which we engaged to manufacture clinical trial materials. (2)Amounts in the table reflect minimum payments due under (i) our two operating leases of laboratory and office space in Woburn, Massachusetts and Oxfordshire, United Kingdom, at a monthly commitment of $7 and $31, respectively, and (ii) our build-to-suit lease of approximately 63,000 square feet of office, manufacturing and laboratory space in Framingham, Massachusetts. Our lease in Woburn expires in March 2021, and our lease in Oxfordshire expires in April 2026 and is terminable by us in April 2021. The lease term for our Framingham lease commenced in November 2018, subject to the landlord completing certain agreed upon landlord improvements. The rent commencement date is estimated to be August 2019. The initial lease term is ten years from the rent commencement date and includes two optional five-year extensions. We enter into contracts in the normal course of business with CROs, CMOs and other third parties for clinical trials and preclinical research studies and testing. Manufacturing and research commitments in the preceding table include agreements that are enforceable and legally binding on us and that specify all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. For obligations with cancellation provisions, the amounts included in the preceding table are limited to the non-cancelable portion of the agreement terms or the minimum cancellation fee. Collaborations BMS On February 26, 2018, we entered into a Clinical Trial Collaboration and Supply Agreement with Bristol- Myers Squibb Company, or BMS. Pursuant to the agreement, BMS will provide to us, at no cost, nivolumab, its anti-PD-1 therapy, for use in combination with RP1 in our ongoing Phase 1/2 clinical trial. Under the agreement, we will sponsor, fund and conduct the clinical trial in accordance with an agreed-upon protocol. Under the agreement, BMS granted us a non-exclusive, non-transferrable, royalty-free license (with a right to sublicense) under its intellectual property to use nivolumab in the clinical trial and has agreed to supply nivolumab, at its cost and for no charge to us, for use in the clinical trial. Both parties will own the study data produced in the clinical trial, other than study data related solely to nivolumab, which will belong solely to BMS or study data related solely to RP1, which will belong solely to us. Unless earlier terminated, the agreement will remain in effect until (i) the completion of the clinical trial, (ii) all related clinical trial data have been delivered to both parties and (iii) the completion of any statistical analyses and bioanalyses contemplated by the clinical trial protocol or any analysis otherwise agreed upon by the parties. The agreement may be terminated by either party (i) in the event of an uncured material breach by the other party, (ii) in the event the other party is insolvent or in bankruptcy proceedings or (iii) for safety reasons. Upon termination, the licenses granted to us to use nivolumab in the clinical trial will terminate. The agreement contains representations, warranties, undertakings and indemnities customary for a transaction of this nature. Regeneron On May 29, 2018, we entered into a Master Clinical Trial Collaboration and Supply Agreement with Regeneron Pharmaceuticals, Inc., or Regeneron. Pursuant to the agreement we agreed to undertake one or more clinical trials with Regeneron for the administration of our product candidates in combination with cemiplimab, an anti-PD-1 therapy developed by Regeneron, across multiple solid tumor types, the first of which is intended to be our planned Phase 2 clinical trial of RP1 in patients with CSCC. Each clinical trial will be conducted pursuant to an agreed study plan which, among other things, will identify the name of the sponsor and which party will manage the particular study, and include the protocol, the budget and a schedule of clinical obligations. The first study plan related to the Phase 2 clinical trial in CSCC has been agreed. Pursuant to the terms of the agreement, each party granted the other party a non-exclusive license of their respective intellectual property and agreed to contribute the necessary resources needed to fulfill their respective obligations, in each case, under the terms of agreed study plans. Development costs of a particular clinical trial will be split equally. The agreement contains representations, warranties, undertakings and indemnities customary for a transaction of this nature. The agreement also contains certain covenants that restrict us from entering into a third-party arrangement with respect to the use of our product candidates in combination with an anti-PD-1 therapy and that restrict Regeneron from entering into a third-party arrangement with respect to the use of cemiplimab in combination with an HSV-1 virus, in each case, for the treatment of a tumor type that is the subject of a clinical trial to which the covenants apply. Unless otherwise mutually agreed in a future study plan, these covenants are only applicable to our planned Phase 2 clinical trial in CSCC, and expire upon the one-year anniversary of the commencement of the applicable study plan. The agreement may be terminated by either party if (i) there is no active study plan for which a final study report has not been completed, (ii) the parties have not entered into a study plan for an additional clinical trial within a period of time after the delivery of the most recent final study report or (iii) in the event of a material breach. Critical accounting policies and significant judgments and 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 greater detail in Note 2 to our consolidated financial statements appearing elsewhere in the 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 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. Examples of estimated accrued research and development expenses include fees paid to: • CROs in connection with performing research activities and conducting preclinical studies and clinical trials on our behalf; • CMOs in connection with the production of preclinical and clinical trial materials; • investigative sites or other service providers in connection with clinical trials; • vendors in connection with preclinical and clinical development activities; and • vendors related to product manufacturing and development and distribution of preclinical and clinical supplies. 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 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. 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. We have to date only issued stock-based awards with service-based vesting conditions and record the expense for these awards using the straight-line method. 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. See Note 10 to our consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K for more information. Forfeitures are accounted for as they occur. The fair value of each stock-based award is estimated on the date of grant based on the fair value of our common stock on that same date. Prior to the adoption of ASC 2018-07, for stock-based awards granted to consultants and non-employees, we recognize compensation expense over the period during which services are rendered by such non-employees and 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. After the adoption of ASC 2018-07, for stock-based awards granted to consultants and non-employees, we measure stock-based these awards based on their fair value on the date of the grant and recognizes compensation expense for those awards over the requisite service period, which is generally the vesting period of the respective award. We have to date only issued stock-based awards with service-based vesting conditions and record the expense for these awards using the straight-line method. 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. We classify stock-based compensation expense in our consolidated statements of operations in the same manner in which the award recipient's payroll costs are classified or in which the award recipient's service payments are classified. Off-balance sheet arrangements We did not have any off-balance sheet arrangements 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 elsewhere in this Annual Report on Form 10-K. Emerging growth company status As an "emerging growth company," the Jumpstart Our Business Startups Act of 2012 permits 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] 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. We discuss factors that we believe could cause or contribute to these differences below and elsewhere in this report, including those set forth under Item 1A. "Risk Factors" and under "Cautionary Note Regarding ForwardLooking Statements" in this Annual Report. Overview We are a clinicalstage biotechnology company committed to applying our leading expertise in the field of oncolytic immunotherapy to transform the lives of cancer patients. We use our proprietary Immulytic platform to design and develop product candidates that are intended to maximally activate the immune system against cancer. Oncolytic immunotherapy is an emerging class of cancer treatment that exploits the ability of certain viruses to selectively replicate in and directly kill tumors, as well as induce a potent, patientspecific, antitumor immune response. Such oncolytic, or "cancer killing," viruses have the potential to generate an immune response targeted to an individual patient's particular set of tumor antigens, including neoantigens that are uniquely present in tumors. Our product candidates incorporate multiple mechanisms of action into a practical "offtheshelf" approach that is intended to maximize the immune response against a patient's cancer and to offer significant advantages over personalized vaccine approaches. We believe that the bundling of multiple approaches for the treatment of cancer into single therapies will simplify the development path of our product candidates, while also improving patient outcomes at a lower cost to the healthcare system than the use of multiple different drugs. The foundation of our Immulytic platform consists of a proprietary, engineered strain of HSV1 that has been "armed" with a fusogenic protein intended to substantially increase antitumor activity. Our platform enables us to incorporate various genes whose expression is intended to augment the inherent properties of HSV1 to both directly destroy tumor cells and induce an antitumor immune response. We believe RP1 will be effective at killing tumors and inducing immunogenic, or immunestimulating, tumor cell death and that it will be highly synergistic with immune checkpoint blockade therapies. We are currently conducting a Phase 1/2 clinical trial with RP1 in approximately 150 patients. We have completed enrollment of the Phase 1 dose rising part of this clinical trial in which we are assessing the safety and tolerability of RP1 administered alone in 22 patients with mixed advanced solid tumor types, and following the review of the data by the SRC, have determined the dose regimen to be administered in the Phase 2 part of this clinical trial. We are completing enrollment of a Phase 1 expansion cohort of approximately 12 patients in which we are assessing the safety and tolerability of RP1 administered in combination with an antiPD1 therapy at the determined Phase 2 dose level. One patient with MSIH/dMMR remains to be enrolled in the expansion cohort. The Phase 2 part of this clinical trial is designed to assess the safety and efficacy of RP1 in combination with an antiPD1 therapy in four cohorts of approximately 30 patients with melanoma, nonmelanoma skin cancers, bladder cancer and MSIH/dMMR. Following SRC review of the Phase 1 data to date, including data from the expansion cohort receiving RP1 with antiPD1 therapy, we have opened enrollment in the United States and the United Kingdom of the melanoma, bladder cancer, and nonmelanoma skin cancer Phase 2 cohorts, and will open enrollment of the MSIHdMMR Phase 2 cohort after a final evaluable MSIH/dMMR patient has been enrolled in the Phase 1 expansion cohort without safety concerns. In the Phase 2 part of the clinical trial we are also evaluating efficacy under the clinical trial protocol, primarily on the basis of the proportion of patients who have a response within each tumor type cohort. Responses are either defined as a partial response (a 30% or greater reduction in tumor size) or a complete response (a complete eradication of the disease). We then intend to analyze each [/INST] Positive. </s>

DIRTT ENVIRONMENTAL SOLUTIONS LTD

2020-02-26

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 for the fiscal years ended December 31, 2019 and 2018 together with our consolidated financial statements and related notes and other financial information appearing in this Annual Report. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report, including information with respect to our plans and strategy for our business, operations, and product candidates, includes forward-looking statements that involve risks and uncertainties. You should review the sections of this Annual Report captioned “Risk Factors” and “Special Note Regarding Forward-Looking Statements” for a discussion of important factors that could cause our actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. We have revised our calculation of Adjusted EBITDA and Adjusted Gross Profit, non-GAAP financial measures, for the presented periods. For additional information, see “- Non-GAAP Financial Measures - EBITDA and Adjusted EBITDA for the Years Ended December 31, 2019, 2018 and 2017.” and “- Non-GAAP Financial Measures - Adjusted Gross Profit and Adjusted Gross Profit Margin for the Years Ended December 31, 2019, 2018 and 2017.” Overview We are an innovative manufacturing company featuring a proprietary software and virtual reality visualization platform, coupled with vertically integrated manufacturing that designs, configures and manufactures prefabricated interior solutions used primarily in commercial, healthcare and educational spaces across a wide range of industries and businesses. We combine innovative product design with our industry-leading, proprietary ICE Software, and technology-driven, lean manufacturing practices and sustainable materials to provide end-to-end solutions for the traditionally inefficient and fragmented interior construction industry. We create customized interiors with the aesthetics of conventional construction but with greater schedule and cost certainty, shorter lead times, greater future flexibility, and better environmental sustainability than conventional construction. Our ICE Software allows us to sell, design, visualize (including 3D virtual reality modeling of interiors), configure, price, communicate, engineer, specify, order and manage projects, thereby reducing challenges associated with traditional construction, including cost overruns, change orders, inconsistent quality, delays and material waste. While other software programs and virtual reality tools are used in the architectural and construction industries, we believe our ICE Software is the only interior construction technology that provides end-to-end integration and management, from design through engineering, manufacturing and installation. Our interior construction solutions include prefabricated, customized interior modular walls, ceilings, and floors; decorative and functional millwork; power infrastructure; network infrastructure; and pre-installed medical gas piping systems. We strive to incorporate environmentally sustainable materials and reusable components into our solutions while creating flexible, functional and well-designed environments for the people who will use them. We offer our interior construction solutions throughout the United States and Canada, as well as in select international markets, through a network of independent Distribution Partners and an internal sales team. Our Distribution Partners use ICE to work with end users to envision and design their spaces, and orders are electronically routed through ICE to our manufacturing facilities for production, packing and shipping. Our Distribution Partners then coordinate the receipt and installations of our interior solutions at the end users’ locations. Summary of Financial Results • Revenues for the year ended December 31, 2019 were $247.7 million, a decline of $27.0 million or 10% from $274.7 million for the year ended December 31, 2018. We believe we have been subject to a disruption in sales activity levels particularly as it relates to larger projects, as discussed below, beginning in 2018 and carrying through 2019. This disruption stems from the distraction of significant management changes during 2018 on a long sales cycle combined with the immature and transitional state of our sales and marketing function, which limited our ability to take advantage of growth opportunities in our market for 2019. Our revenue in 2019 was directly affected by this disruption and we experienced a sequential decrease in revenues in the fourth quarter of 2019 from the third quarter of 2019. • Gross profit for the year ended December 31, 2019 was $86.4 million or 34.9% of revenue, a decline of $20.6 million or 19% from $107.0 million or 39.0% of revenue for the year ended December 31, 2018. This reduction was attributable to our decline in revenues, the impact of fixed costs on lower revenues, $2.5 million of incremental costs to mitigate a previously disclosed tile warping issue, and a $2.5 million increase in our provision because we determined that timber included in certain projects installed between 2016 and 2019 may not meet certain building class fire retardant specifications under which they were sold. We are in the process of notifying customers and are actively testing solutions which, if successful, could significantly reduce this liability. • Adjusted Gross Profit (see “- Non-GAAP Financial Measures”) for the year ended December 31, 2019 was $97.9 million or 39.5% of revenue, a $18.6 million or 16.0% decline from $116.5 million or 42.4% of revenue for the year ended December 31, 2018 for the above noted reasons. Excluded from Adjusted Gross Profit in 2019 are $2.2 million of costs of overhead associated with operating at lower than normal capacity levels in the fourth quarter, which were charged directly and separately to cost of sales rather than as costs attributable to production. • Net loss for the year ended December 31, 2019 was $4.4 million, a reduction of $10.0 million from net income of $5.6 million for the year ended December 31, 2018. The decline reflects the above noted reduction in gross profit, $5.7 million of one-time costs, discussed below, $1.3 million of litigation costs and a $4.5 million increase in foreign exchange loss. These cost increases were partially offset by a $3.4 million reduction in commission expenses, a $2.8 million reduction in reorganization expenditures, no impairments in 2019 compared to an $8.7 million impairment in 2018, a $2.3 million reduction in income tax expense, and other operating expenditure reductions. • Adjusted EBITDA (see “- Non-GAAP Financial Measures”) for the year ended December 31, 2019 was $18.2 million or 7.4%, a decline of $20.9 million or 53% from $39.1 million or 14.2% for the year ended December 31, 2018 for the above noted reasons. In the current period, we changed our calculation of Adjusted EBITDA to exclude the impacts of foreign exchange to improve year-on-year comparability of Adjusted EBITDA. Outlook On November 12, 2019, DIRTT unveiled a four-year strategic plan for the Company, based on three key pillars: commercial execution, manufacturing excellence and innovation. This plan lays out a roadmap to transform a founder-led start-up into a professionally managed operating company. Our objective is to scale our operations to profitably capture the significant market opportunity available from driving conversion from conventional construction to DIRTT’s process of modular, prefabricated interiors. The strategic plan is designed to create a foundation for sustainable and profitable growth; however, in the interim, we have been subject to a disruption in sales activity levels particularly as it relates to larger projects, as discussed below, beginning in 2018 and carrying through 2019. This disruption stems from the distraction of significant management changes during 2018 on a long sales cycle combined with the immature and transitional state of our sales and marketing function, which limited our ability to take advantage of growth opportunities in our market for 2019. Our revenue in 2019 was directly affected by this disruption and we experienced a sequential decrease in revenues in the fourth quarter of 2019 from the third quarter of 2019. A similar percentage decrease has continued into the first two months of 2020 relative to the first two months of the fourth quarter of 2019. We have a stable base business of small- to mid-size projects that our distribution partners and sales representatives are well positioned to maintain and grow, but we currently lack a pipeline of larger projects. We consider larger projects as projects or clients greater than $2 million with such projects often spanning multiple reporting periods. We are actively working to build this pipeline with our new strategic accounts and large project teams and an enhanced commercial function. This is a key goal of our strategic plan; however, such projects require a longer sales cycle and, as discussed at our November 12, 2019 Analyst Day, the realization of sales from our activities is not expected until the second half of 2020 at the earliest or into 2021. Within the commercial function - which encompasses people and organizational structure; strategic marketing; sales excellence and Distribution Partner experience - we have been actively recruiting for the 50 newly-created or open positions we identified as key to building out our sales and marketing organization. As of February 25, 2020, we have hired 11 individuals. These include the key roles of vice president of strategic marketing, who will be critical to creating a strategic marketing capability that has never existed at DIRTT, as well as a vice president of commercial operations, who is expected to significantly enhance our sales analysis and forecasting. Although identifying and recruiting the right mix of experience and talent is a time-consuming process, our goal remains to have all open positions filled by the end of 2020. Our targeted approach to developing and growing strategic national accounts is showing early promise. In particular, we are actively working on agreements for four new accounts and the expansion of two existing accounts with several other relationships in development. These opportunities often entail a multi-year sales effort and generally start with smaller projects, growing over time as the commercial relationship strengthens. We expect several small projects to commence in the second half of 2020. Enhancing our Distribution Partner network, an integral part of our go-to-market strategy, remains a priority. As of February 25, 2020, we have increased our regional coverage with seven existing Distribution Partners expanding into new regions, including two in a major commercial real estate market in the Eastern U.S. that was highly underpenetrated and contains substantial growth opportunities. These are strong partners with a demonstrated track record of success and commitment to DIRTT and who appreciate how we can work together to capitalize on market opportunities. In 2019, these partners accounted for approximately 14% of DIRTT’s sales. In late 2019 and early 2020, we terminated relationships with four underperforming Distribution Partners representing 1.5% of 2019 sales in the aggregate who did not align with our partnership model and strategic growth priorities. In February 2020, we launched two digital marketing campaigns, a first for our organization, to increase brand awareness. These target general contractors and key decision makers in our healthcare and education market verticals. We also began a full refresh of our Chicago DIRTT Experience Center (“DXC”) which we anticipate being completed in time to host our annual Connext tradeshow in June. In addition, we are exploring the development or refresh of DXCs in other key geographic areas. Within our manufacturing operation, we achieved a 50% reduction in safety-related total recordable incident frequency (TRIF) rates at year end compared to 2018, and in January of 2020, we had a recordable injury-free month. We believe our goal of having TRIF rates below the Bureau of Labor Statistics standard is achievable in 2020. We are recording improvements in both quality and delivery objectives, a key contributor to achieving sales excellence with our partners and clients, which will continue to be a focus in 2020. In February 2020, we commissioned a new manufacturing line enabling us to bring in-house the priming function that addresses the tile warping issue that occurred in 2018 and 2019. At a total cost of $1.8 million, we anticipate a payback of 18 to 24 months. In late 2019 and early 2020, we identified and addressed excess labor capacity in our factories. Initiatives undertaken and planned include both planned shutdowns of our production facilities during slower periods and a 14% head count reduction of factory employees. We believe that the productivity and efficiency improvements outlined in our strategic plan will enable us to return to higher revenue levels without reinstating headcount. We will continue to monitor activity levels over the course of the year and adjust as necessary. Innovation remains at the core of our strategy and we continue to invest accordingly. We are working to bring our newest innovations, the Inspire low profile and Reflect ultra-sleek glass wall systems, into our proprietary ICE software system in the second and third quarters of 2020, respectively. This simplifies the design and specification for the sales function, streamlines the interaction with the factory and speeds up the delivery of new products to meet the strong reception we have received from partners and clients. We are also developing related sales and marketing materials for our Distribution Partners. We are focused on maintaining a strong balance sheet and are actively managing both operational and capital expenditures even as we continue to make investments that directly support our commercial strategy and innovation efforts. Our capital investments are focused on improving safety and advancing our commercial and innovation strategies. Excluding the South Carolina facility, discussed in more detail below, capital expenditures in 2020 are expected to be between $12 million and $15 million. These expenditures include our Chicago DXC refresh, CRM implementation and software development activities as well as ongoing sustaining activities in our plants and offices. With respect to our new South Carolina tile and millwork facility, approximately $4.5 million of equipment deposits were paid in 2019. This facility reduces single plant reliance risk and is designed to improve material yield and significantly improved labor efficiency. Construction of the building shell by the developer is underway, and key components of the manufacturing equipment are expected to be delivered to site in the third quarter of 2020, with related 2020 spending of approximately $7.5 million. The $6.5 million balance of the facility’s $18.5 million expected cost relates primarily to commissioning and other activities. We are on schedule and on budget for the commencement of commercial operations in the first quarter of 2021. We have flexibility to defer the $6.5 million of expenditures and amend the commissioning date based on business activity levels. During 2019, we made substantial progress in our working capital management, finishing the year with net working capital of $58.6 million compared to $69.8 million at December 31, 2018. This included cash balances of $47.2 million with no debt compared to cash, net of debt, at December 31, 2018 of $47.8 million. We will continue this focus on working capital efficiency in 2020. Looking forward, we see early indications of improvements in activity levels and are encouraged by ongoing discussions with Distribution Partners. We are enthused about the quality of candidates we have hired into the sales and marketing organization and have had strong reception to the new products we introduced in October. It remains too early to quantify the impact that this progress will have on our revenues for 2020. We remain confident in the roadmap we laid out to deliver positive change within the organization; however, given the slower start to the year, 2020 may be a lower revenue year than 2019. We are intently focused on exiting the year with the organizational foundation in place to support our strategic plan and achieve our financial targets for 2023, which call for revenue of $450 million to $550 million and an Adjusted EBITDA Margin of 18% - 22%. Non-GAAP Financial Measures Note Regarding Use of Non-GAAP Financial Measures Our consolidated financial statements are prepared in accordance with GAAP. These GAAP financial statements include non-cash charges and other charges and benefits that we believe are unusual or infrequent in nature or that we believe may make comparisons to our prior or future performance difficult. As a result, we also provide financial information in this Annual Report that is not prepared in accordance with GAAP and should not be considered as an alternative to the information prepared in accordance with GAAP. Management uses these non-GAAP financial measures in its review and evaluation of the financial performance of the Company. We believe that these non-GAAP financial measures also provide additional insight to investors and securities analysts as supplemental information to our GAAP results and as a basis to compare our financial performance from period-over-period and to compare our financial performance with that of other companies. We believe that these non-GAAP financial measures facilitate comparisons of our core operating results from period to period and to other companies by removing the effects of our capital structure (net interest income on cash deposits, interest expense on outstanding debt, or foreign exchange movements), asset base (depreciation and amortization), the impact of under-utilized capacity on gross profit, tax consequences and stock-based compensation. In addition, management bases certain forward-looking estimates and budgets on non-GAAP financial measures, primarily Adjusted EBITDA. For the current year, we removed the impact of all foreign exchange from Adjusted EBITDA. Foreign exchange gains and losses can vary significantly period-on-period due to the impact of changes in the U.S. and Canadian dollar exchange rates on foreign currency denominated monetary items on the balance sheet and are not reflective of the underlying operations of the Company. We have presented a reconciliation to our prior calculation of Adjusted EBITDA for all years presented. Additionally, in the current year, we have excluded from Adjusted Gross Profit costs associated with under-utilized capacity. Fixed production overheads are allocated to inventory on the basis of normal capacity of the production facilities. In periods where production levels are abnormally low, unallocated overheads are recognized as an expense in the period in which they are incurred. Reorganization expenses, impairment expenses, depreciation and amortization, stock-based compensation, and foreign exchange are excluded from our non-GAAP financial measures because management considers them to be outside of the Company’s core operating results, even though some of those expenses may recur, and because management believes that each of these items can distort the trends associated with the Company’s ongoing performance. We believe that excluding these expenses provides investors and management with greater visibility to the underlying performance of the business operations, enhances consistency and comparativeness with results in prior periods that do not, or future periods that may not, include such items, and facilitates comparison with the results of other companies in our industry. The following non-GAAP financial measures are presented in this Annual Report, and a description of the calculation for each measure is included. Adjusted Gross Profit, as previously presented Gross profit before deductions for depreciation and amortization Adjusted Gross Profit Gross profit before deductions for costs of under-utilized capacity, depreciation and amortization Adjusted Gross Profit Margin Adjusted Gross Profit divided by revenue EBITDA Net income before interest, taxes, depreciation and amortization Adjusted EBITDA, as previously presented EBITDA adjusted for non-cash foreign exchange gains or losses on debt revaluation; impairment expenses; stock-based compensation expense; reorganization expenses; and any other non-core gains or losses Adjusted EBITDA EBITDA adjusted for foreign exchange gains or losses; impairment expenses; stock-based compensation expense; reorganization expenses; and any other non-core gains or losses Adjusted EBITDA Margin Adjusted EBITDA divided by revenue You should carefully evaluate these non-GAAP financial measures, the adjustments included in them, and the reasons we consider them appropriate for analysis supplemental to our GAAP information. Each of these non-GAAP financial measures has important limitations as an analytical tool due to exclusion of some but not all items that affect the most directly comparable GAAP financial measures. You should not consider any of these non-GAAP financial measures in isolation or as substitutes for an analysis of our results as reported under GAAP. You should also be aware that we may recognize income or incur expenses in the future that are the same as, or similar to, some of the adjustments in these non-GAAP financial measures. Because these non-GAAP financial measures may be defined differently by other companies in our industry, our definitions of these non-GAAP financial measures may not be comparable to similarly titled measures of other companies, thereby diminishing their utility. EBITDA and Adjusted EBITDA for the Years Ended December 31, 2019, 2018 and 2017 The following table presents a reconciliation for the year-to-date results of 2019, 2018 and 2017 of EBITDA and Adjusted EBITDA to our net income (loss), which is the most directly comparable GAAP measure for the periods presented: (1) As discussed previously, in prior filings, only foreign exchange movements on debt revaluation was included in Adjusted EBITDA. (2) Net income divided by revenue. As discussed above, we have removed the impact of all foreign exchange from Adjusted EBITDA and have presented a reconciliation to our prior calculation of Adjusted EBITDA for the periods presented above. For the year ended December 31, 2019, Adjusted EBITDA and Adjusted EBITDA Margin decreased to $18.2 million or 7.4% from $39.1 million or 14.2% in the same period of 2018. This reflects a $18.6 million decrease in Adjusted Gross Profit as discussed below, the $2.2 million costs of underutilized capacity, the impacts of $5.7 million of one-time costs in operating expenses (which included $2.0 million related to the Sales & Marketing Plan, as defined below, $2.6 million of costs associated with our listing of common shares on Nasdaq (the “U.S. Listing”) and $1.1 million of operations consulting costs) compared to $2.1 million of one-time costs in 2018 related to advisory and other costs associated with activist defense and board, advisor and other costs associated with the work of a special committee of the Board in response to an unsolicited and unsuccessful acquisition bid by a third party. In addition, approximately $1.3 million of litigation costs incurred in 2019 were partially offset by ongoing cost reductions. The change in calculation of Adjusted EBITDA, discussed previously, benefited 2019 with the exclusion of an additional $1.5 million in net foreign exchange losses and 2018 Adjusted EBITDA was reduced by the exclusion of $3.8 million of foreign exchange gains. Adjusted EBITDA and Adjusted EBITDA Margin increased respectively to $39.1 million or to 14.2% of revenue in 2018 from $10.2 million or 4.5% of revenue in 2017. These increases were due to increased sales activity and associated gross profit and a reduction in operating expenses. Additionally, revenue and associated Adjusted EBITDA for the fourth quarter of 2017 were reduced by construction delays resulting from hurricanes in parts of the United States. These reductions in 2017 partially contributed to the increases to 2018 revenue and Adjusted EBITDA. The change in calculation of Adjusted EBITDA, discussed previously, reduced 2018 Adjusted EBITDA due to the exclusion of $3.8 million of foreign exchange gains, whereas 2017 Adjusted EBITDA benefited from the exclusion of $1.4 million of foreign exchange losses. Adjusted Gross Profit and Adjusted Gross Profit Margin for the Years Ended December 31, 2019, 2018 and 2017 The following table presents a reconciliation for the years ended December 31, 2019, 2018, and 2017 of Adjusted Gross Profit to our gross profit, which is the most directly comparable GAAP measure for the periods presented: Gross profit and gross profit margin decreased to $86.4 million, or 34.9%, for the year ended December 31, 2019, from $107.0 million or 39.0% for the year ended December 31, 2018. The decrease is largely due to reduced fixed cost leverage due to a $27.0 million decline in revenues. During the year, we incurred $2.5 million of incremental costs (1.1% reduction in gross profit margin) to mitigate further warping of our tiles. Following the completion of third-party testing in 2019, we determined that timber included in certain projects installed between 2016 and 2019 potentially did not meet the fire-retardant specifications that the projects were sold under. As a result, we recorded an additional $2.5 million liability and are in the process of contacting customers to determine appropriate remedial actions, if any. We are also in the process of evaluating solutions which, if successful, could significantly reduce the associated liability. We also experienced a $0.7 million reduction in gross profit due to reductions in second quarter gross profit on installation revenue. During the fourth quarter of 2019, we determined that we were carrying abnormally excess capacity in our manufacturing facilities as a result of the slowdown in sales. Accordingly, we separately classified $2.2 million as costs attributable to our under-utilized capacity (0.9% in gross profit margin) in cost of sales. Subsequent to year end, we took further steps to manage our excess capacity, including the reduction in staffing by 14% and planned factory shutdowns. Results of Operations Year Ended December 31, 2019 Compared to the Year Ended December 31, 2018 (1) Certain comparative figures have been reclassified to conform to the current year presentation. Revenue The following table sets forth the contribution to revenue of our DIRTT Solutions and related offerings. Product revenue decreased in the year ended December 31, 2019 by $25.4 million, or 11%, compared to the same period of 2018. Revenue decreased due to several factors as discussed above in “- Summary of Financial Results” and “- Outlook”, including the impact of certain large projects in 2018 that were not replaced in 2019. We have been subject to a disruption in sales activity levels particularly as it relates to larger projects, as discussed below, beginning in 2018 and carrying through 2019. This disruption stems from the distraction of significant management changes during 2018 on a long sales cycle combined with the immature and transitional state of our sales and marketing function, which limited our ability to take advantage of growth opportunities in our market for 2019. Due to the long sales cycle, particularly for larger projects which can be two years or more, this had a corresponding negative effect on our revenue in 2019, especially in the last half of the year and continuing into 2020. The effect of this has lasted longer than we had anticipated. We are in the process of making substantial improvements to our commercial function, including building an appropriate organizational structure, improving the sales effectiveness of our existing sales force and attracting new sales talent, establishing strategic marketing and lead generation functions, as well as expanding and better supporting our Distribution Partner network. While we believe these actions are critical to driving long-term, sustainable growth, these actions did not have a measurable effect on 2019 revenues. Installation and other services revenue of $7.1 million for the year ended December 31, 2019 was $1.2 million lower than the same period in 2018. The decrease in installation revenue is primarily due to the timing of projects. Except under certain circumstances, our Distribution Partners perform installation services rather than us; accordingly, we do not anticipate significant growth in this revenue stream. Our success is partly dependent on our ability to profitably develop our Distribution Partner network to expand our market penetration and ensure best practices are shared across local markets. We had 87 Distribution Partners at December 31, 2019. Our clients, as serviced primarily through our Distribution Partners, exist within a variety of industries, including healthcare, education, financial services, government and military, manufacturing, non-profit, energy, professional services, retail, technology and hospitality. We periodically analyze our revenue growth by vertical markets in the defined markets of commercial, healthcare, government and education. The following table presents our product and transportation revenue by vertical market. (1) Excludes license fees from Distribution Partners. Revenue decreased by 10% for the year ended December 31, 2019 compared to the prior year primarily due to decreased healthcare sales, which reflects the completion of a major healthcare project in 2018 that was not replaced in 2019 and reductions in government sales mainly as a result of the timing of projects and reduced installation activity, partially offset by growth in the education sector. Revenue continues to be derived almost exclusively from projects in North America and predominantly from the United States, with periodic international projects from North American Distribution Partners. The following table presents our revenue dispersion by geography. Sales & Marketing Expenses Sales and marketing expenses decreased $6.7 million to $33.9 million for the year ended December 31, 2019, from $40.6 million for the year ended December 31, 2018. Included in sales and marketing expenses for the year ended December 31, 2019 were $2.0 million of one-time consulting costs related to the sales and marketing plan developed with the assistance of an internationally recognized consulting firm (“Sales & Marketing Plan”). These costs were offset by a reduction of $3.4 million in commission expense for the year ended December 31, 2019, respectively, on lower revenues. We reduced travel meals and entertainment by $2.6 million due to continued attention to cost reductions. None of these expense reductions are expected to materially affect our future sales revenue. Salaries and benefits declined $1.0 million due to reductions in sales and marketing personnel year on year, of which we are working to appropriately fill open positions as previously discussed. Finally, the current year includes a $0.9 million reduction from 2018 as a result of lower rent and operating costs associated with closure of certain of the Company’s DXC’s at the end of 2018. Our sales and marketing efforts in 2019 were largely concentrated on commencing the establishment of an appropriate sales organization, significantly improving our marketing approach and driving returns on sales and marketing expenditures. In the second and third quarters of 2019, we developed our Sales & Marketing Plan to evaluate our current sales and marketing approach and assist in the development of action plans necessary to drive accelerated growth. These action plans are a key component of the strategic plan which we presented in November 2019. As we implement this plan, we expect sales and marketing expense to increase as a percentage of revenues, reflecting targeted increases in our commercial organization headcount, establishment of strategic marketing campaigns, and implementation of related systems and tools to improve both the effectiveness of our sales force and our overall Distribution Partner support. Our ongoing focus is to continue to control costs by emphasizing return on investment on our sales and marketing expenditures. General and Administrative Expenses General and administrative (“G&A”) expenses decreased $1.1 million to $27.6 million for the year ended December 31, 2019 from $28.7 million for the year ended December 31, 2018. In 2019, personnel costs were lower as a result of reductions in headcount and variable compensation offset by $1.3 million in costs associated with ongoing litigation, as discussed in this Annual Report. In 2018, we incurred $1.4 million in costs associated with activist defense and $0.7 million of board, advisor and other costs associated with the work of a special committee of the Board in response to an unsolicited and unsuccessful acquisition bid by a third party. These reductions were partially offset by $2.6 million of costs related to the U.S. Listing incurred in the year ended December 31, 2019. We anticipate in 2020 that ongoing and incremental non-U.S. Listing related costs as a result of becoming a U.S. registrant will be approximately $1.5 to $2.0 million higher in 2020 than in 2019, driven largely by increased director and officer insurance premiums, the costs of maintaining two listings, and expected increases in audit, legal, and other compliance costs. Operations Support Expenses Operations support is comprised primarily of project managers, order entry and other professionals that facilitate the integration of our Distribution Partner project execution and our manufacturing operations. Operations support expenses increased $3.0 million to $11.0 million for the year ended December 31, 2019, from $8.1 million for the year ended December 31, 2018, due to an increase in consulting costs during the year, as well as increases in personnel costs. Consultant costs of $1.1 million were incurred to assist with the evaluation of current operations and to assist with the rectification of the tile warping issue and increases in personnel costs due to increased headcount to better support project execution and support of our Distribution Partners. Technology and Development Expenses Technology and development includes our software development teams and our product development activities. Technology and development expenses increased $3.6 million to $7.8 million for the year ended December 31, 2019, compared to $4.2 million for the year ended December 31, 2018. These increases are due to a $1.7 million decrease in capitalized salaries for the year ended December 31, 2019, as the current mix of projects undertaken by us included a higher portion of efforts related to business process improvements that were not eligible for capitalization. Additionally, for the year ended December 31, 2019 we had additional salary and benefit costs of $0.7 million that were classified as cost of sales of technical services during the year ended December 31, 2018. Stock-Based Compensation During the third quarter of 2018, we determined that we no longer qualified as a Foreign Private Issuer (“FPI”) under the rules of the SEC. To minimize any undue effects on employees, our Board approved the availability of a cash surrender feature for certain options, including options issued under our Amended and Restated Incentive Stock Option Plan (“Option Plan”), until such time as we requalified as a FPI or we registered our common shares with the SEC, which occurred on October 9, 2019 upon our listing on Nasdaq. Accordingly, we accounted for the fair value of outstanding stock options at the end of the reporting period as a liability, with changes in the liability recorded through net income as a stock-based compensation fair value adjustment. On October 9, 2019, we ceased allowing cash surrender of options and returned to equity accounting under the Option Plan without quarterly fair value adjustments at that date. Stock-based compensation for the year ended December 31, 2019 was $3.9 million compared to $3.7 million for the same period of 2018. Prior to the return to equity settled accounting, we had a liability of $1.8 million. Stock-based compensation for the year ended December 31, 2018 included a $0.2 million fair value adjustments on cash settled stock options. Reorganization Expenses We recorded $4.6 million of reorganization expenses in 2019 compared to $7.4 million for the year ended December 31, 2018. These costs included severance payments, and related legal and consulting costs associated with management and organizational changes. Impairment Expenses DIRTT Timber During 2018, management decided to shift from the early stage development of its DIRTT Timber market to a commercialized approach focused on large, standalone timber projects and as a tie-in to our other DIRTT Solutions. Management concluded that this strategy required significantly less timber capacity than existed and took steps to adjust its timber capacity by the end of 2018. Management determined these decisions to be an indicator of impairment of the assets of the DIRTT Timber solution. During 2018, management performed an assessment of the carrying values of DIRTT Timber’s property, plant and equipment (“PP&E”). To determine the impairment of the DIRTT Timber assets, the net book value of the assets was evaluated against the fair value of the assets. The fair value of the DIRTT Timber assets reflects current projected sales for timber projects on a standalone basis and the pull-through impact to other DIRTT Solutions. In its evaluation, management determined it was unable to reliably quantify the pull-through impact of timber on other DIRTT Solutions. The equipment related to the timber market was custom built for DIRTT, and there is no active market for resale. Therefore, the fair value was determined to be management’s estimate of scrap value for the specialized assets and an estimated resale value for less specialized assets that cannot be redeployed for other DIRTT Solutions. Management estimated the expected resale values based on the current market and industry knowledge. The fair value of the timber assets was estimated to be $1.1 million. This assessment resulted in an impairment charge of $6.1 million during 2018. Leasehold and Other Assets During 2018, management reviewed the facilities used in our operations and the corresponding leases in place to determine whether assets were impaired or whether the costs of meeting lease obligations exceeded the economic benefits expected to be received. The outcome of this review was the consolidation of our production in Kelowna, British Columbia, into other plants, the consolidation of a distribution center in Calgary, Alberta, into an existing facility, and discontinued use of other locations that were not considered necessary in our operations. In 2018, we recognized a lease exit liability of $0.5 million related to these facilities, net of $1.0 million of estimated recoveries from subleases. The lease exit liability represents the present value of the difference between the minimum future lease payments that we are obligated to make under the non-cancellable operating lease contract and any estimated sublease recoveries. This estimate may vary as a result of changes in estimated sublease recoveries. The lease exit liability is estimated to be settled in periods up to and including the year 2023. In connection with management’s review of our facilities, certain leasehold assets were identified as no longer having future value. These assets related to leases of locations where activity is being relocated, as well as projects in process that were eliminated. These leasehold and other assets represented assets with a carrying value of $2.0 million in 2018. As these assets cannot be resold and there is no future use for the assets, the entire carrying amount was impaired and a corresponding impairment charge of $2.0 million was recorded. Income Tax Alberta’s general provincial tax rate decreased on June 28, 2019 from 11.5% to 11% for the second half of 2019, to 10% for 2020, to 9% for 2021 and to 8% thereafter. As a result of this rate change, we reduced our deferred tax asset by $0.9 million, with a corresponding deferred income tax expense recorded in the second quarter of 2019. The provision for income taxes is comprised of federal, state, provincial and foreign taxes based on pre-tax income. Income tax expense for the year ended December 31, 2019, inclusive of the previously noted charge associated with the Alberta tax rate change, was $1.0 million, compared to $3.3 million for the year-ended December 31, 2018. The reduction was primarily due to a reduction in current taxes as a result of lower activity. As at December 31, 2019, we had C$38.1 million of loss carry-forwards in Canada and none in the United States, compared to C$43.6 million in Canada and none in the United States on December 31, 2018. These loss carry-forwards will begin to expire in 2030. Net Income (loss) On a year-to-date basis, net loss was $4.4 million or $0.05 net loss per share for the year ended December 31, 2019, compared to net income of $5.6 million or $0.07 net income per share for the prior year. The variances are primarily the result of a $20.6 million decrease in gross margin, partially offset by a $12.4 million decrease in operating expenses as described above, as well as a foreign exchange loss of $1.3 million in 2019 compared to a foreign exchange gain of $3.2 million in 2018. Foreign exchange gains or losses are primarily derived from U.S. dollar denominated cash and intercompany account balances in the Canadian parent company. Year Ended December 31, 2018 Compared to the Year Ended December 31, 2017 Discussion and analysis of our financial condition and results of operations for the fiscal year ended December 31, 2018 compared to the fiscal year ended December 31, 2017 is included under the heading Item 2. “Financial Information - Management’s Discussion and Analysis of Financial Condition and Results of Operations,” in our Registration Statement on Form 10, as filed with the SEC on September 20, 2019. Seasonality The construction industry has historically seen seasonal slowdowns related to winter weather conditions and holiday schedules in the fourth and first quarters. Our business has generally, but not always, followed this trend with a slight time lag, leading to stronger sales in the second half of the year versus the first half. Due to the fixed nature of some of our manufacturing costs, periods of higher revenue volume tend to generate higher gross profit and operating income. Quarters that contain consistent monthly manufacturing volumes tend to generate higher gross profit than those where manufacturing levels vary significantly from month to month. Product and service revenue mix also tends to impact gross profit, as simplistic product and service revenue mix can result in lower gross profit, while “full solution” or comprehensive product and service revenue mixes tend to have higher gross profit. Liquidity and Capital Resources Cash and cash equivalents at December 31, 2019 totaled $47.2 million, a decrease of $6.2 million from $53.4 million on December 31, 2018. On January 31, 2019, we repaid $5.6 million of long-term debt outstanding with cash on hand, without penalty. In July 2019, we entered into a C$50.0 million revolving operating facility with the Royal Bank of Canada (“RBC Credit Facility”). Draw-downs under the RBC Credit Facility are available in both Canadian and U.S. dollars. The RBC Credit Facility replaced the $18.0 million revolving operating facility with Comerica Bank (“Comerica Credit Facility”) that expired on June 30, 2019. Management believes that existing cash and cash equivalents and cash flows from operations will be sufficient to support ongoing working capital and capital expenditure requirements for at least the next 12 months. Our future capital requirements will depend on many factors, including growth rate, the continued expansion of sales and marketing activities and the introduction of new solutions, software and product enhancements. To the extent existing cash and cash equivalents and cash flows from operations are not sufficient to fund future activities, we may seek to raise additional funds through equity or debt financings. If additional funds are raised through the incurrence of indebtedness, such indebtedness may have rights that are senior to holders of our equity securities and could contain covenants that restrict operations. Any additional equity financing may be dilutive to our existing shareholders. Since inception, we have financed operations primarily through cash flows from operations, long-term debt, and the sale of equity securities. Over the past three years, the we have funded our operations and capital expenditures through a combination of cashflow from operations and cash on hand. We had no amount outstanding under the RBC Credit Facility at December 31, 2019. The following table summarizes our consolidated cash flows for the years indicated: Operating Activities Net cash flows provided by operating activities increased to $13.4 million for the year ended December 31, 2019 from $10.1 million for the comparative period in 2018. Net cash flows from operations before changes in operating assets and liabilities was $8.4 million (calculated as $4.4 million of net loss plus $12.8 million of non-cash adjustments) in 2019, compared to $29.1 million (calculated as $5.6 million of net income plus $23.5 million of non-cash adjustments) in 2018, which largely reflects the 2019 reduction in adjusted gross profit discussed above. Non-cash adjustments include, among other things, depreciation and amortization expense, impairment expense, stock-based compensation net of cash paid on surrenders of stock options, and unrealized foreign exchange impacts. The increase in cash flows from operations is largely due to an increase in collections on accounts receivable balances partially offset by a decrease in accounts payable resulting from timing of payments. Investing Activities We invested $12.7 million in PP&E during 2019 compared to $8.6 million in 2018. The increase was primarily due to manufacturing equipment purchases for the new tile and millwork facility, of which $4.5 million was incurred in the second half of 2019. We invested $3.5 million on capitalized software and other assets during 2019, as compared to $5.2 million in 2018. The reduction is due to the current mix of projects undertaken by the Company and included a higher portion of efforts related to business process improvements that were not eligible for capitalization. Financing Activities Net cash used in financing activities was $5.5 million in 2019. We repaid the balance of $5.6 million on long-term debt outstanding and related interest during the first quarter of 2019. Cash used in financing activities was $3.1 million in 2018. We currently expect to fund anticipated future investments with available cash. Apart from cash flow from operations, issuing equity and debt has been our primary source of capital to date. Additional debt or equity financing may be pursued in the future as we may deem appropriate. We may also use debt or pursue equity financing depending on the share price at the time, interest rates, and nature of the investment opportunity and economic climate. Credit Facility At December 31, 2019, we had no amounts drawn on our RBC Credit Facility, and we were in compliance with all covenants thereunder. In 2018, we did not draw on the Comerica Credit Facility. The Comerica Credit Facility expired on June 30, 2019. On July 19, 2019, we entered into a C$50.0 million senior secured revolving credit facility with the Royal Bank of Canada. The RBC Credit Facility has a three-year term and can be extended for up to two additional years at our option. Interest is calculated at the Canadian or U.S. prime rate with no adjustment, or the bankers’ acceptance rate plus 125 basis points. We are required to comply with certain financial covenants under the RBC Credit Facility, including maintaining a minimum fixed charge coverage ratio of 1.15:1 and a maximum debt to Adjusted EBITDA ratio of 3.0:1. We are also required to comply with certain non-financial covenants, including, among other things, covenants restricting our ability to (i) dispose of our property, (ii) enter into certain transactions intended to effect or otherwise permit a material change in our corporate or capital structure, (iii) incur any debt, other than permitted debt, and (iv) permit certain encumbrances on our property. We are generally restricted from making dividends or distributions on our outstanding capital shares (other than any distribution by way of the payment of dividends by the issuance of equity securities). We may also declare and pay dividends to our shareholders provided that such dividends do not exceed 50% of the Free Operating Cash Flow (as defined in the RBC Credit Facility) for the most recently completed fiscal year and meet certain other conditions. We may also make a one-time Permitted Special Distributions (as defined in the RBC Credit Facility) provided that we maintain a minimum balance of at least C$20.0 million in our account and meet certain other conditions. The RBC Credit Facility is secured by substantially all of our real property located in Canada and the United States. Contractual Obligations The following table summarizes DIRTT’s contractual obligations at December 31, 2019: Significant Accounting Policies and Estimates Our significant accounting policies are described in Note 2 to our Consolidated Financial Statements appearing elsewhere in this Annual Report. Our critical accounting estimates include the areas where we have made what we consider to be particularly difficult, subjective or complex judgements in making estimates, and where these estimates can significantly affect our financial results under different assumptions and conditions. We prepare our financial statements in conformity with GAAP. As a result, we are required to make estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates, judgments and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and reported amounts of revenue and expenses during the periods presented. Actual results could be different from these estimates. Critical estimates and assumptions made by management include: Estimates of liabilities associated with the potential and amount of warranty, legal claims and other contingencies We have warranty obligations with respect to manufacturing defects on most of our manufactured products. Warranty periods generally range from 1 to 10 years. We have recorded a reserve for estimated warranty and related costs based on historical experience and periodically adjust these provisions to reflect actual experience. We assess the adequacy of our warranty accrual on a quarterly basis, and adjust the previous amounts recorded, if necessary, to reflect the change in estimate of the future costs of claims yet to be serviced. Typically, product deficiencies requiring our warranty are identified and remediated within a year of production. The following provides information with respect to our warranty accrual. At December 31, 2019 and 2018, we had $4.0 million and $1.5 million, respectively, accrued for warranty and other provisions, and third-party costs associated with remedying deficiencies were $2.6 million during the fiscal 2019, as compared to $2.1 million during fiscal 2018. Following the completion of third-party testing in 2019, we determined that timber included in certain projects installed between 2016 and 2019 potentially did not meet the fire-retardant specifications that the projects were sold under. As a result, we recorded a $2.5 million liability and are in the process of contacting customers to determine appropriate remedial actions, if any. We are in discussions with our insurance carrier to determine how much, if any, of this liability is covered by insurance. We have ceased selling timber to projects with those particular specifications until such time as we have a permanent solution. We are also in the process of evaluating solutions which, if successful, could significantly reduce the associated liability. The current year expenditures primarily relates to the previously noted increase in the incidence of tile warping as a result of a change in the composition of the underlying medium density fiberboard substrate. This issue is currently being addressed, and our warranty provision may change as the assessment of this issue changes. We establish reserves for estimated legal contingencies when we believe a loss on litigation is probable and the amount of the loss can be reasonably estimated. Revisions to contingent liability reserves are reflected in operations in the period in which there are changes in facts and circumstances that affect our previous assumptions with respect to the likelihood or amount of loss. Reserves for contingent liabilities are based upon our assumptions and estimates regarding the probable outcome of the matter. We estimate the probable cost by evaluating historical precedent as well as the specific facts relating to each contingency (including the opinion of outside advisors). Should the outcome differ from our assumptions and estimates, or other events result in a material adjustment to the accrued estimated reserves, revisions to the estimated reserves for contingent liabilities would be required and would be recognized in the period the new information becomes known. At December 31, 2019 and 2018, we had $0.7 million and $2.0 million, respectively, provided for legal provisions. Estimates of useful lives of depreciable assets and the fair value of long-term assets used for impairment calculations We evaluate the recoverability of our PP&E and capitalized software costs when events or changes in circumstances indicate a potential impairment exists. If impairment is indicated, the impairment loss is measured as the amount the assets carrying value exceeds the fair value of the assets. Our determination of the fair value associated with long-term assets involve significant estimates and assumptions, including those with respect to the determination of asset groups, future cash inflows and outflows, discount rates, and asset lives. These significant estimates require considerable judgment, which could affect our future results if the current estimates of future performance and fair values change. We estimate the useful lives of PP&E and capitalized software costs based on the period over which the assets are expected to be available for use. The estimated useful lives are reviewed annually and are updated if expectations differ from previous estimates due to physical wear and tear, technical or commercial obsolescence and legal or other limits on the use of the relevant assets. In addition, the estimation of the useful lives of the relevant assets may be based on internal technical evaluation and experience with similar assets. It is possible, however, that future results of operations could be materially affected by changes in the estimates brought about by changes in factors mentioned above. The amounts and timing of recorded expenses for any period would be affected by changes in these factors and circumstances. A reduction in the estimated useful lives of the PP&E and capitalized software assets would increase the recorded expenses and decrease the non-current assets. Estimates of future taxable earnings used to assess the realizable value of deferred tax assets We use the asset and liability method of accounting for income taxes. Under this method, deferred income tax assets and liabilities arise from temporary differences between the tax bases of assets and liabilities and their carrying amounts reported in the financial statements. Deferred income tax assets also reflect the benefit of unutilized tax losses that can be carried forward to reduce income taxes in future years. Such method requires the exercise of significant judgment in determining whether or not our deferred tax assets are probable of recovery from taxable income of future years and, therefore, can be recognized in the financial statements. Also, estimates are required to determine the expected timing upon which tax assets will be realized and upon which tax liabilities will be settled. We assess the ability to recover our deferred tax assets every quarter and concluded that deferred tax assets should be recovered in the normal course of operations. Tax interpretations, regulations and legislations in the various jurisdictions in which the Company and its subsidiaries operate The determination of our provision for income taxes requires significant judgment, the use of estimates and the interpretation and application of complex tax laws. Our provision for income taxes reflects a combination of income earned and taxed in the various U.S. federal and state, and Canadian federal and provincial jurisdictions. Jurisdictional tax law changes increase or decreases in permanent differences between book and tax items, accruals or adjustments of accruals for tax contingencies or valuation allowances, and the change in the mix of earnings from these taxing jurisdictions all affect the overall effective tax rate. We have no liability for uncertain tax positions. However, should we accrue for such liabilities, when and if they arise in the future, we will recognize interest and penalties associated with uncertain tax positions as part of our income tax provision. Estimates of the fair value of stock awards, including whether the performance criteria will be met and measurement of the ultimate payout amount We use a fair-value based approach for measuring stock-based compensation and record compensation expense over an award’s vesting period based on the award’s fair value at the date of grant. Our awards vest based on service conditions, and compensation expense is recognized on a straight-line basis. Stock-based compensation expense is recognized only for those awards that ultimately vest. Prior to October 2019, we allowed certain vested share options to be surrendered for cash, resulting in the share options being accounted for as liabilities at fair value every period, which increases the sensitivity of our accounting to share price movements. Estimates of ability and timeliness of customer payments of accounts receivable Our allowance for doubtful accounts reflects reserves for customer receivables to reduce receivables to amounts expected to be collected. Management uses significant judgment in estimating uncollectible amounts. In estimating uncollectible accounts, management considers factors such as current overall economic conditions, industry-specific economic conditions, historical customer performance and anticipated customer performance. While we believe these processes effectively address our exposure for doubtful accounts and credit losses have historically been within expectations, changes in the economy, industry, or specific customer conditions may require adjustments to the allowance for doubtful accounts. We have a contract with a trade credit insurance provider, whereby a portion of its trade receivables are insured. The trade credit insurance provider determines the coverage amount, if any, on a customer-by-customer basis. Based on our trade receivables balance as at December 31, 2019 and 2018, nil and 70%, respectively, of that balance was covered by trade credit insurance provider. At December 31, 2019 and 2018, we had an allowance for doubtful accounts of $0.1 million. Recent Accounting Pronouncements Please refer to Note 3 to our Consolidated Financial Statements presented elsewhere in this Annual Report.

<s>[INST] We have revised our calculation of Adjusted EBITDA and Adjusted Gross Profit, nonGAAP financial measures, for the presented periods. For additional information, see “ NonGAAP Financial Measures EBITDA and Adjusted EBITDA for the Years Ended December 31, 2019, 2018 and 2017.” and “ NonGAAP Financial Measures Adjusted Gross Profit and Adjusted Gross Profit Margin for the Years Ended December 31, 2019, 2018 and 2017.” Overview We are an innovative manufacturing company featuring a proprietary software and virtual reality visualization platform, coupled with vertically integrated manufacturing that designs, configures and manufactures prefabricated interior solutions used primarily in commercial, healthcare and educational spaces across a wide range of industries and businesses. We combine innovative product design with our industryleading, proprietary ICE Software, and technologydriven, lean manufacturing practices and sustainable materials to provide endtoend solutions for the traditionally inefficient and fragmented interior construction industry. We create customized interiors with the aesthetics of conventional construction but with greater schedule and cost certainty, shorter lead times, greater future flexibility, and better environmental sustainability than conventional construction. Our ICE Software allows us to sell, design, visualize (including 3D virtual reality modeling of interiors), configure, price, communicate, engineer, specify, order and manage projects, thereby reducing challenges associated with traditional construction, including cost overruns, change orders, inconsistent quality, delays and material waste. While other software programs and virtual reality tools are used in the architectural and construction industries, we believe our ICE Software is the only interior construction technology that provides endtoend integration and management, from design through engineering, manufacturing and installation. Our interior construction solutions include prefabricated, customized interior modular walls, ceilings, and floors; decorative and functional millwork; power infrastructure; network infrastructure; and preinstalled medical gas piping systems. We strive to incorporate environmentally sustainable materials and reusable components into our solutions while creating flexible, functional and welldesigned environments for the people who will use them. We offer our interior construction solutions throughout the United States and Canada, as well as in select international markets, through a network of independent Distribution Partners and an internal sales team. Our Distribution Partners use ICE to work with end users to envision and design their spaces, and orders are electronically routed through ICE to our manufacturing facilities for production, packing and shipping. Our Distribution Partners then coordinate the receipt and installations of our interior solutions at the end users’ locations. Summary of Financial Results Revenues for the year ended December 31, 2019 were $247.7 million, a decline of $27.0 million or 10% from $274.7 million for the year ended December 31, 2018. We believe we have been subject to a disruption in sales activity levels particularly as it relates to larger projects, as discussed below, beginning in 2018 and carrying through 2019. This disruption stems from the distraction of significant management changes during 2018 on a long sales cycle combined with the immature and transitional state of our sales and marketing function, which limited our ability to take advantage of growth opportunities in our market for 2019. Our revenue in 2019 was directly affected by this disruption and we experienced a sequential decrease in revenues in the fourth quarter of 2019 from the third quarter of 2019. Gross profit for the year ended December 31, 2019 was $86.4 million or 34.9% of revenue, a decline of $20.6 million or 19% from $107.0 million or 39.0% of revenue for the year ended December 31, 2018. This reduction was attributable to our decline in revenues, the impact of fixed costs on lower revenues, $2.5 million of incremental costs to mitigate a previously disclosed tile warping issue, and a $2.5 million increase in our provision because we determined that timber included in certain projects installed between 2016 and 2019 may not meet certain building [/INST] Negative. </s>

Sundance Energy Inc.

2020-05-15

2019-12-31

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 our Consolidated Financial Statements and Notes thereto included in Part II, Item 8. “Financial Statements and Supplementary Data” of this annual report. Our discussion and analysis includes forward-looking information that involves risks and uncertainties and should be read in conjunction with Part I, Item 1A. “Risk Factors” along with “Cautionary Statement Regarding Forward-Looking Statements” on page 2 of this annual report for information on the risks and uncertainties that could cause our actual results to be materially different from our forward-looking statements. Overview and Executive Summary We are an onshore independent oil and natural gas company focused on the development, production and exploration of large, repeatable resource plays in North America. Our operations are located in the Eagle Ford formation in south Texas. Our strategy is to acquire and/or develop assets where we are operator and have high working interests, positioning us to efficiently control the pace and scope of our development and the allocation of our capital resources. We also believe that serving as operator allows us to control the drilling, completion, operations and marketing of sold volumes. In 2019, we continued to focus on developing high-return assets from our portfolio while reducing our operating costs and per well drilling and completion costs. We took the following actions during 2019 in support of our corporate strategy: · On November 26, 2019, we successfully redomiciled to the U.S. from Australia, and our common stock began trading on the Nasdaq Global Market, under the ticker symbol “SNDE”. · We completed and had initial production from 22 net operated wells (two of which were subsequently sold during October 2019), which increased our average daily net production 38% from 2018 to 13,248 Boe/d. · In October 2019, we completed the divestiture of 19 gross producing wells located on approximately 6,100 net acres located in Dimmit County, Texas for proceeds of $21.5 million, including effective date to closing date adjustments, less transaction costs of $0.5 million. Sales volumes from these wells was approximately 1,153 Boe/d during the first nine months of 2019. The divesture provided additional liquidity to allow development of our higher return assets. · In January 2020, we amended our Revolving Facility to increase the overall facility from $250 million to $500 million, and to increase our borrowing base to $210 million (with initial elected borrowing commitments of $190 million). We are currently restricted in our ability to make draws until the finalization of our second quarter borrowing base redetermination. See Part II, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under “Credit Facilities” for additional information regarding our credit facilities. Business and Industry Outlook Market prices for crude oil, natural gas and NGLs are inherently volatile. In 2019, WTI oil prices averaged approximately $56.98 per Bbl versus $65.23 per Bbl in 2018. Despite price support in the first half of 2019 driven by supply tightness, geopolitical tensions, 2019 WTI oil prices overall were negatively impacted by trade concerns and economic slowdown fears. In March 2020, NYMEX WTI oil prices declined sharply to less than $20 per Bbl and in April 2020, for a short period of time were negative, primarily due to drastic price cutting and increased production by Saudi Arabia coupled with an expected demand reduction caused by the global COVID-19 outbreak. The U.S. domestic natural gas market remains oversupplied as production has continued to grow due to drilling efficiencies, higher incremental volumes of associated gas from oil wells and de-bottlenecking of transportation infrastructure. Henry Hub gas prices averaged approximately $2.56 per MMBtu in 2019 versus $3.15 per MMBtu in 2018. Natural gas and NGL prices faced strong headwinds in 2019 due to U.S. supply growth far outpacing demand for both commodities domestically and internationally. These factors continue to weigh on natural gas and NGL prices. To mitigate our exposure to commodity price volatility and ensure our financial strength, we continue to execute a hedging program. We expect capital expenditures to be in the range of $40 - $45 million for 2020. However, we intend to flexibly manage our operations, including capital expenditure levels, based on existing and expected market conditions to protect our balance sheet and retain liquidity. We expect to be able to fund our planned capital program for 2020 with cash flow generated from operating activities (which includes proceeds from settlements of hedging contracts) and cash on hand. As of the date of this annual report, we also had $58.6 million available under our Revolving Facility. See Part II, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under “Cash flows used in investing activities” for further discussion of our capital expenditures. Year Ended December 31, 2019 Compared to the Year Ended December 31, 2018 Revenues and Sales Volume. The following table provides the components of our revenues for the years ended December 31, 2019 and 2018, as well as each period’s respective sales volumes: Boe and average net daily production. Sales volumes increased by 1,327,395 Boe (3,636 Boe/d) to 4,835,663 Boe (13,248 Boe/d) for the year ended December 31, 2019 compared to 3,508,268 Boe (9,612 Boe/d) for the prior year primarily due to our 2019 and 2018 drilling programs, which was back-loaded in the second half of 2018, partially offset by normal field production declines and downtime resulting from midstream capacity constraints, well equipment failure and simultaneous operations. We had initial production from 22 net operated wells in 2019 and 20 net operated wells in the second half of 2018. Beginning in the fourth quarter of 2018 through May 2019, we experienced capacity constraints at a midstream facility. We and our midstream partner completed the first phase of a capacity expansion of the gas processing plant through the installation of two additional compressors in May 2019. In the fourth quarter of 2019, our midstream partner commenced an additional expansion project to ensure capacity for future development. The second phase of the expansion project was completed in the first quarter of 2020. Our sales volume is oil-weighted, with oil representing 64% of total sales volume for both the years ended December 31, 2019 and 2018, and liquids (oil and NGLs) representing 80% and 78% of total sales volumes for the years ended December 31, 2019 and 2018, respectively. Our oil sales and liquid sales volumes as a percentage of total sales volumes was lower in 2019 than what we expect it to be prospectively primarily due to the gassier sales volumes produced from our Dimmit County assets, which were divested in October 2019. Oil sales. Oil sales increased by $37.6 million (27%) to $177.9 million for the year ended December 31, 2019 from $140.2 million for the prior year. The increase in oil revenue was driven by higher sales volumes ($51.0 million), offset by lower product pricing ($13.4 million). The average realized price on the sale of our oil decreased by 7% to $57.81 per Bbl for the year ended December 31, 2019 (a $0.83 premium to the average WTI price for the same period) from $62.16 per Bbl for the prior year. We are able to sell oil at a premium to WTI due to our proximity to Gulf Coast refining and export markets. Oil sales volumes increased 36% to 3,076,582 Bbls for the year ended December 31, 2019 compared to 2,256,043 Bbls for the prior year. Natural gas sales. Natural gas sales increased by $0.5 million (4%) to $12.6 million for the year ended December 31, 2019 from $12.0 million for the prior year. The increase in natural gas revenues was the result of higher sales volumes ($3.2 million), partially offset by lower product pricing ($2.7 million). Natural gas sales volumes increased 27% to 5,767,779 Mcf for the year ended December 31, 2019 compared to 4,533,604 Mcf for the prior year. The average realized price on the sale of our natural gas decreased by 18% to $2.18 per Mcf (net of certain transportation and marketing costs) for the year ended December 31, 2019 from $2.65 per Mcf for the prior year. NGL sales. NGL sales increased by $0.5 million (4%) to $13.2 million for the year ended December 31, 2019 from $12.7 million for the prior year. The increase in NGL revenues was the result of higher sales volumes ($7.7 million), offset by lower product pricing ($7.2 million). NGL sales volumes increased 301,160 Bbls (61%) to 797,784 Bbls for the year ended December 31, 2019 compared to 496,624 Bbls for the prior year. The average realized price on the sale of our NGLs decreased by 35% to $16.51 per Bbl for the year ended 31 December 2019 from $25.51 per Bbl for the prior year. The following table provides a summary of our operating expenses on a per BOE basis: (1) Lease operating expense and workover expense are included together in lease operating and workover expenses on the consolidated statement of operations. (2) Excludes depreciation related to corporate assets. Lease operating expense. Our LOE increased by $0.1 million (less than 1%) to $28.3 million for the year ended December 31, 2019 from $28.2 million in the prior year, and decreased $2.19 per Boe to $5.85 per Boe from $8.04 per Boe. In addition to realizing economies of scale on some of our fixed LOE costs, we implemented several cost saving initiatives in early 2019 primarily focused on labor, automating measurements through supervisory control and data acquisition (“SCADA”) and compression, which have resulted in lower LOE on a per Boe basis. Workover expense. Our workover expenses decreased $0.4 million to $5.4 million for the year ended December 31, 2019, as compared to $5.8 million for the year ended December 31, 2018. Workover expense per Boe decreased $0.53 to $1.11 per Boe for the year ended December 31, 2019 as compared to the prior year. The increased sales volumes have diluted the workover costs on a per unit basis due to the wells being brought online recently having higher production, but requiring less workovers. Gathering, processing and transportation expense (“GP&T”). GP&T increased by $8.5 million (98%) to $17.1 million ($3.53 per Boe) for the year ended December 31, 2019 as compared to $8.6 million ($2.46 per Boe) for the year ended December 31, 2018. GP&T fees are primarily incurred on production from the properties we acquired in April 2018. Approximately $14.7 million and $5.9 million of the GP&T expense was incurred in normal course under various midstream agreements for the years ended December 31, 2019 and 2018, and the remainder of the expense was related to MRC shortfalls, as discussed below. Through our development, sales volumes from the acquired assets have increased 140% in 2019 as compared to 2018. Certain of our midstream agreements contain MRCs related to fees due on oil, natural gas and NGL volumes gathered, processed and/or transported. Under the terms of the contracts, if we fail to pay fees equal to or greater than the MRC under any of the contracts, we are required to pay a deficiency payment equal to the shortfall. Our MRC commitment totaled $15.8 million and $11.1 million for the years ended December 31, 2019 and 2018, respectively. The shortfall totaled $2.3 million ($0.49 per Boe) and $2.8 million ($0.79 per Boe) for the years ended December 31, 2019 and 2018, respectively. We do not expect to meet the minimum revenue commitment in 2020 at the current pace of drilling. See Part I, Item 1. “Business” under “Delivery Commitments” for additional information. Production taxes. Our production taxes increased by $2.2 million (24%) to $11.5 million for the year ended December 31, 2019 from $9.3 million for the prior year, which was driven by our overall increase in production. Production taxes were 5.6% of total revenue for both the years ended December 31, 2019 and 2018. Depletion, depreciation and amortization expense (“DD&A”). Our DD&A expense related to proved oil and natural gas properties increased by $29.3 million (47%) to $91.7 million for the year ended December 31, 2019 from $62.4 million for the prior year. On a per Boe basis, DD&A increased to $18.96 per Boe for the year ended December 31, 2019 compared to $17.78 per Boe in 2018. Impairment expense. We recorded impairment expense of $10.0 million and $43.8 million for the years ended December 31, 2019 and 2018, respectively related to our Dimmit County oil and gas properties, which were classified as held for sale through 2018 until they were divested in October 2019. Impairment expense was recorded to reduce the carrying value to the estimated net sales proceeds, less the costs to sell the assets. We continued to extract oil and gas from the assets while held for sale, although in accordance with accounting standards, we did not record DD&A for assets classified as held for sale. General & Administrative expense (“G&A”). G&A decreased by $8.3 million (27%) to $22.3 million for the year ended December 31, 2019 as compared to $30.5 million for the prior year. 2018 G&A included one-time transaction costs related to our Eagle Ford acquisition totaling $12.4 million, or $3.53 per Boe. During 2019, we incurred one-time costs, primarily legal and accounting fees, to complete our redomiciliation to the U.S of $2.7 million, or $0.55 per Boe. G&A, excluding the costs associated with these discrete transaction, increased on an absolute basis as compared to prior year primarily due to higher salary and salary-related expense ($1.2 million), as we have increased our in-house technical staff since our Eagle Ford acquisition in 2018. G&A on a per Boe basis, excluding the discrete transactions discussed above, decreased to $4.05 per Boe for the year ended December 31, 2019 as compared to $5.17 per Boe for the year ended December 31, 2018. Gain/loss on commodity derivative financial instruments. Our commodity derivative contracts are marked to market at the end of each reporting period with the changes in fair value being recognized as gain (loss) on commodity derivative financial instruments, net. Cash flow, however, is only impacted by the monthly settlements paid to or received by the counterparty, which are also recorded as gain(loss) on commodity derivative financial instruments, net. We had a loss on derivative financial instruments of $20.5 million for the year ended December 31, 2019 as compared to a $40.2 million gain in the prior year. In 2019, the loss on commodity hedging consisted of $31.6 million of unrealized losses on commodity derivative contracts and $11.1 million of realized gains on commodity derivative contracts. The prior year gain on commodity hedging consisted of $40.8 million of unrealized gains on commodity derivative contracts and $0.6 million of realized losses on commodity derivative contracts. Interest expenses, net of amounts capitalized. The components of interest expense, net of amounts capitalized was as follows (in thousands): The increase in interest expense on our Term Loan, Revolving Facility and other for the year ended December 31, 2019 as compared to the year ended December 31, 2018 was driven by the increase in the average amount of outstanding debt, slightly offset by a decrease in market interest rates. Our weighted average debt outstanding during 2019 was $347 million versus $250 million for 2018. Our weighted average effective cash interest rate was 9.2% during 2019 compared to 9.7% during 2018. In April 2018, contemporaneous with the closing of our Eagle Ford acquisition, we entered into our Revolving Facility and Term Loan, and used a portion of the proceeds to repay the previous credit facilities. The refinance of the Term Loan was accounted for as a debt modification under ASC 470. As a result, we recognized expense of $0.9 million for third party legal fees. The remaining fees paid of $15.8 million were deferred and are being amortized over the life of the Term Loan. We recognized a loss on our interest rate swap of $4.3 million and $2.4 million for the years ended December 31, 2019 and 2018, respectively. Our interest rate swaps are marked to market at the end of each reporting period, with the changes in fair value being recognized as interest expense. Cash settlements paid to or received by our counterparty are also recorded as interest expense. In 2019, the loss on the interest rate swap consisted of $3.6 million of unrealized losses and $0.6 million of realized cash settlements. In 2018, the loss on the interest rate swap consisted of $2.1 million of unrealized losses and $0.3 million of realized cash settlements. Gain on foreign currency derivative financial instruments. We did not have any foreign currency derivatives in place during the year ended December 31, 2019. During the year ended December 31, 2018, we realized a gain of $6.8 million related to derivative contracts put into place to protect the capital commitments made by investors as part of our 2018 equity raise. At the time of the equity raise, our shares were traded on the ASX, and the derivative instruments provided protection from changes in the AUD to USD exchange rate during the period from launch of equity raise to receipt of funds. Income Tax Expense (Benefit). The components of our provision for income tax expense (benefit) and our effective income tax rates were as follows (in thousands): Our effective income tax rate, as shown above, differs from the statutory rate (21%) primarily due to our valuation allowance. See Note 9 to the consolidate financial statements for more information. Other income (expense). During the year ended December 31, 2019, other income (expense) was primarily comprised of expense of $0.7 million for a litigation settlement related to a historical sale of non-operated North Dakota properties in 2013 and expense of $0.9 million for early termination of our drilling rig. Other income (expense) was not material for the year ended December 31, 2018. Adjusted EBITDAX. Management has historically used both GAAP and certain non-GAAP measures to assess our performance. Adjusted EBITDAX is a supplemental non-GAAP financial measure that is used by our management and certain external users of our consolidated financial statements, such as investors, industry analysts and lenders. We define “Adjusted EBITDAX” as earnings before interest expense, income taxes, DD&A, property impairments, gain/(loss) on sale of non-current assets, exploration expense, stock-based compensation, gains and losses on commodity hedging, net of settlements of commodity hedging and certain other non-cash or non-recurring income/expense items. Our management believes Adjusted EBITDAX is useful because it allows us to more effectively evaluate our operating performance, identify operating trends (which may otherwise be masked by the excluded items) and compare the results of our operations from period to period without regard to our financing policies and capital structure. Adjusted EBITDAX should not be considered as an alternative to, or more meaningful than, net income as determined in accordance with GAAP, or as an indicator of our operating performance or liquidity. (1) Management has excluded the MRC shortfall incurred in 2018 from Adjusted EBITDAX. The MRC is calculated on a calendar year basis, however, we did not operate the related assets until the 2018 Eagle Ford acquisition closed on April 23, 2019. Due to the timing of the closing, our development plan was back-loaded into 2018, and we were unable to meet the MRC under the midstream agreements. (2) In 2019, other items of expense, net, was primarily related to litigation settlement expense of $0.8 million. In 2018, other items of expense, net, included litigation settlements of $(0.1) million and other non cash gains of $0.3 million. Liquidity and Capital Resources Our primary sources of liquidity to date have been borrowings under our credit facilities, cash flow from operations, and strategic dispositions of non-core oil and gas properties. From time to time we have also raised additional equity from investors. Our primary use of capital has been for the acquisition and development of oil and natural gas properties. Our future ability to grow our reserves and production will be highly dependent on the capital resources available to us. We and our wholly owned subsidiary, SEI, are parties to the syndicated $250.0 million Term Loan with Morgan Stanley Capital Administrators Inc., as administrative agent, and the Revolving Facility, which is a syndicated reserve-based revolver with Toronto Dominion (Texas) LLC, as administrative agent. The Revolving Facility has a borrowing base of $210.0 million (with a $190 million elected commitment), of which $115.0 million was outstanding as of December 31, 2019. As of the date of this annual report, $58.6 million was undrawn (net of $16.4 million of outstanding letters of credit), although we are currently restricted from making any new draws under the Revolving Facility until completion of the borrowing base redetermination to be completed in the second quarter of 2020. The Revolving Facility matures October 23, 2022, and the Term Loan matures on April 23, 2023. Our Term Loan and Revolving Facility require us to maintain a variety of financial ratios. Of the financial ratio requirements under our credit facilities, our business is generally most sensitive to the Current Ratio. At times, it may be necessary to slow our development pace in order to maintain the required ratio. In addition, as a result of the recent sharp decrease in oil prices, our business is sensitive to the Asset Coverage ratio, particularly in the near-term. See “Credit Facilities” below for a description of the material terms of our credit facilities, financial ratio requirements, and our compliance with these requirements. At December 31, 2019, our cash balance totaled $12.4 million and we had a working capital deficit of $34.0 million. Due to the amounts that we incur related to our drilling and completion program and the timing of such expenditures, we may continue to incur working capital deficits at times in the future. As a result of the decline in commodity prices since December 31, 2019, we expect our 2020 capital program to be in the range of $40 - $45 million. However, we plan to respond flexibly to market conditions to protect our balance sheet and retain liquidity. We believe that our cash flow generated from operating activities (which includes proceeds from settlements of hedging contracts) and cash on hand at December 31, 2019 will be sufficient to execute this plan. Our liquidity is highly dependent on prices we receive for the sale of oil, gas, and NGLs we produce. Prices we receive are determined by prevailing market conditions and greatly influence our revenue, cash flow, profitability, ability to comply with financial and other covenants in our credit facilities, access to capital and future rate of growth. We expect that in the future, our commodity derivative positions will help us stabilize a portion of our expected cash flows from operations despite potential declines in the price of oil and natural gas. However, in a portion of our current positions, our hedging activity may also reduce our ability to benefit from increases in oil and natural gas prices. We may realize losses to the extent our derivatives contract prices are lower than market prices and, conversely, we will realize gains to the extent our derivatives contract prices are higher than market prices. At times, we may choose to liquidate derivative positions before the contract ends in order realize the current value of our existing positions, to the extent permitted by our credit facilities. Please see Note 10 to our Consolidated Financial Statements included in Part II, Item 8. “Financial Statements and Supplementary Data” of this annual report for a summary of our outstanding derivative positions as of December 31, 2019. Similar to what we have experienced in previous periods of sustained low commodity prices, the prevailing market price for oil and gas services has also decreased, including the types of costs included in our lease operating expenses, drilling costs, completion costs and costs to equip our wells. Since the sharp decline in oil pricing in March 2020, we have renegotiated pricing with a number of our vendors and we have secured contractual arrangements with drilling and completion service providers at reduced costs relative to those in place during 2019 and the assumed cost structure used in our year-end reserve report. Additionally, we have changed our field operating procedures in response to the material drop in oil prices which further serves to reduce our cost structure relative to that assumed in the Company’s year-end reserve report. We are actively working to secure additional cost savings and if commodity prices remain low for a sustained period of time, we expect further reductions to our costs. If commodity prices remain depressed for an extended period of time or the capital/credit markets become constrained, the borrowing capacity under our Revolving Facility could be adversely affected. In the event of a reduction in the borrowing base under our Revolving Facility, we may be required to prepay some or all of our indebtedness prior to maturity, which would adversely affect our capital expenditure program. The amount, timing and allocation of these and other future expenditures is largely discretionary. As a result, the amount of funds devoted to any particular activity may increase or decrease significantly, depending on available opportunities, timing of projects and market conditions. Cash Flows Our cash flows for the years ended December 31, 2019 and 2018 are as follows: Cash flows provided by operating activities. Cash provided by operating activities for the year ended December 31, 2019 was $111.2 million, an increase of $67.4 million compared to the prior year ($43.8 million). This increase was primarily due to higher revenues resulting from an increase in production volumes, partially offset by lower pricing. Including the impact of derivative settlements, our realized price per Boe decreased 5% to $44.39 per Boe as compared to $46.84 per Boe. During 2019, we had cash settlements from our derivative contracts of $11.3 million, of which $3.6 million was generated from unwound derivative contracts. Despite our 38% increase in production volumes, we have been able to realize lower LOE and workover and G&A costs on a per Boe basis due to economies of scale and internal cost saving initiatives, which increased our operating margin in 2019. Due to payment timing, our cash flows from operations for the year ended December 31, 2019 included three quarterly interest payments on our Term Loan, whereas, the year ended December 31, 2018 included four quarterly interest payments, which resulted in higher cash flows in 2019 of $6.5 million. During 2018, we paid federal withholding taxes of $2.3 million related to a U.S. tax restructuring for our subsidiaries. Cash flows used in investing activities. Cash used in investing activities for the year ended December 31, 2019 decreased to $150.0 million as compared to $386.8 million in prior year. In 2019 net cash flows used in investing activities was primarily for development of proved properties ($166.7 million), partially offset by the sale of our Dimmit County, Texas, oil and gas assets in October 2019 ($17.3 million). We expect to receive the additional proceeds from the sale of $4.2 million in 2020. Net cash used in investing activities in 2018 included $215.8 million for the Company’s Eagle Ford acquisition and $169.0 million for development of our oil and gas properties. See Capital Expenditures below for additional information regarding our investment in oil and gas properties. Cash flows provided by financing activities. Cash provided by financing activities for the year ended December 31, 2019 decreased to $49.6 million as compared to $338.8 million for the year ended December 31, 2018. During 2019, we borrowed $50.0 million on our Revolving Facility to fund a portion of our 2019 drilling program. In 2018, we raised $250.1 million (net of fees and including the impact of our foreign currency derivatives) in connection with the Eagle Ford acquisition, plus proceeds from borrowings of $315 million as a result of entering into our Term Loan and Revolving Facility. This was partially offset by the repayment of our previous credit facility of $192 million, the repayment of a production advance from our then oil purchaser, of $18.2 million and borrowing costs of $16.0 million. Capital Expenditures The following table summarizes our capital expenditures incurred (excluding acquisitions and changes related to its asset retirement obligation) for the years ending December 31, 2019 and 2018. (1) Capital expenditures for unproved properties includes costs incurred at our Dimmit County properties, which were held for sale and disposed of in October 2019, of nil and $1.0 million during the years ended December 31, 2019 and 2018, respectively. Capital expenditures for proved properties includes costs incurred at the Dimmit County properties of $8.4 million and $5.3 million as of December 31, 2019 and 2018, respectively. We began drilling two wells in late 2018 in Dimmit County to extend the acreage lease term. Our capital expenditures for proved properties for the year ended December 31, 2019 decreased 17% to $149.8 million, as compared to $181.5 million in the prior year. Our drilling and completion costs totaled $125.0 million, which included costs to add 22.3 net producing wells and there were 2.0 additional net operated wells waiting on completion and 0.3 non operated wells in the process of being drilled. In addition, we invested $13.6 million into shared facility projects during the year ended December 31, 2019. Credit Facilities We and our wholly owned subsidiary, SEI, are parties to the Term Loan, which is syndicated $250.0 million second lien term loan with Morgan Stanley Capital Administrators Inc., as administrative agent, and the Revolving Facility, which is a syndicated reserve-based revolver with Toronto Dominion (Texas) LLC, as administrative agent, which has a borrowing base of $210.0 million, an elected commitment of $190 million, and $115.0 million outstanding as of December 31, 2019. The Revolving Facility matures October 23, 2022, and the Term Loan matures on April 23, 2023. We refer to our Revolving Facility and Term Loan collectively as our “credit facilities”. Interest on the Revolving Facility accrues at LIBOR plus a margin that ranges from 2.25% to 3.25% based upon the amount drawn. Interest on the Term Loan accrues at LIBOR (with a LIBOR floor of 1.0%) plus 8.0%. Under the Revolving Facility, we are required to maintain the following financial ratios: · a minimum Current Ratio, consisting of consolidated current assets (as defined in the Revolving Facility) including undrawn borrowing capacity to consolidated current liabilities (as defined in the Revolving Facility), of not less than 1.0 to 1.0 as of the last day of any fiscal quarter; · a maximum Leverage Ratio, consisting of consolidated Total Debt to adjusted consolidated EBITDAX (as defined in the Revolving Facility), of not greater than 3.5 to 1.0 as of the last day of any fiscal quarter; and · a minimum Interest Coverage Ratio, consisting of EBITDAX to Consolidated Interest Expense (as defined in the Revolving Facility), of not less than 1.5 to 1.0 as of the last day of any fiscal quarter (for such time as there a similar covenant under ours or SEI’s subordinated indebtedness). Under the Term Loan, we are required to maintain the following financial ratios: · a minimum Interest Coverage Ratio, consisting of EBITDAX to Consolidated Interest Expense (as defined in the Term Loan), of not less than 1.5 to 1.0 as of the last day of any fiscal quarter (for such time as there a similar covenant under ours or SEI’s subordinated indebtedness); and · an Asset Coverage Ratio, consisting of Total Proved PV9% to Total Debt (as defined in the Term Loan agreement), of not less than 1.50 to 1.0. The Revolving Facility agreement requires us to hedge at least 50% of reasonably projected oil and gas production from the Proved Reserves classified as “Developed Producing Reserves” for a rolling 36 month period, but not more than 85% of reasonably projected production from the Proved Reserves for a rolling 24 months and not more than 75% of the reasonably projected production from the Proved reserves for months 25-60. EBITDAX, as defined in the Term Loan and the Revolving Facility, is calculated as consolidated net income (loss) less the impact of interest, income taxes, depreciation, depletion, amortization, exploration expenses and other non-cash charges and income (including stock-based compensation, and unrealized gains and loss on derivative instruments). In addition, our Credit Agreements contain various covenants that limit our ability to take certain actions, including, but not limited to, the following: · incur indebtedness or grant liens on any of our assets; · enter into certain commodity hedging agreements; · sell, transfer, assign or convey assets, including a sale of all or substantially all of our assets, or engage in certain mergers or acquisitions; · make certain distributions (including payments of dividends); · make certain loans, advances and investments; and · engage in transactions with affiliates. If an event of default exists under either the Revolving Facility or the Term Loan, the administrative agents will be able to terminate the commitments under the credit facilities and accelerate the maturity of all loans made pursuant to our credit facilities and exercise other rights and remedies. Events of default include, but are not limited to, the following events: · failure to pay any principal when due under the Revolving Facility or Term Loan; · failure to pay any other obligation when due and payable within three business days after same becomes due · failure to observe or perform any covenant, condition or agreement in the Revolving Facility or Term Loan or other loan documents, subject, in certain instances, to certain cure periods; · failure of any representation and warranty made in connection with the loan documents to be true and correct in all material respects; · bankruptcy or insolvency events involving us or our subsidiaries; · cross-default to other indebtedness in excess of $5 million; · certain ERISA events involving us or our subsidiaries; · a violation of the terms of the Intercreditor Agreement; and · a change of control (as defined in our credit facilities). We and SEI and their respective subsidiaries have also executed and delivered certain other related agreements and documents pursuant to the credit facilities, including a guarantee and collateral agreement and mortgages for both the Revolving Facility and the Term Loan. Our obligations as well as those of SEI and SEI’s respective subsidiaries under the Revolving Facility are secured by a first priority security interest in favor of the lenders, in our, SEI’s and SEI’s respective subsidiaries’ tangible and intangible assets, and proved reserves, among other things. Our obligations as well as those of SEI and SEI’s respective subsidiaries under the Term Loan are secured by a second priority security interest in favor of the lenders, in our, SEI’s and SEI’s respective subsidiaries’ tangible and intangible assets, and proved reserves, among other things. A breach of any covenant, including the Asset Coverage Ratio, in our credit agreements will result in default under both our Term Loan and cross default on our Revolving Credit Facility, after any applicable grace period. A default, if not waived, could result in acceleration of the amounts outstanding under the credit facilities. In the event that some or all of the amounts outstanding under our credit facilities are accelerated and become immediately due and payable, we may not have the funds to repay, or the ability to refinance, such outstanding amounts and our lenders could foreclose upon our assets. If we are unable to remain in compliance with our financial and non-financial covenants, we intend to seek a waiver or covenant relief. However, no assurances can be given that we will be able to obtain such relief. As of December 31, 2019, we were in compliance with all the covenants in our Revolving Facility and Term Loan. As described above, we are required to maintain an Asset Coverage Ratio of not less than 1.5 to 1.0, which is calculated as the value of our Total Proved Reserves (PV 9%) using Nymex pricing and giving consideration to the value of our commodity derivative instruments, to Total Debt. The value of our oil and gas reserves, (including “Total Proved Reserves” as described in the Term Loan agreement) is highly sensitive to future commodity prices, and as a result of the decline in prices since year-end, there is uncertainty regarding our ability to maintain the covenant through the 12 months following the date of this report. We regularly enter into commodity derivative contracts to protect the cash flows associated with our proved developed producing wells and to provide supplemental liquidity to mitigate decreases in revenue due to reductions in commodity prices. As described above, we believe, based on historical experience, that the prevailing market price for oil and gas services also decreases during periods of sustained low commodity prices, and we have secured numerous cost reductions to date in 2020. Despite the risks and uncertainties described above, we believe we have or likely will be able to implement plans to substantially mitigate any potential breach of covenant related to this pricing downturn. However, since we cannot guarantee our ability to maintain compliance with the Asset Coverage Ratio and other covenants and cannot guarantee that we will be able to obtain waivers if a covenant is breached, it raises uncertainty about our ability to continue as a going concern. As described above, the Revolving Facility and Term Loan each contain reporting covenants that require delivery of audited consolidated financial statements and related reports and certificates on or before certain deadlines, provided for in each of the Revolving Facility and Term Loan Facility. Additionally, our financial statements must be delivered without a going concern or like qualification or exception. Failure to comply with these covenants would constitute a default under both the Revolving Facility and Term Loan. The report of the Company’s independent registered public accounting firm that accompanies our audited consolidated financial statements in this annual report contains an explanatory paragraph regarding the substantial doubt about the Company’s ability to continue as a going concern. To address this, and any potential default arising from a failure to deliver consolidated audited financial statements and related reports and certificates by the applicable deadlines, we have entered into waivers with our lenders under the Revolving Facility and Term Loan. These waivers were effective as of April 29, 2020, subject to the conditions set forth in the waivers, which included delivery of our audited consolidated financial statements for the fiscal year ended December 31, 2019 and related reports and certificates, and payment of the fees and expenses of the administrative agent incurred in connection with such waivers In consideration for the waiver under our Revolving Facility, we agreed to certain limitations on our ability to effect draws under the Revolving Facility until such time as the May 2020 borrowing base redetermination has been completed. In addition, in consideration for the waiver with respect to the Term Loan, we agreed to amend certain covenants in the Term Loan, as to be mutually agreed with the Term Loan lenders within 15 days. The waiver under our Revolving Facility also provides for a right to require corresponding amendments of that facility manner, as requested by the administrative agent in its discretion. Failure to enter into such amendment with respect to our Term Loan within 15 days (or a similar amendment with respect to our Revolving Facility on the date the Term Loan is amended) would constitute an event of default under our credit facilities, in which case the amounts outstanding under our credit facilities could be accelerated and become immediately due and payable. While we believe that we will finalize such amendments within the required time frame, there can be no assurance that our efforts will result in any finalizing these amendments or the ultimate terms of any such amendments. With respect to the Term Loan, we have engaged in preliminary discussions regarding the terms of the required amendment. In addition, we and have agreed to explore in good faith with our Term Loan Lenders options to reduce our overall level of indebtedness and leverage and limit capital and general and administrative expenditures for some specified period of time. As described above, the lenders under our Revolving Facility may request corresponding amendments under the Revolving Facility. 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 statements, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. 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. The preparation of the consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in our financial statements. Actual results could differ from our estimates and assumptions, and these differences could result in material changes to our financial statements. The following discussion presents information about our most critical accounting policies and estimates. Our significant accounting policies are further described in Note 1 to our audited consolidated financial statements included in “Item 8. Financial Statements and Supplemental Data” of this annual report. Estimates of Oil and Gas Reserve Quantities. The estimated quantities of oil, natural gas and NGL reserves are integral to the calculation of DD&A and to assessments of possible impairment of assets. Proved oil and gas reserves are those quantities of oil and gas which, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be economically producible-from a given date forward, from known reservoirs and under existing economic conditions, operating methods, and government regulations. These estimates require significant judgements to be made regarding future development and production costs, development plans and fiscal regimes. The estimates of reserves may change from period to period as the economic assumptions used to estimate the reserves can change from period to period and as additional geological data is generated during the course of operations. Ryder Scott prepared 100% of our proved reserve estimates as of December 31, 2019 and 2018. In connection with Ryder Scott performing their independent reserve estimations, we furnish them with the following information that they review: (i) technical support data, (ii) technical analysis of geologic and engineering support information, (iii) economic and production data and (iv) our well ownership interests and (v) expected future development plans. Depreciation, Depletion and Amortization. The quantities of estimated proved oil and gas reserves are a significant component of our calculation of DD&A expense, and revisions in such estimates may alter the rate of future expense. Holding all other factors constant, if reserve quantities were revised upward or downward, net income would increase or decrease, respectively. DD&A of the cost of proved oil and gas properties is calculated using the unit-of-production method. The reserve base used to calculate depreciation, depletion and amortization for proved leasehold acquisition costs is the sum of proved developed reserves and proved undeveloped reserves. With respect to lease and well equipment costs, which include development costs and successful exploration drilling costs, the reserve base includes only proved developed reserves. We have one unit-of-production field, the Eagle Ford formation. This method considers the geographic concentration, operating similarities within the area, geologic considerations and common cost environments in this area. Proved Property Impairment. We assess our proved oil and gas properties for impairment whenever events or circumstances indicate that the carrying value of the assets may not be recoverable. We estimate the expected future cash flows of our oil and gas properties and compare these undiscounted cash flows to the carrying value of the oil and gas properties to determine if the carrying value is recoverable. We may apply an additional risk-adjustment factor to the undiscounted cash flows from proved undeveloped reserves. If the carrying value exceeds the estimated undiscounted future cash flows, we will write down the carrying amount of the oil and gas properties to fair value. The factors used to determine fair value include, but are not limited to, estimates of reserves, future commodity prices, future production estimates, estimated future capital expenditures, estimated future operating costs, and discount rates commensurate with the risk associated with realizing the projected cash flows. Our impairment analysis requires us to apply judgment in identifying impairment indicators and estimating future cash flows of our oil and gas properties. If actual results are not consistent with our assumptions and estimates or our assumptions and estimates change due to new information, we may incur impairment expense. As a result of lower commodity prices and their impact on our estimated future cash flows, we have continued to review our proved oil and gas properties for impairment. At December 31, 2019, using SEC defined pricing as described in Note 16, our expected undiscounted future cash flows exceeded the carrying value of our proved oil and gas properties by approximately $801 million, or 112%. As of December 31, 2019, our reserve estimate, updated with management’s future pricing assumptions as of that date, was higher than the SEC reserve value. Unproved Property Impairment. Unproved properties consist of costs incurred to acquire undeveloped leases as well as purchases of unproved reserves. Undeveloped lease costs and unproved reserve acquisitions are initially capitalized, and when successful wells are drilled on undeveloped leaseholds, unproved property costs are reclassified to proved properties and depleted on a unit-of-production basis. We evaluate significant unproved properties for impairment based on remaining lease term, drilling results, reservoir performance, or future plans to develop acreage. Derivative Financial Instruments. We use derivative financial instruments to mitigate our exposure to changes in commodity prices arising in the normal course of business. We primarily utilize commodity price swap, option and costless collar contracts. We do not trade in derivative financial instruments for speculative purposes. None of our derivative contracts have been designated as cash flow hedges for accounting purposes, and as a result, all of our derivative contracts are recorded in the consolidated financial statements at fair value, with changes in derivative fair value being recognized currently in earnings. We determine the recorded amounts of our derivative instruments measured at fair value utilizing third-party valuation specialists, who utilize industry-standard models that consider various assumptions, including quoted forward prices for commodities, time to maturity, volatility and credit risk. We review these valuations, including the related model inputs and assumptions, and analyze changes in fair value measurements between periods. We corroborate such inputs, calculations and fair value changes using various methodologies, and review unobservable inputs for reasonableness utilizing relevant information from other published sources. We also utilize counterparty valuations to assess the reasonableness of our valuations. The values we report in our financial statements change as the assumptions used in these valuations are revised to reflect changes in market conditions (particularly those for oil and natural gas forward prices) or other factors, many of which are beyond our control. Income Taxes. We provide for deferred income taxes on the difference between the tax basis of an asset or liability and its carrying amount in our financial statements. This difference will result in taxable income or deductions in future years when the reported amount of the asset or liability is recovered or settled, respectively. Considerable judgment is required in predicting when these events may occur and whether recovery of an asset is more likely than not, including judgments and assumptions about future taxable income and future operating conditions (particularly as related to prevailing oil and natural gas prices). For the year ended December 31, 2019, we did not recognize tax assets of $64.9 million as the recovery was not determined to be more likely than not. Some or all of these deferred tax assets could be recognized in future periods against future taxable income. Additionally, our federal and state income tax returns are generally not filed before the consolidated financial statements are prepared. Therefore, we estimate the tax basis of our assets and liabilities at the end of each period as well as the effects of tax rate changes, tax credits, and net operating and capital loss carryforwards and carrybacks. Adjustments related to differences between the estimates we use and actual amounts we report are recorded in the periods in which we file our income tax returns. These adjustments and changes in our estimates of asset recovery and liability settlement could have an impact on our results of operations. Revisions to our estimated effective tax rate could increase or decrease our reported income tax expense or benefit. Our effective and statutory income tax rates could be impacted by the state income tax rates in which we operate, and the effective and statutory income tax rates are not significantly different as the amount of permanent differences resulting from treatment that differs for assets and liabilities for financial and tax reporting purposes is not significant. The tax impact of temporary differences, primarily oil and gas properties, is reflected in deferred income taxes. At December 31, 2019 and 2018, we had no unrecognized tax benefits that would impact our effective tax rate and we have not provided for interest or penalties related to uncertain tax positions. Asset Retirement Obligations. Asset retirement obligations (“ARO”) relate to future costs associated with the plugging and abandonment of oil and gas wells, removal of equipment and facilities from leased acreage and returning such land to its original condition in accordance with applicable local, state and federal laws as well as the terms of our lease agreements. The discounted fair value of a liability for an asset retirement obligation is recorded in the period in which it is incurred (typically when a well is spud or acquired) with the associated asset retirement cost capitalized as part of the carrying cost of the oil and gas asset. The liability is accreted each period through charges to DD&A expense, and the capitalized cost is depleted on a unit-of-production basis over the proved developed reserves of the related asset. Revisions may occur due to changes in estimated abandonment costs or well economic lives, and such revisions result in adjustments to the related capitalized asset and corresponding liability. Revenue Recognition. Our revenue is derived from the sale of produced oil, natural gas and NGLs. Revenue is recorded in the month the product is delivered to the purchaser, while payment is received up to 60 days after delivery. At the end of each month, we estimate the amount of production delivered to purchasers and the price we will receive. Variances between our estimated revenue and actual payment are recorded in the month the payment is received. Historically the differences have not been material. Transfer of control drives the statement of operations classification of transportation, gathering, processing, and marketing expenses (“fees and other deductions”) within the accompanying statements of operations. Fees and other deductions incurred prior to control transfer are recorded within gathering, processing and transportation expense line item on the accompanying statements of operations, while fees and other deductions incurred subsequent to control transfer are recorded as a reduction of revenue. Recently Issued Accounting Pronouncements. See Note 1 to our Consolidated Financial Statements included in Part II, Item 8. “Financial Statements and Supplementary Data” of this annual report for discussion of the recent accounting pronouncements.

<s>[INST] Overview and Executive Summary We are an onshore independent oil and natural gas company focused on the development, production and exploration of large, repeatable resource plays in North America. Our operations are located in the Eagle Ford formation in south Texas. Our strategy is to acquire and/or develop assets where we are operator and have high working interests, positioning us to efficiently control the pace and scope of our development and the allocation of our capital resources. We also believe that serving as operator allows us to control the drilling, completion, operations and marketing of sold volumes. In 2019, we continued to focus on developing highreturn assets from our portfolio while reducing our operating costs and per well drilling and completion costs. We took the following actions during 2019 in support of our corporate strategy: · On November 26, 2019, we successfully redomiciled to the U.S. from Australia, and our common stock began trading on the Nasdaq Global Market, under the ticker symbol “SNDE”. · We completed and had initial production from 22 net operated wells (two of which were subsequently sold during October 2019), which increased our average daily net production 38% from 2018 to 13,248 Boe/d. · In October 2019, we completed the divestiture of 19 gross producing wells located on approximately 6,100 net acres located in Dimmit County, Texas for proceeds of $21.5 million, including effective date to closing date adjustments, less transaction costs of $0.5 million. Sales volumes from these wells was approximately 1,153 Boe/d during the first nine months of 2019. The divesture provided additional liquidity to allow development of our higher return assets. · In January 2020, we amended our Revolving Facility to increase the overall facility from $250 million to $500 million, and to increase our borrowing base to $210 million (with initial elected borrowing commitments of $190 million). We are currently restricted in our ability to make draws until the finalization of our second quarter borrowing base redetermination. See Part II, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under “Credit Facilities” for additional information regarding our credit facilities. Business and Industry Outlook Market prices for crude oil, natural gas and NGLs are inherently volatile. In 2019, WTI oil prices averaged approximately $56.98 per Bbl versus $65.23 per Bbl in 2018. Despite price support in the first half of 2019 driven by supply tightness, geopolitical tensions, 2019 WTI oil prices overall were negatively impacted by trade concerns and economic slowdown fears. In March 2020, NYMEX WTI oil prices declined sharply to less than $20 per Bbl and in April 2020, for a short period of time were negative, primarily due to drastic price cutting and increased production by Saudi Arabia coupled with an expected demand reduction caused by the global COVID19 outbreak. The U.S. domestic natural gas market remains oversupplied as production has continued to grow due to drilling efficiencies, higher incremental volumes of associated gas from oil wells and debottlenecking of transportation infrastructure. Henry Hub gas prices averaged approximately $2.56 per MMBtu in 2019 versus $3.15 per MMBtu in 2018. Natural gas and NGL prices faced strong headwinds in 2019 due to U.S. supply growth far outpacing demand for both commodities domestically and internationally. These factors continue to weigh on natural gas and NGL prices. To mitigate our exposure to commodity price volatility and ensure our financial strength, we continue to execute a hedging program. We expect capital expenditures to be in the range of $40 $45 million for 2020. However, we intend to flexibly manage our operations, including capital expenditure levels, based on existing and expected market conditions to protect our balance sheet and retain liquidity. We expect to be able to fund our planned capital program for 2020 with cash flow generated from [/INST] Negative. </s>

Black Diamond Therapeutics, Inc.

2020-03-24

2019-12-31

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 Part II, Item 6. “Selected Financial Data” and our consolidated financial statements and related notes included elsewhere in this Annual Report. This discussion and analysis and other parts of this Annual Report contain forward-looking statements based upon current beliefs, plans and expectations that involve risks, uncertainties and assumptions, such as statements regarding our plans, objectives, expectations, intentions 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 Part I, Item 1A “Risk Factors” and elsewhere in this Annual Report. You should carefully read the “Risk Factors” section of this Annual Report to gain an understanding of the important factors that could cause actual results to differ materially from our forward-looking statements. Please also see the section entitled “Special Note Regarding Forward-Looking Statements.” Overview We are a precision oncology medicine company pioneering the discovery and development of small molecule, tumor-agnostic therapies. We target undrugged oncogenic driver mutations in patients with genetically-defined cancers. The foundation of our company is built upon a deep understanding of cancer genetics, protein structure and function, and medicinal chemistry. Our proprietary technology platform, which we refer to as our Mutation-Allostery-Pharmacology, or MAP, platform, is designed to allow us to analyze population-level genetic sequencing data to discover oncogenic mutations that promote cancer across tumor types. Our goal is to identify families of mutations that can be inhibited with a single small molecule therapy in a tumor-agnostic manner. We have designed our lead product candidate, BDTX-189, to potently and selectively inhibit a family of oncogenic proteins defined by mutations which occur outside the adenosine triphosphate, or ATP site, and which we refer to as non-canonical mutations. Non-canonical mutations occur across a range of tumor types that affect both the epidermal growth factor receptor, or EGFR, and the tyrosine-protein kinase ErbB-2, or HER2. We have designed BDTX-189 to bind to the active site of these mutant kinases and inhibit their function. BDTX-189 is also designed to spare normal, or wild type, EGFR, which we believe will improve upon the toxicity profiles of current ErbB kinase inhibitors. We submitted our IND for BDTX-189 in November 2019, which was allowed by the U.S. Food and Drug Administration, or FDA, on December 13, 2019. We have since begun enrollment and dosing of patients in the Phase 1 portion of our MasterKey-01 trial to pursue a tumor-agnostic development strategy. We are also leveraging our MAP platform to identify other families of non-canonical mutations in validated oncogenes beyond ErbB, which has the potential to expand the reach of targeted therapies. Since our inception in 2014, we have devoted substantially all of our efforts and financial resources to organizing and staffing our company, business planning, raising capital, acquiring, discovering product candidates and securing related intellectual property rights and conducting 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. We may never be able to develop or commercialize a marketable product. We have not yet successfully completed any pivotal clinical trials, obtained any regulatory approvals, manufactured a commercial-scale drug, or conducted sales and marketing activities. Through December 31, 2019, we had received net proceeds of $200.6 million from sales of our preferred stock and net cash proceeds of $1.8 million from borrowings under convertible promissory notes. We have incurred significant operating losses since inception. Our net losses were $35.3 million and $8.9 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $51.0 million. 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. We expect that our expenses and capital requirements will increase substantially in connection with our ongoing activities, particularly if and as we: •continue preclinical studies and initiate or advance clinical trials for BDTX-189, our glioblastoma program and other product candidates; •advance the development of our product candidate pipeline; •continue to develop and expand our proprietary MAP platform to identify additional product candidates; •obtain, maintain, expand and protect our intellectual property portfolio; •seek marketing approvals for our product candidates that successfully complete clinical trials, if any; •hire additional clinical, scientific and commercial personnel; •acquire or in-license additional product candidates; •expand our infrastructure and facilities to accommodate our growing employee base; and •add operational, financial and management information systems and personnel, including personnel to support our research and development programs, any future commercialization efforts and our transition to operating as a public company. 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 through the sale of equity, debt financings or other capital sources, which may include collaborations with other companies or other strategic transactions. 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 and cash equivalents of $154.7 million. We believe that the net proceeds from our IPO, together with our existing cash and cash equivalents, will enable us to fund our operating expenses and capital expenditure requirements into 2023. 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. If we are unable to raise additional capital in sufficient amounts or on terms acceptable to us, we may have to significantly delay, scale back or discontinue the development or commercialization of our product candidates or other research and development initiatives. Components of our results of operations Revenue To date, we have not generated any revenue from any sources, including from product sales, and we do not expect to generate any revenue from the sale of products in the foreseeable future. If our development efforts for our product candidates are successful and result in regulatory approval, or license agreements with third parties, we may generate revenue in the future from product sales. However, there can be no assurance as to when we will generate such revenue, if at all. Operating expenses Research and development expenses (inclusive of amounts with a related party) 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. We expense research and development costs as incurred, which include: •expenses incurred under our services agreement with Ridgeline Therapeutics GmbH, or Ridgeline; •expenses incurred to conduct the necessary preclinical studies and clinical trials required to obtain regulatory approval; •expenses incurred under agreements with contract research organizations, or CROs, that are primarily engaged in the oversight and conduct of our drug discovery efforts and preclinical studies, clinical trials and contract manufacturing organizations, or CMOs, that are primarily engaged to provide preclinical and clinical drug substance and product for our research and development programs; •other costs related to acquiring and manufacturing materials in connection with our drug discovery efforts and preclinical studies and clinical trial materials, including manufacturing validation batches, as well as investigative sites and consultants that conduct our clinical trials, preclinical studies and other scientific development services; •payments made in cash or equity securities under third-party licensing, acquisition and option agreements; •employee-related expenses, including salaries and 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-related 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. 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. Any nonrefundable 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. Such amounts are expensed as the related 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. We do not track our research and development expenses on a program-by-program basis. Our direct external research and development expenses consist primarily of external costs, such as fees paid to outside consultants, CROs, CMOs and research laboratories in connection with our preclinical development, process development, manufacturing and clinical development activities. Our direct research and development expenses also include fees incurred under license, acquisition and option agreements. We do not allocate employee costs, costs associated with our discovery efforts, laboratory supplies, and facilities, 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 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. 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 as we commence our planned clinical trials for BDTX-189, as well as conduct other preclinical and clinical development, including submitting regulatory filings for our other product candidates. Historically, many of our research and development activities have been conducted pursuant to our services agreement with Ridgeline, a related party, and we are transitioning many of these activities internally as we increase our internal capacity. While the service fee we have historically paid under our Ridgeline Services Agreement will be reduced significantly as a result of that transition, we expect that we will incur increased personnel and overhead costs associated with moving those functions in-house, which we expect will offset that reduction in Ridgeline services fees. In addition, we expect our discovery research efforts and our related personnel costs will increase and, as a result, we expect our research and development expenses, including costs associated with stock-based compensation, will increase above historical levels. In addition, we may incur additional expenses related to milestone and royalty payments payable to third parties with whom we may enter into license, acquisition and option agreements to acquire the rights to future product candidates. 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. The successful development and commercialization of our product candidates is highly uncertain. This uncertainty is due to the numerous risks and uncertainties associated with product development and commercialization, including the uncertainty of the following: •the scope, progress, outcome and costs of our preclinical development activities, clinical trials and other research and development activities; •establishing an appropriate safety and efficacy profile with IND enabling studies; •successful patient enrollment in and the initiation and completion of clinical trials; •the timing, receipt and terms of any marketing approvals from applicable regulatory authorities including the FDA and non-U.S. regulators; •the extent of any required post-marketing approval commitments to applicable regulatory authorities; •establishing clinical and commercial manufacturing capabilities or making arrangements with third-party manufacturers in order to ensure that we or our third-party manufacturers are able to make product successfully; •development and timely delivery of clinical-grade and 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; and •maintaining a continued acceptable safety profile of our product candidates following approval, if any, of our product candidates. 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. General and administrative expenses (inclusive of amounts with a related party) General and administrative expenses consist primarily of salaries and benefits, travel and stock-based compensation expense for personnel in executive, business development, finance, human resources, legal, information technology, pre-commercial and support personnel functions. General and administrative expenses also include direct and allocated facility-related costs as well as insurance costs and 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 to support our continued research activities and development of our product candidates and prepare for potential commercialization activities. We also anticipate that we will incur significantly 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. 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. Other income (expense) Interest income Interest income consists of income earned on our cash balance. Our interest income has not been significant due to low balances and low interest earned on those balances. Change in fair value of derivative liabilities Our issuance of Series A and Series B preferred stock provided investors the right to participate in subsequent offerings of Series A and Series B preferred stock, respectively, in the event specified developmental and regulatory milestones were achieved (see Note 6 to our consolidated financial statements). We classified the tranche rights as derivative liabilities on our consolidated balance sheets. We remeasured the derivative liabilities associated with tranche rights to fair value at each reporting date, and recognized changes in the fair value of the derivative liabilities in the consolidated statements of operations. Upon the closing of our IPO on February 3, 2020, the preferred stock warrants became exercisable for common stock instead of preferred stock, and the fair value of the warrant liability at that time was reclassified to additional paid-in capital. As a result, we will no longer remeasure the fair value of the warrant liability at each reporting date. Other income (expense) Other income (expense) consists primarily of realized and unrealized foreign currency transaction gains and losses. 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 (inclusive of amounts with a related party) Research and development expenses were $21.8 million for the year ended December 31, 2019, compared to $7.0 million for the year ended December 31, 2018. The increase of $14.8 million was primarily due to an increase in headcount and external fees related to the continued development of our MAP platform and our product candidates, including BDTX-189. We do not currently track expenses on a program-by-program basis. General and administrative (inclusive of amounts with a related party) General and administrative expenses were $7.6 million for the year ended December 31, 2019, compared to $2.0 million for the year ended December 31, 2018. The increase of $5.6 million was primarily a result of higher personnel-related costs due to additional headcount and higher legal and other professional fees. Interest income Interest income was $0.5 million for the year ended December 31, 2019, compared to less than $0.1 million for the year ended December 31, 2018. Change in fair value of derivative liabilities The change in the fair value of derivative liabilities was $6.4 million for the year ended December 31, 2019, compared to less than $0.1 million for the year ended December 31, 2018. The increase was due to the remeasurement of derivative liabilities related to the tranche right on our Series B preferred stock primarily due to an increase in the probability of a liquidity event during the year ended December 31, 2019. Other income (expense) Other income (expense) was less than $0.1 million for the years ended December 31, 2019 and 2018. Liquidity and capital resources Sources of liquidity Since our inception, we have not generated any revenue from any product sales or any other sources, 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. We have funded our operations to date primarily with proceeds from the sale of preferred stock and borrowings under convertible promissory notes. On February 3, 2020, we completed an IPO of 12,174,263 shares of our common stock, including the exercise in full by the underwriters of their option to purchase up to 1,587,947 additional shares of common stock, for aggregate gross proceeds of $231.3 million. The Company received $212.4 million in net proceeds after deducting underwriting discounts and commissions and other estimated offering expenses payable by the Company. Through December 31, 2019, we had received net cash proceeds of $200.6 million from sales of our preferred stock and net cash proceeds of $1.8 million from borrowings under convertible promissory notes and as of December 31, 2019, we had cash and cash equivalents of $154.7 million. Cash flows The following table summarizes our sources and uses of cash for each of the periods presented (in thousands): Operating activities During the year ended December 31, 2019, we used cash in operating activities of $24.7 million, primarily resulting from our net loss of $35.3 million, partially offset by the non-cash charge related to the change in fair value of derivative liabilities of $6.4 million, an increase in prepaid expenses and other current assets primarily due to payments for research services and a decrease in amounts due to related parties due to payments made to Ridgeline. During the year ended December 31, 2018, we used cash in operating activities of $8.5 million, primarily resulting from our net loss of $8.9 million, partially offset by an increase in accrued expenses. Changes in accounts payable and accrued expenses in all periods were generally due to growth in our business, the advancement of our product candidates, and the timing of vendor invoicing and payments. Investing activities During the year ended December 31, 2019, we used cash in investing activities of less than $0.1 million, consisting solely of purchases of equipment. During the year ended December 31, 2018, we used cash in investing activities of $0.1 million, consisting solely of purchases of equipment. Financing activities During the year ended December 31, 2019, we had cash provided by financing activities of $127.8 million, consisting primarily of proceeds from the issuance of convertible preferred stock. During the year ended December 31, 2018, we had cash provided by financing activities of $52.3 million, consisting primarily of proceeds from the issuance of convertible preferred stock. 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 incur additional costs associated with operating as a public company, including significant legal, accounting, investor relations and other expenses. The timing and amount of our operating expenditures will depend largely on our ability to: •advance BDTX-189 through the clinic; •advance preclinical development of our early-stage programs, including in GBM; •manufacture, or have manufactured on our behalf, our preclinical and clinical drug material and develop processes for late state and commercial manufacturing; •seek regulatory approvals for any product candidates that successfully complete clinical trials; •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; •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; and •obtain, maintain, expand and protect our intellectual property portfolio. As of December 31, 2019, we had cash and cash equivalents of $154.7 million. We believe that our existing cash and cash equivalents, including net proceeds from our IPO, will enable us to fund our operating expenses and capital expenditure requirements into 2023. 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. We anticipate that we will require additional capital as we seek regulatory approval of our product candidates and if we choose to pursue in-licenses or acquisitions of other product candidates. If we receive regulatory approval for BDTX-189 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. Because of the 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. Our future funding requirements will depend on and could increase significantly as a result of many factors, including: •the scope, progress, results and costs of researching and developing our product candidates, and conducting preclinical and clinical trials; •the costs, timing and outcome of regulatory review of our product candidates; •the costs, timing and ability to manufacture our product candidates to supply our clinical and preclinical development efforts and our clinical trials; •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 product and necessary inventory to support commercial launch; •the ability to receive additional non-dilutive funding; •the revenue, if any, received from commercial sale of our products, should any of our product candidates receive marketing approval; •the costs of preparing, filing and prosecuting patent applications, obtaining, maintaining, expanding 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; and •the extent to which we acquire or in-license other product candidates and technologies. Until such time, if ever, as we can generate substantial product revenue, we expect to finance our operations through a combination of public or private equity offerings, debt financings, collaborations, strategic partnerships and alliances or marketing, distribution or licensing arrangements with third parties. To the extent that we raise additional capital through the sale of equity or convertible debt securities, your ownership interest may be materially diluted, and the terms of such securities could include liquidation or other preferences that adversely affect your rights as a common stockholder. Debt financing and preferred equity financing, if available, may involve agreements that include restrictive covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. In addition, debt financing would result in fixed payment obligations. If we raise additional funds through collaborations, strategic partnerships and 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. 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 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 have, any off-balance sheet arrangements, as defined under applicable SEC rules. Critical accounting policies and significant judgments and use of 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 and judgments that affect the reported amounts of assets, liabilities, costs and expenses. 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 (including amounts due to related party) 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, including research laboratories, in connection with preclinical development activities; •CROs and investigative sites in connection with preclinical studies and clinical trials; and •CMOs in connection with drug substance and drug product formulation of preclinical studies 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 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 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 options and other stock-based awards granted to employees and directors based on their 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 and restricted share awards with service-based vesting conditions and record the expense for these awards using the straight-line method. We would apply the graded-vesting method to all stock-based awards with performance-based vesting conditions or to awards with both service-based and performance-based vesting conditions. The Company accounts for stock-based awards granted to employees and non-employees at fair value, which is measured using the Black-Scholes option-pricing model. The measurement date for employee awards is generally the date of grant. Prior to the adoption of Accounting Standards Update (“ASU”) No. 2018-07, Compensation - Stock Compensation (Topic 718)("ASU 2018-07"), which simplifies the accounting for non-employee share based payment transactions and is discussed in Note 2 to our consolidated financial statements appearing elsewhere in this Annual Report, the fair value measurement date for non-employee awards was the date the performance of services was completed. Stock-based compensation costs are recognized as expenses over the requisite service period, which is generally the vesting period, on a straight-line basis for all time-vested awards. We estimate the fair value of each stock option grant using the Black-Scholes option-pricing model, which 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 stock options, the risk-free interest rate for a period that approximates the expected term of our stock options and our expected dividend yield. Valuation of derivative liabilities Tranche rights Our issuance of Series A and Series B preferred stock (see Note 6 to our consolidated financial statements) provided investors the right to participate in subsequent offerings of Series A and Series B preferred stock, respectively, in the event specified developmental and regulatory milestones were or are achieved. We classify the tranche rights as derivative liabilities on our consolidated balance sheets as we determined that the tranche rights met the definition of a freestanding financial instrument since they are legally detachable. We also determined that such instruments represent forward sale contracts on redeemable shares and, accordingly, the instrument should be accounted for as a liability separate from the convertible preferred stock. We remeasure the derivative liabilities associated with tranche rights to fair value at each reporting date, and recognize changes in the fair value of the derivative liabilities in our consolidated statements of operations. The fair value of the derivative liabilities was determined using a back solve approach based on the price paid for the underlying preferred stock and the derivative liability. The derivative liabilities were valued as forward contracts which considered inputs including, but not limited to, the probability of attaining milestones, market-based assumptions for expected term and the risk free rate. Changes to these assumptions could have a significant impact on the fair value of the derivative liabilities. 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 elsewhere in this Annual Report. Internal control over financial reporting In preparation of our financial statements to meet the requirements of our IPO, we determined that material weaknesses in our internal control over financial reporting existed during fiscal 2017 and remain unremediated as of December 31, 2019. See Item 9A of this Annual Report. Emerging growth company and smaller reporting 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 to not “opt out” of this provision and, as a result, we will adopt new or revised accounting standards at the time private companies adopt the new or revised accounting 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. We are also a “smaller reporting company” meaning that the market value of our stock held by non-affiliates is less than $700 million and our annual revenue was less than $100 million during the most recently completed fiscal year. We may continue to be a smaller reporting company if either (i) the market value of our stock held by non-affiliates is less than $250 million or (ii) our annual revenue was less than $100 million during the most recently completed fiscal year and the market value of our stock held by non-affiliates is less than $700 million. If we are a smaller reporting company at the time we cease to be an emerging growth company, we may continue to rely on exemptions from certain disclosure requirements that are available to smaller reporting companies. Specifically, as a smaller reporting company we may choose to present only the two most recent fiscal years of audited financial statements in our Annual Report and, similar to emerging growth companies, smaller reporting companies have reduced disclosure obligations regarding executive compensation.

<s>[INST] Overview We are a precision oncology medicine company pioneering the discovery and development of small molecule, tumoragnostic therapies. We target undrugged oncogenic driver mutations in patients with geneticallydefined cancers. The foundation of our company is built upon a deep understanding of cancer genetics, protein structure and function, and medicinal chemistry. Our proprietary technology platform, which we refer to as our MutationAllosteryPharmacology, or MAP, platform, is designed to allow us to analyze populationlevel genetic sequencing data to discover oncogenic mutations that promote cancer across tumor types. Our goal is to identify families of mutations that can be inhibited with a single small molecule therapy in a tumoragnostic manner. We have designed our lead product candidate, BDTX189, to potently and selectively inhibit a family of oncogenic proteins defined by mutations which occur outside the adenosine triphosphate, or ATP site, and which we refer to as noncanonical mutations. Noncanonical mutations occur across a range of tumor types that affect both the epidermal growth factor receptor, or EGFR, and the tyrosineprotein kinase ErbB2, or HER2. We have designed BDTX189 to bind to the active site of these mutant kinases and inhibit their function. BDTX189 is also designed to spare normal, or wild type, EGFR, which we believe will improve upon the toxicity profiles of current ErbB kinase inhibitors. We submitted our IND for BDTX189 in November 2019, which was allowed by the U.S. Food and Drug Administration, or FDA, on December 13, 2019. We have since begun enrollment and dosing of patients in the Phase 1 portion of our MasterKey01 trial to pursue a tumoragnostic development strategy. We are also leveraging our MAP platform to identify other families of noncanonical mutations in validated oncogenes beyond ErbB, which has the potential to expand the reach of targeted therapies. Since our inception in 2014, we have devoted substantially all of our efforts and financial resources to organizing and staffing our company, business planning, raising capital, acquiring, discovering product candidates and securing related intellectual property rights and conducting 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. We may never be able to develop or commercialize a marketable product. We have not yet successfully completed any pivotal clinical trials, obtained any regulatory approvals, manufactured a commercialscale drug, or conducted sales and marketing activities. Through December 31, 2019, we had received net proceeds of $200.6 million from sales of our preferred stock and net cash proceeds of $1.8 million from borrowings under convertible promissory notes. We have incurred significant operating losses since inception. Our net losses were $35.3 million and $8.9 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $51.0 million. 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. We expect that our expenses and capital requirements will increase substantially in connection with our ongoing activities, particularly if and as we: continue preclinical studies and initiate or advance clinical trials for BDTX189, our glioblastoma program and other product candidates; advance the development of our product candidate pipeline; continue to develop and expand our proprietary MAP platform to identify additional product candidates; obtain, maintain, expand and protect our intellectual property portfolio; seek marketing approvals for our product candidates that successfully complete clinical trials, if any; hire additional clinical, scientific and commercial personnel; acquire or inlicense additional product candidates; expand our infrastructure and facilities to accommodate our growing employee base; and add operational, financial and management information systems and personnel, including personnel to support our research and development programs, any future commercialization efforts and our transition to operating [/INST] Positive. </s>

Akero Therapeutics, 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 our financial statements and accompanying footnotes appearing 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. See “Special Note Regarding Forward-Looking Statements.” Because of many factors, including those factors set forth in Part 1, Item 1A, “Risk Factors” in 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. We do not assume any obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. Overview We are a cardio-metabolic nonalcoholic steatohepatitis, or NASH, company dedicated to developing pioneering medicines that restore metabolic balance and improve overall health for NASH patients. NASH is a severe form of nonalcoholic fatty liver disease, or NAFLD, characterized by inflammation and fibrosis in the liver that can progress to cirrhosis, liver failure, cancer and death. Our lead product candidate, AKR-001, is an analog of fibroblast growth factor 21, or FGF21, which is an endogenously expressed hormone that regulates metabolism of lipids, carbohydrates and proteins throughout the body. FGF21 also plays a critical role in protecting many types of cells from various forms of stress. In previous clinical trials in patients with type 2 diabetes, or T2D, administration of AKR-001 was associated with substantial improvements in lipid metabolism and insulin sensitivity. We believe these data, coupled with clinical results from other FGF21 analogs, demonstrate AKR-001's potential to serve as a cornerstone for the treatment of NASH. We are currently conducting a Phase 2a clinical trial, the BALANCED study, which is evaluating AKR-001 in the treatment of NASH patients. We expect to complete collection of data for the BALANCED main study week 12 primary endpoint, and report top-line results related to reductions in liver fat, in the first quarter of 2020. Top-line results related to secondary endpoints, including safety and tolerability as well as paired biopsies, will be reported in the second quarter of 2020. We also plan to expand the BALANCED study to include an additional cohort of subjects with NASH who have compensated cirrhosis (F4), Child-Pugh Class A, with study initiation expected in the second quarter of 2020. We were incorporated in January 2017 and have devoted substantially all of our efforts to organizing and staffing our company, business planning, raising capital, in-licensing rights to AKR-001, research and development activities for AKR-001, building our intellectual property portfolio and providing general and administrative support for these operations. To date, we have principally raised capital through the issuance of convertible preferred stock and the initial public offering of our common stock. We have incurred significant operating losses since inception. Our ability to generate product revenue sufficient to achieve profitability will depend heavily on the successful development and eventual commercialization of AKR-001 and any future product candidates. Our net losses were $43.8 million and $81.7 million for the years ended December 31, 2019 and 2018, respectively. The net loss for the year ended December 31, 2018 included non-cash charges of $62.2 million related to the change in fair value of our preferred stock tranche obligation and $5.8 million related to the change in fair value of our anti-dilution right liability. As of December 31, 2019, we had an accumulated deficit of $130.3 million. We expect to continue to incur significant expenses for at least the next several years as we advance AKR-001 through later-stage clinical development, develop additional product candidates and seek regulatory approval of any product candidates that complete clinical development. In addition, if we obtain marketing approval for any 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, which may include collaborations with other companies or other strategic transactions. 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, reduce or eliminate 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 marketable securities of $136.4 million. Components of our results of operations Revenue We have not generated any revenue since our inception and do not expect to generate any revenue from the sale of products in the near future, if at all. If our development efforts for AKR-001 or additional product candidates that we may develop in the future are successful and result in marketing approval or if we enter into collaboration or license agreements with third parties, we may generate revenue in the future from a combination of product sales or payments from such collaboration or license agreements. Operating expenses Research and development expenses Research and development expenses consist primarily of costs incurred in connection with the development of AKR-001, as well as unrelated discovery program expenses. 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 under agreements with contract research organizations, or CROs, that are primarily engaged in the oversight and conduct of our clinical trials; contract manufacturing organizations, or CMOs, that are primarily engaged to provide drug substance and product for our clinical trials, research and development programs, as well as investigative sites and consultants that conduct our clinical trials, nonclinical studies and other scientific development services; · the cost of acquiring and manufacturing nonclinical and clinical trial materials, including manufacturing registration and validation batches; · costs related to compliance with quality and regulatory requirements; and · payments made under third-party licensing agreements. 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. 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. Product candidates in later stages of clinical development, such as AKR-001, 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 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 clinical development of AKR-001 and any future product candidates. 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; · the number of doses that patients receive; · the drop-out or discontinuation rates of patients enrolled in clinical trials; · 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. The successful development and commercialization of 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 nonclinical and clinical development activities; · the number and scope of nonclinical and clinical programs we decide to pursue; · the ability to raise necessary additional funds; · the progress of the development efforts of parties with whom we may enter into collaboration arrangements; · our ability to maintain our current development program 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 FDA or any comparable foreign regulatory authority; · the receipt and related terms of regulatory approvals from applicable regulatory authorities; · the availability of drug substance and drug product for use in production of our product candidate; · establishing and maintaining agreements with third-party manufacturers for clinical supply for our clinical trials and commercial manufacturing, if our product candidate is approved; · 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 candidate, if and when approved; · obtaining and maintaining third-party insurance coverage and adequate reimbursement; · the acceptance of our product candidate, 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 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 for personnel in executive, finance, corporate and business development, and administrative functions. General and administrative expenses also include legal fees relating to patent and corporate matters; professional fees for accounting, auditing, tax and administrative consulting services; insurance costs; administrative travel expenses; marketing expenses and other operating costs. We anticipate that our general and administrative expenses will increase in the future as we increase our headcount to support development of AKR-001 and our continued research activities. We also anticipate that we will incur increased accounting, audit, legal, tax, regulatory, compliance, and director and officer insurance costs, as well as investor and public relations expenses associated with maintaining compliance with exchange listing and SEC requirements. Other income (expense), net Change in fair value of preferred stock tranche obligation In connection with our June 2018 issuance and sale of Series A preferred stock, we provided for a first tranche closing, a second tranche closing, and a call option to purchase additional shares of Series A preferred stock. We classified the preferred stock tranche obligation for the future purchase and option to purchase Series A preferred stock as a liability on our consolidated balance sheets as the preferred stock tranche obligation is a freestanding financial instrument that will require us to transfer equity instruments upon future closings of the Series A preferred stock. The preferred stock tranche obligation liability was initially recorded at fair value upon the date of issuance and was subsequently remeasured to fair value at each reporting date. Changes in the fair value of the preferred stock tranche obligation are recognized as a component of other expense in the consolidated statements of operations and comprehensive loss. Changes in the fair value of the preferred stock tranche obligation were recognized until the tranche obligations were fulfilled or otherwise extinguished in the fourth quarter of 2018. In November 2018, in connection with our issuance and sale of Series A preferred stock, we satisfied our obligation to issue additional shares under the second tranche closing and accordingly reclassified the carrying value of the preferred stock tranche obligation associated with the future purchase obligation, equal to the then current value of $32.8 million, to the carrying value of the Series A preferred stock. In December 2018, in connection with our issuance and sale of Series B preferred stock, we terminated the option to purchase Series A preferred stock provided under the Series A Preferred Stock Purchase Agreement, or 2018 Series A Agreement. We accounted for the termination of the call option associated with the preferred stock tranche obligation as a liability extinguishment between related parties and recognized a gain on extinguishment of $36.8 million, equal to the then current fair value, within additional paid-in capital in the statement of stockholder's equity (deficit). Change in fair value of anti-dilution right liability We classified the anti-dilution right under our license agreement with Amgen Inc., or the Amgen Agreement, as a derivative liability on our consolidated balance sheets as the anti-dilution right represented a freestanding financial instrument that required us to transfer equity instruments upon future equity closings. The anti-dilution right liability was initially recorded at fair value upon the date of issuance and was subsequently remeasured to fair value at each reporting date. The issuance date fair value of the derivative liability was recognized as a research and development expense upon entering into the agreement with Amgen. Changes in the fair value of the anti-dilution right liability were recognized as a component of other expense in the consolidated statements of operations and comprehensive loss. Changes in the fair value of the anti-dilution right liability were recognized until the anti-dilution rights obligation was satisfied in the fourth quarter of 2018. In November 2018, in connection with our issuance and sale of Series A preferred stock, we satisfied our anti-dilution rights obligation under the Amgen Agreement by issuing 3,205,128 shares of Series A preferred stock to Amgen for a total value of $7.4 million. We reclassified the carrying value of the anti-dilution right liability, equal to the then current fair value of $7.4 million, to the carrying value of the Series A preferred stock. Other income (expense), net Other income (expense), net consists primarily of interest income earned on our cash, cash equivalents and short-term marketable securities. Income taxes Since our inception, we have not recorded any income tax benefits for the net losses we have incurred in each period or for our earned research and development tax credits, as we believe, based upon the weight of available evidence, that it is more likely than not that all of our net operating loss 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 $51.1 million and $10.2 million, respectively, which may be available to offset future income tax liabilities and expire at various dates beginning in 2037. The federal net operating loss carryforwards include $48.8 million, which may be carried forward indefinitely As of December 31, 2019, we also had U.S. federal and state research and development tax credit carryforwards of $1.1 million and $0.2 million, respectively, which may be available to offset future tax liabilities which expire at various dates beginning in 2032. 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: * Percentage change is not meaningful Research and development expenses The following table summarizes our research and development expenses incurred during the years ended December 31, 2019 and 2018: Research and development expenses were $37.0 million for the year ended December 31, 2019, compared to $11.9 million for the year ended December 31, 2018. Direct costs for our AKR-001 program increased $23.1 million during the 2019 period, with $15.3 million related to third-party contract manufacturing, $11.3 million related to external CRO costs associated with our ongoing Phase 2a clinical trial, $2.0 million related to other third-party development studies and $2.5 million was a clinical milestone paid to Amgen. The 2019 period did not include $8.0 million in one-time cash and non-cash charges associated with the Amgen license that were incurred during the 2018 period. Personnel and related costs increased $2.1 million during the 2019 period related to the hiring of personnel in our research and development department. General and administrative expenses General and administrative expenses were $8.6 million for the year ended December 31, 2019 compared to $1.9 million for the year ended December 31, 2018. Increased personnel costs accounted for $3.4 million of the increase, primarily due to hiring additional personnel in our general and administrative functions related to our growth in becoming a public company. Legal, accounting, other professional service fees and rent increased $3.3 million, also related to our growth in becoming a public company. Other income (expense), net Other income (expense), net for the year ended December 31, 2019 is comprised primarily of $1.9 million of interest income from our cash, cash equivalents and short-term marketable securities. We did not record interest income for the year ended December 31, 2018. Other expense for the year ended December 31, 2018 was $67.9 million, consisting of $62.2 million and $5.8 million in expenses related to the changes in fair value of the preferred stock tranche obligation and the fair value of the anti-dilution right liability, respectively. Liquidity and capital resources From our inception through December 31, 2019, we have incurred significant operating losses. We have not yet commercialized any products and we do not expect to generate revenue from sales of products for several years, if at all. To date, we have funded our operations primarily with proceeds from the sale of our redeemable convertible preferred stock and common stock in our initial public offering. Through December 31, 2019, we had received gross proceeds of $196.3 million from sales of our redeemable convertible preferred stock and the initial public offering of our common stock. As of December 31, 2019, we had cash, cash equivalents and short-term marketable securities of $136.4 million. We have invested our cash resources primarily in liquid money market accounts and corporate debt securities. On June 24, 2019, we completed an IPO, at which time we issued 6,612,500 shares of common stock, including the exercise in full by the underwriters of their option to purchase up to 862,500 additional shares of common stock, at a public offering price of $16.00 per share. We received $98.4 million, net of underwriting discounts and commissions, but before deducting offering costs payable by the Company, which were $2.9 million The following table summarizes our cash flows for the periods indicated: Cash flows from operating activities Cash used in operating activities for the year ended December 31, 2019 was $35.6 million, consisting of a net loss of $43.8 million, which was partially offset by non-cash charges of $1.8 million for stock-based compensation expense and net cash provided by changes in our operating assets and liabilities of $6.5 million. The change in operating assets and liabilities was primarily due to a reduction in accrued expenses and other current liabilities of $7.4 million, of which $6.1 million was due to the timing of payments to our clinical research organization, or CRO, and contract manufacturing organization, or CMO, vendors and $1.3 million was related to employee compensation. These amounts were partially offset by a $0.5 million increase in prepaid expenses and other current assets and a $0.4 million decrease in accounts payable, both related to the timing of prepayments and payments to our CROs, CMOs and insurance vendors. Cash used in operating activities for the year ended December 31, 2018 was $4.6 million, resulting from our net loss of $81.7 million, partially offset by non-cash charges of $76.0 million primarily related to our issuance of preferred stock to Amgen, changes in the fair value of preferred stock tranche obligation and anti-dilution right liability and net cash provided by changes in operating assets and liabilities of $1.1 million. Net cash provided by changes in our operating assets and liabilities primarily consisted of a $1.3 million increase in accounts payable due to outstanding invoices to CROs and other vendors in connection with our increased level of operating activities in 2018 and a $0.8 million increase in accrued expenses, which was primarily due to increased costs associated with our AKR-001 program. Increases were partially offset by an increase in prepaid expenses and other assets of $1.1 million primarily attributed to CRO deposits related to our clinical trials for AKR-001. Cash flows from investing activities Cash used in investing activities for the year ended December 31, 2019 was $71.5 million, consisting of purchases of short-term marketable securities. Cash used in investing activities for the year ended December 31, 2018 was $5.0 million, consisting of licensing fees related to the acquisition of technology under the Amgen Agreement. Cash flows from financing activities Cash provided by financing activities for the year ended December 31, 2019 was $96.0 million, consisting of $98.4 million of IPO proceeds, net of underwriting discounts and commissions, offset by $2.9 million of related offering costs and $0.5 million in proceeds from the exercise of stock options and the issuance of employee stock purchase shares. Cash provided by financing activities for the year ended December 31, 2018 was $85.0 million, primarily consisting of proceeds from our issuances of Series A and Series B preferred stock, net of issuance costs of $0.4 million. Funding requirements Our primary uses of capital are, and we expect will continue to be, research and development services, compensation and related expenses and general overhead costs. We expect to continue to incur significant expenses and operating losses for the foreseeable future. In addition, with the closing of our IPO, we expect to incur additional costs associated with operating as a public company. We anticipate that our expenses will increase significantly in connection with our ongoing activities. The timing and amount of our operating expenditures will depend largely on: · the initiation, progress, timing, costs and results of nonclinical studies and clinical trials for AKR-001 or any future product candidates we may develop; · our ability to maintain our license to AKR-001 from Amgen; · the outcome, timing and cost of seeking and obtaining regulatory approvals from the FDA and comparable foreign regulatory authorities, including the potential for such authorities to require that we perform more nonclinical studies or clinical trials than those that we currently expect or change their requirements on studies or trials that had previously been agreed to; · the cost to establish, maintain, expand, enforce and defend the scope of our intellectual property portfolio, including the amount and timing of any payments we may be required to make, or that we may receive, in connection with licensing, preparing, filing, prosecuting, defending and enforcing any patents or other intellectual property rights; · the effect of competing technological and market developments; · market acceptance of any approved product candidates, including product pricing, as well as product coverage and the adequacy of reimbursement by third-party payors; · the cost of acquiring, licensing or investing in additional businesses, products, product candidates and technologies; · the cost and timing of selecting, auditing and potentially validating a manufacturing site for commercial scale manufacturing; · the cost of establishing sales, marketing and distribution capabilities for any product candidates for which we may receive regulatory approval and that we determine to commercialize; and · our need to implement additional internal systems and infrastructure, including financial and reporting systems. We expect that we will require additional funding to complete the clinical development of AKR-001, commercialize AKR-001, if we receive regulatory approval, and pursue in-licenses or acquisitions of other product candidates. If we receive regulatory approval for AKR-001 or 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 AKR-001 ourselves. Until such time, if ever, as we can generate substantial product revenue, we expect to finance our cash needs through a combination of equity offerings, debt financings, collaborations, strategic alliances, and marketing, distribution or licensing arrangements with third parties. To the extent that we raise additional capital through the sale of equity or convertible debt securities, ownership interest may be materially diluted, and the terms of such securities could include liquidation or other preferences that adversely affect your rights as a common stockholder. 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. If we raise 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. If we are unable to raise additional funds through equity or debt financings or other arrangements 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. Contractual obligations and other commitments The following table summarizes our contractual obligations as of December 31, 2019: (1) Amounts reflect the non-cancelable purchase commitments under agreements with our external CROs and CMOs, which we have engaged to conduct clinical and nonclinical development activities and clinical trials and to manufacture clinical development materials. (2) Amounts reflect minimum payments due under our operating lease for office space in South San Francisco, California and our use agreement for office space in Cambridge, Massachusetts. The lease in South San Francisco was originally due to expire in April 2019 with the option to renew on a month to month basis thereafter. In March 2019, we amended our lease agreement associated with our office space in South San Francisco, California, extended the term of the lease to March 2021 and expanded the square footage of the existing leased office space. On February 14, 2020, the Company entered into a seven-year lease agreement for 6,647 square feet of office space in South San Francisco, California. Under the agreement, the Company is required to make $2.3 million in minimum payments during the lease term. Minimum payments due as a result of the new lease agreement are excluded from the table above. Apart from the contracts with payment commitments that we have reflected in the table, we have entered into other contracts in the normal course of business with certain CROs, CMOs, and other third parties for nonclinical 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 addition, under the Amgen Agreement, we are required to make milestone payments and pay royalties based upon specified milestones. 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 Amgen Agreement, we are obligated to make aggregate milestone payments of up to $37.5 million upon the achievement of specified remaining clinical and regulatory milestones and aggregate milestone payments of up to $75.0 million upon the achievement of specified commercial milestones for all products licensed under the agreement. Commencing on the first commercial sale of licensed products, we are obligated to pay tiered royalties on escalating tiers of annual net sales of licensed products ranging from low to high single-digit percentages. The first clinical milestone, in the amount of $2.5 million, was paid to Amgen in July 2019. 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 and judgments that affect the reported amounts of assets, liabilities, 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 elsewhere in this Annual 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. Cash and cash equivalents We consider all highly liquid investments with original maturities of three months or less at the time of purchase to be cash equivalents. Cash equivalents, which consist primarily of amounts invested in money market accounts, are stated at fair value. Short-term marketable securities We invest in short-term marketable securities, primarily money market funds, commercial paper, U.S. treasury securities and corporate debt securities. We classify our short-term marketable securities as available-for-sale securities and report them at fair value in cash equivalents or short-term marketable securities on the consolidated balance sheets with related unrealized losses included within accumulated other comprehensive loss on the consolidated balance sheets. The amortized cost of debt securities is adjusted for amortization of premiums and accretion of discounts to maturity, which is included in other income (expense), net on the consolidated statements of operations and comprehensive loss. Realized gains and losses and declines in value judged to be other-than-temporary, if any, on available-for-sale securities are included in other income (expense), net. The cost of securities sold is based on the specific identification method. Interest and dividends on securities classified as available-for-sale are included in other income (expense), net. We regularly review all of our investments for other-than-temporary declines in estimated fair value. Our review includes the consideration of the cause of the impairment, including the creditworthiness of the security issuers, the number of securities in an unrealized loss position, the severity and duration of the unrealized losses, whether we have the intent to sell the securities and whether it is more likely than not that we will be required to sell the securities before the recovery of their amortized cost basis. When we determine that the decline in estimated fair value of an investment is below the amortized cost basis and the decline is other-than-temporary, we reduce the carrying value of the security and record a loss for the amount of such decline. 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 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 nonclinical development activities; " CROs and investigative sites in connection with nonclinical studies and clinical trials; and " CMOs in connection with the production of nonclinical and clinical trial materials. We base the expense recorded related to external research and development 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 nonclinical 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. 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 all stock-based awards granted to employees and nonemployees based on the 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, on a straight-line basis. We account for forfeitures as they occur. We estimate the fair value of stock option grants using the Black-Scholes option pricing model. Prior to our initial public offering, the exercise price for all stock options granted was at the estimated fair value of the underlying common stock as determined on the date of grant by our board of directors. 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. We completed our IPO in June 2019 and accordingly, we lack sufficient company-specific historical and implied volatility information for our shares traded in the public markets. Therefore, we estimate our expected share price volatility based on the historical volatility of publicly traded peer companies and 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 that qualify as "plain-vanilla" options. 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 we have never paid cash dividends on our common stock and do not expect to pay any cash dividends in the foreseeable future. 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. Compensation expense for purchases under the Employee Stock Purchase Plan is recognized based on the fair value of the common stock estimated based on the closing price of our common stock as reported on the date of offering, less the purchase discount percentage provided for in the plan. Stock-based compensation expense was $1.8 million and $0.1 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had $15.6 million of unrecognized stock-based compensation costs, which we expect to recognize over a weighted-average period of 3.08 years. We have not recognized, and we do not expect to recognize in the near future, any tax benefit related to 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. Valuation of preferred stock tranche obligation In connection with our issuance of Series A preferred stock in June 2018, we recognized a preferred stock tranche obligation. We classified the preferred stock tranche obligation for the future purchase, and option to purchase, Series A preferred stock as a liability on our consolidated balance sheets as the preferred stock tranche obligation is a freestanding financial instrument that required us to transfer equity instruments upon future closings of the Series A preferred stock. The preferred stock tranche obligation was initially recorded at fair value upon the date of issuance and was subsequently remeasured to fair value at each reporting date. Changes in the fair value of the preferred stock tranche obligation were recognized as a component of other expense in the consolidated statements of operations and comprehensive loss. Changes in the fair value of the preferred stock tranche obligation were recognized until the tranche obligations were fulfilled or otherwise extinguished in the fourth quarter of 2018. The fair value of the liability was estimated based on results of a third-party valuation performed in connection with the issuance of Series A preferred stock in June 2018. We determined that this valuation represented the fair value of the liability at the reporting date. The liability includes (i) an obligation to issue shares in a second tranche of Series A preferred stock and (ii) an obligation to issue shares under the call option to purchase Series A preferred stock following the second tranche. The fair value of the obligation to purchase a second tranche of Series A preferred stock was estimated by utilizing the future value of the underlying Series A preferred stock, the Series A original issue price and the number of shares subject to future purchase. The future value of the Series A preferred stock was determined through a backsolve calculation. The present value of the forward contract was then multiplied by a probability of occurrence for the second tranche closing. The fair value of the obligation for the call option to purchase Series A preferred stock was estimated using the hybrid method which employed the Black-Scholes option-pricing model adjusted to reflect the timing and probability of closing a second tranche of Series A preferred stock. The hybrid method incorporates assumptions and estimates to value the obligation. Estimates and assumptions impacting the fair value measurement include the fair value per share of the underlying shares of our Series A preferred stock, risk-free interest rate, expected dividend yield, expected volatility of the price of the underlying preferred stock, the remaining years to liquidity, the discount rate and probability (expressed as a percentage) of closing a second Tranche. The most significant assumption in the hybrid model impacting the fair value of the call option is the fair value of our preferred stock as of each remeasurement date. We determine the fair value per share of the underlying preferred stock by taking into consideration our most recent sales of our preferred stock, results obtained from third-party valuations and additional factors that are deemed relevant. We have historically been a private company and lack company-specific historical and implied volatility information of our stock. Therefore, we estimate expected stock volatility based on the historical volatility of publicly traded peer companies for a term equal to the remaining contractual term of the call option. The risk-free interest rate is determined by reference to the U.S. Treasury yield curve for time periods approximately equal to the remaining years to liquidity. We have estimated a 0% dividend yield based on the expected dividend yield and the fact that we have never paid or declared dividends. In November 2018, in connection with our issuance and sale of Series A preferred stock, we satisfied our obligation to issue additional shares under the second tranche closing. In December 2018, in connection with our issuance and sale of Series B preferred stock, we terminated the option to purchase Series A preferred stock provided under the 2018 Series A Agreement. Valuation of anti-dilution right We assessed the anti-dilution rights provided to Amgen pursuant to the Amgen Agreement and determined that the rights (i) met the definition of a freestanding financial instrument that was not indexed to our own stock and (ii) did not meet the definition of a derivative. As the rights did not meet the definition of a derivative and did not qualify for equity classification, we determined to classify the anti-dilution rights as a liability on our consolidated balance sheet. The anti-dilution right liability was initially recorded at fair value upon the license agreement and was subsequently remeasured to fair value at each reporting date. Changes in the fair value of the anti-dilution right liability were recognized as a component of other expense in the consolidated statements of operations and comprehensive loss. Changes in the fair value of the anti-dilution right liability were recognized until the anti-dilution obligation was satisfied in the fourth quarter of 2018. The fair value of the anti-dilution right was estimated using a probability weighted scenario which considers as inputs the probability of occurrence of events that would trigger the issuance of shares, including a (i) second tranche closing of Series A preferred stock, (ii) initial public offering, and (ii) no future sale of equity securities. The weighted average fair values of each scenario were calculated utilizing the fair value per share of the underlying Series A preferred stock and common stock. Changes in our estimated fair value and the probability of achieving different financing scenarios can have a significant impact on the fair value of the anti-dilution right liability. In November 2018, in connection with our issuance and sale of Series A preferred stock, we satisfied our anti-dilution rights obligation under the Amgen Agreement. 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 consolidated financial statements or in our tax returns. Deferred tax assets and liabilities are determined based on the difference between the consolidated financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year 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. Potential for recovery of deferred tax assets is evaluated by estimating the future taxable profits expected and considering prudent and feasible tax planning strategies. We account for uncertainty in income taxes recognized in the consolidated 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 consolidated 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. Utilization of our NOL carryforwards may be subject to a substantial annual limitation due to ownership changes that may have occurred or that could occur in the future, as required by Section 382 of the Internal Revenue Code of 1986, as amended, or the Code, and similar state provisions. These ownership change limitations may limit the amount of NOL carryforwards and other tax attributes that can be utilized annually to offset future taxable income and tax, respectively. In general, an “ownership change” as defined by Section 382 of the Code results from a transaction or series of transactions over a three-year period resulting in an ownership change of more than 50 percentage points (by value) of the outstanding stock of a company by certain stockholders. Since our formation, we have raised capital through the issuance of capital stock on several occasions, which separately or combined with the purchasing stockholders’ subsequent disposition of those shares, resulted in such ownership changes on March 24, 2017 and on June 7, 2018, or could result in ownership changes in the future. 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. Recent accounting pronouncements See Note 2 to our consolidated financial statements included in Part I, Item 8, “Notes to Consolidated Financial Statements,” of this Annual Report on Form 10-K for a description of recent accounting pronouncements applicable to our business. Emerging Growth Company Status We are an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act of 2012 (JOBS Act), and are eligible to take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies. 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 of 1933 for complying with new or revised accounting standards issued subsequent to the enactment of the JOBS Act until such time as those standards apply to private 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. We have elected to avail ourselves of this exemption from complying with new or revised accounting standards and, therefore, will not be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies. As an emerging growth company, we intend to rely upon other exemptions and reduced reporting requirements under the JOBS Act, 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 consolidated financial statements, known as the auditor discussion and analysis. We will remain an emerging growth company until the earlier of (a) the last day of the fiscal year in which we have total annual gross revenue of $1.07 billion or more; (b) the last day of the fiscal year following the fifth anniversary of the date of the completion of our initial public offering; (c) the date on which we have issued more than $1.0 billion in nonconvertible debt during the previous three years; or (d) the date on which we are deemed to be a large accelerated filer under the rules of the SEC.

<s>[INST] Overview We are a cardiometabolic nonalcoholic steatohepatitis, or NASH, company dedicated to developing pioneering medicines that restore metabolic balance and improve overall health for NASH patients. NASH is a severe form of nonalcoholic fatty liver disease, or NAFLD, characterized by inflammation and fibrosis in the liver that can progress to cirrhosis, liver failure, cancer and death. Our lead product candidate, AKR001, is an analog of fibroblast growth factor 21, or FGF21, which is an endogenously expressed hormone that regulates metabolism of lipids, carbohydrates and proteins throughout the body. FGF21 also plays a critical role in protecting many types of cells from various forms of stress. In previous clinical trials in patients with type 2 diabetes, or T2D, administration of AKR001 was associated with substantial improvements in lipid metabolism and insulin sensitivity. We believe these data, coupled with clinical results from other FGF21 analogs, demonstrate AKR001's potential to serve as a cornerstone for the treatment of NASH. We are currently conducting a Phase 2a clinical trial, the BALANCED study, which is evaluating AKR001 in the treatment of NASH patients. We expect to complete collection of data for the BALANCED main study week 12 primary endpoint, and report topline results related to reductions in liver fat, in the first quarter of 2020. Topline results related to secondary endpoints, including safety and tolerability as well as paired biopsies, will be reported in the second quarter of 2020. We also plan to expand the BALANCED study to include an additional cohort of subjects with NASH who have compensated cirrhosis (F4), ChildPugh Class A, with study initiation expected in the second quarter of 2020. We were incorporated in January 2017 and have devoted substantially all of our efforts to organizing and staffing our company, business planning, raising capital, inlicensing rights to AKR001, research and development activities for AKR001, building our intellectual property portfolio and providing general and administrative support for these operations. To date, we have principally raised capital through the issuance of convertible preferred stock and the initial public offering of our common stock. We have incurred significant operating losses since inception. Our ability to generate product revenue sufficient to achieve profitability will depend heavily on the successful development and eventual commercialization of AKR001 and any future product candidates. Our net losses were $43.8 million and $81.7 million for the years ended December 31, 2019 and 2018, respectively. The net loss for the year ended December 31, 2018 included noncash charges of $62.2 million related to the change in fair value of our preferred stock tranche obligation and $5.8 million related to the change in fair value of our antidilution right liability. As of December 31, 2019, we had an accumulated deficit of $130.3 million. We expect to continue to incur significant expenses for at least the next several years as we advance AKR001 through laterstage clinical development, develop additional product candidates and seek regulatory approval of any product candidates that complete clinical development. In addition, if we obtain marketing approval for any 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. 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, which may include collaborations with other companies or other strategic transactions. 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, reduce [/INST] Negative. </s>

Datadog, 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 audited consolidated financial statements and related notes appearing elsewhere in this Annual Report on Form 10- K. This discussion, particularly information with respect to our future results of operations or financial condition, business strategy and plans and objectives of management for future operations, includes forward-looking statements that involve risks and uncertainties as described under the heading “Special Note Regarding Forward-Looking Statements” in this Annual Report on Form 10-K. You should review the disclosure under the heading “Part I, Item 1A. Risk Factors” in this Annual Report on Form 10-K for a discussion of important factors that could cause our actual results to differ materially from those anticipated in these forward-looking statements. Overview Datadog is the monitoring and analytics platform for developers, IT operations teams and business users in the cloud age. Our SaaS platform integrates and automates infrastructure monitoring, application performance monitoring and log management to provide unified, real-time observability of our customers’ entire technology stack. Datadog is used by organizations of all sizes and across a wide range of industries to enable digital transformation and cloud migration, drive collaboration among development, operations and business teams, accelerate time to market for applications, reduce time to problem resolution, understand user behavior and track key business metrics. We generate revenue from the sale of subscriptions to customers using our cloud-based platform. Our paid subscriptions are available in Pro and Enterprise tiers. The terms of our subscription agreements are primarily monthly or annual. Customers also have the option to purchase additional products, such as additional containers to monitor, custom metrics packages, anomaly detection and app analytics. Professional services are generally not required for the implementation of our products and revenue from such services has been immaterial to date. We employ a land-and-expand business model centered around offering products that are easy to adopt and have a very short time to value. Our customers can expand their footprint with us on a self-service basis. Our customers often significantly increase their usage of the products they initially buy from us and expand their usage to other products we offer on our platform. We grow with our customers as they expand their workloads in the public and private cloud. As of December 31, 2019, we had $601.2 million in cash, cash equivalents and restricted cash and $176.7 million in marketable securities. We have grown rapidly in recent periods, with revenues for the fiscal years ended December 31, 2019, 2018 and 2017 of $362.8 million, $198.1 million, and $100.8 million, respectively, representing year-over-year growth of 83% from the fiscal year ended December 31, 2018 to the fiscal year ended December 31, 2019 and 97% from the fiscal year ended December 31, 2017 to the fiscal year ended December 31, 2018. Substantially all of our revenue is subscription software sales. We expect that the rate of growth in our revenue will decline as our business scales, even if our revenue continues to grow in absolute terms. We have continued to make significant expenditures and investments, including in personnel-related costs, sales and marketing, infrastructure and operations, and have incurred net loss in each period since our inception, including net loss of $(16.7) million, $(10.8) million and $(2.6) million for the fiscal years ended December 31, 2019, 2018 and 2017, respectively. Our operating cash flow was $24.2 million, $10.8 million and $13.8 million for the years ended December 31, 2019, 2018 and 2017 respectively. Our free cash flow was $0.8 million, $(5.0) million and $6.0 million for the years ended December 31, 2019, 2018 and 2017 respectively. See the section titled “-Liquidity and Capital Resources-Non-GAAP Free Cash Flow” below. Our employee headcount has increased to 1,403 employees as of December 31, 2019 from 886 as of December 31, 2018. We plan to continue to aggressively invest in the growth of our business to take advantage of our market opportunity. Factors Affecting Our Performance Acquiring New Customers We believe there is substantial opportunity to continue to grow our customer base. We intend to drive new customer acquisition by continuing to invest significantly in sales and marketing to engage our prospective customers, increase brand awareness and drive adoption of our platform and products. We also plan to continue to invest in building brand awareness within the development and operations communities. As of December 31, 2019, we had approximately 10,500 customers spanning organizations of a broad range of sizes and industries. Our ability to attract new customers will depend on a number of factors, including the effectiveness and pricing of our products, offerings of our competitors, and the effectiveness of our marketing efforts. We define the number of customers as the number of accounts with a unique account identifier for which we have an active subscription in the period indicated. Users of our free trials or tier are not included in our customer count. A single organization with multiple divisions, segments or subsidiaries is generally counted as a single customer. However, in some cases where they have separate billing terms, we may count separate divisions, segments or subsidiaries as multiple customers. Expanding Within Our Existing Customer Base Our base of customers represents a significant opportunity for further sales expansion. As of December 31, 2019, we had 858 customers with annual run-rate revenue, or ARR, of $100,000 or more, up from 453 as of December 31, 2018. We define ARR as the annual run-rate revenue of subscription agreements from all customers at a point in time. We calculate ARR by taking the monthly run-rate revenue, or MRR, and multiplying it by 12. MRR for each month is calculated by aggregating, for all customers during that month, monthly revenue from committed contractual amounts, additional usage and monthly subscriptions. ARR and MRR should be viewed independently of revenue, and do not represent our revenue under U.S. GAAP on a monthly or annualized basis, as they are operating metrics that can be impacted by contract start and end dates and renewal rates. ARR and MRR are not intended to be replacements or forecasts of revenue. We believe that our land-and-expand business model allows us to efficiently increase revenue from our existing customer base. Our customers often expand the deployment of our platform across large teams and more broadly within the enterprise as they migrate more workloads to the cloud, find new use cases for our platform, and generally realize the benefits of our platform. We intend to continue to invest in enhancing awareness of our brand and developing more products, features and functionality, which we believe are important factors to achieve widespread adoption of our platform. Our ability to increase sales to existing customers will depend on a number of factors, including our customers’ satisfaction with our solution, competition, pricing and overall changes in our customers’ spending levels. Sustaining Innovation and Technology Leadership Our success is dependent on our ability to sustain innovation and technology leadership in order to maintain our competitive advantage. We believe that we have built a highly differentiated platform that will position us to further extend the adoption of our platform and products. Datadog is frequently deployed across a customer’s entire infrastructure, making it ubiquitous. Datadog is a daily part of the lives of developers, operations engineers and business leaders. We employ a land-and-expand business model centered around offering products that are easy to adopt and have a very short time to value. Our efficient go-to-market model enables us to prioritize significant investment in innovation. We have proven initial success of our platform approach, through expansion beyond our initial infrastructure monitoring solution, to include APM in 2017 and logs in 2018. In 2019, we launched user experience monitoring and network performance monitoring, and announced the addition of security monitoring to our platform. As of December 31, 2019, approximately 60% of our customers were using more than one product, up from approximately 25% a year earlier. We believe these metrics indicate strong momentum in the uptake of our newer platform products. We intend to continue to invest in building additional products, features and functionality that expand our capabilities and facilitate the extension of our platform to new use cases. We also intend to continue to evaluate strategic acquisitions and investments in businesses and technologies to drive product and market expansion. Our future success is dependent on our ability to successfully develop, market and sell existing and new products to both new and existing customers. Expanding Internationally We believe there is a significant opportunity to expand usage of our platform outside of North America. Revenue, as determined based on the billing address of our customers, from regions outside of North America was 25% for the year ended December 31, 2019. In addition, we have made and plan to continue to make significant investments to expand geographically, particularly in EMEA and APAC. Although these investments may adversely affect our operating results in the near term, we believe that they will contribute to our long-term growth. Beyond North America, we now have sales presence internationally, including in Dublin, London, Paris, Amsterdam, Singapore, Sydney and Tokyo. Components of Results of Operations Revenue We generate revenue from the sale of subscriptions to customers using our cloud-based platform. The terms of our subscription agreements are primarily monthly or annual, with the majority of our revenue coming from annual subscriptions. Our customers can enter into a subscription for a committed contractual amount of usage that is apportioned ratably on a monthly basis over the term of the subscription period, a subscription for a committed contractual amount of usage that is delivered as used, or a monthly subscription based on usage. To the extent that our customers’ usage exceeds the committed contracted amounts under their subscriptions, either on a monthly basis in the case of a ratable subscription or once the entire commitment is used in the case of a delivered-as-used subscription, they are charged for their incremental usage. Usage is measured primarily by the number of hosts or by the volume of data indexed. A host is generally defined as a server, either in the cloud or on-premise. Our infrastructure monitoring, APM and network performance monitoring products are priced per host, our logs product is primarily priced per log events indexed and secondarily by events ingested. Customers also have the option to purchase additional products, such as additional container or serverless monitoring, custom metrics packages, anomaly detection, synthetic monitoring and app analytics. In the case of subscriptions for committed contractual amounts of usage, revenue is recognized ratably over the term of the subscription agreement, generally beginning on the date that our platform is made available to a customer. As a result, much of our revenue is generated from subscriptions entered into during previous periods. Consequently, any decreases in new subscriptions or renewals in any one period may not be immediately reflected as a decrease in revenue for that period, but could negatively affect our revenue in future quarters. This also makes it difficult for us to rapidly increase our revenue through the sale of additional subscriptions in any period, as revenue is recognized over the term of the subscription agreement. In the case of a subscription for a committed contractual amount of usage that is delivered as used, a monthly subscription based on usage, or usage in excess of a ratable subscription, we recognize revenue as the product is used, which may lead to fluctuations in our revenue and results of operations. In addition, historically, we have experienced seasonality in new customer bookings, as we typically enter into a higher percentage of subscription agreements with new customers in the fourth quarter of the year. Due to ease of implementation of our products, professional services generally are not required and revenue from such services has been immaterial to date. Cost of Revenue Cost of revenue primarily consists of expenses related to providing our products to customers, including payments to our third-party cloud infrastructure providers for hosting our software, personnel-related expenses for operations and global support, including salaries, benefits, bonuses and stock-based compensation, payment processing fees, information technology, depreciation and amortization related to the amortization of acquired intangibles and internal-use software and other overhead costs such as allocated facilities. We intend to continue to invest additional resources in our platform infrastructure and our customer support and success organizations to expand the capability of our platform and ensure that our customers are realizing the full benefit of our platform and products. The level, timing and relative investment in our infrastructure could affect our cost of revenue in the future. Gross Profit and Gross Margin Gross profit represents revenue less cost of revenue. Gross margin is gross profit expressed as a percentage of revenue. Our gross margin may fluctuate from period to period as our revenue fluctuates, and as a result of the timing and amount of investments to expand our products and geographical coverage. Operating Expenses Our operating expenses consist of research and development, sales and marketing, and general and administrative expenses. Personnel costs are the most significant component of operating expenses and consist of salaries, benefits, bonuses, stock-based compensation expense and sales commissions. Operating expenses also include overhead costs for facilities and shared IT-related expenses, including depreciation expense. Research and Development Research and development expense consists primarily of personnel costs for our engineering, service and design teams. Additionally, research and development expense includes contractor fees, depreciation and amortization and allocated overhead costs. Research and development costs are expensed as incurred. We expect that our research and development expense will increase in absolute dollars as our business grows, particularly as we incur additional costs related to continued investments in our platform. Sales and Marketing Sales and marketing expense consists primarily of personnel costs for our sales and marketing organization, costs of general marketing and promotional activities, including the free tier and free introductory trials of our products, travel-related expenses and allocated overhead costs. Sales commissions earned by our sales force are deferred and amortized on a straight-line basis over the expected period of benefit, which we have determined to be four years. We expect that our sales and marketing expense will increase in absolute dollars and continue to be our largest operating expense for the foreseeable future as we expand our sales and marketing efforts. However, we expect that our sales and marketing expense will decrease as a percentage of our revenue over the long term. General and Administrative General and administrative expense consists primarily of personnel costs and contractor fees for finance, legal, human resources, information technology and other administrative functions. In addition, general and administrative expense includes non-personnel costs, such as legal, accounting and other professional fees, hardware and software costs, certain tax, license and insurance-related expenses and allocated overhead costs. We expect to incur additional expenses as a result of operating as a newly public company, including costs to comply with the rules and regulations applicable to companies listed on a national securities exchange, costs related to compliance and reporting obligations, and increased expenses for insurance, investor relations and professional services. We expect that our general and administrative expense will increase in absolute dollars as our business grows. Other Income, Net Other income, net consists of income earned on our money market funds included in cash and cash equivalents and on our marketable securities. Provision for Income Taxes Provision for income taxes consists of U.S. federal and state income taxes and income taxes in certain foreign jurisdictions in which we conduct business. We maintain a full valuation allowance on our federal and state deferred tax assets as we have concluded that it is not more likely than not that the deferred tax assets will be realized. Results of Operations The following table sets forth our consolidated statements of operations data for the periods indicated: (1) Includes stock-based compensation expense as follows: (2) Includes amortization of acquired intangibles expense as follows: (3) Includes a $2.3 million, $0.4 million and $2.3 million benefit within Research and development, Sales and marketing and General and administrative expenses, respectively, related to the release of a non-income tax liability for the year ended December 31, 2019. See Note 9 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for further discussion. The following table sets forth our consolidated statements of operations data expressed as a percentage of revenue for the periods indicated: Comparison of the Years Ended December 31, 2019 and 2018 Revenue Revenue increased by $164.7 million, or 83%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase in revenue was primarily due to growth from existing customers, with the remaining increase attributable to new customers. Cost of Revenue and Gross Margin Cost of revenue increased by $42.4 million, or 91%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. This increase was primarily due to an increase of $35.2 million in third-party cloud infrastructure hosting and software costs, an increase of $3.2 million in personnel expenses as a result of increased headcount, an increase of $2.5 million of depreciation and amortization expense, an increase of $0.8 million in credit card processing fees and other fees, and an increase of $0.7 million in allocated overhead costs as a result of an increase in overall costs necessary to support the growth of the business and related infrastructure. Our gross margin declined by 2% for the year ended December 31, 2019 compared to the year ended December 31, 2018, primarily as the result of the timing and amount of our investments to expand the capacity of our third-party cloud infrastructure providers. Research and Development Research and development expense increased by $56.2 million, or 102%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. This increase was primarily due to an increase of $38.5 million in personnel costs for our engineering, product and design teams as a result of increased headcount, and an increase of $17.7 million in cloud infrastructure related investments and in allocated overhead costs necessary for supporting the growth of the business. Sales and Marketing Sales and marketing expense increased by $57.8 million, or 65%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. This increase was primarily due to an increase of $39.6 million in personnel costs for our sales and marketing organization as a result of increased headcount and increased variable compensation for our sales personnel, an increase of $10.4 million in allocated overhead costs as a result of an increase in overall costs necessary to support the growth of the business and related infrastructure, and an increase of $7.8 million in marketing and promotional activities. General and Administrative General and administrative expense increased by $17.3 million, or 93%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. This increase was primarily due to an increase of $8.6 million in personnel expenses as a result of increased headcount, an increase of $6.9 million related to outside professional fees primarily related to legal and accounting services, an increase of $1.8 million in allocated overhead expenses related to an increase in overall costs necessary to support the growth of the business and related infrastructure. Comparison of the Years Ended December 31, 2018 and 2017 Revenue Revenue increased by $97.3 million, or 97%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. Approximately 60% of the increase in revenue was attributable to the growth from existing customers, and the remaining increase in revenue was attributable to new customers. Cost of Revenue and Gross Margin Cost of revenue increased by $23.1 million, or 99%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. This increase was primarily due to an increase of $17.2 million in third-party cloud infrastructure hosting and software costs, an increase of $2.5 million in personnel expenses as a result of increased headcount, an increase of $1.8 million of depreciation and amortization expense, an increase of $0.9 million in credit card processing fees and other fees, and an increase of $0.7 million in allocated overhead costs as a result of an increase in overall costs necessary to support the growth of the business and related infrastructure. Our gross margin remained relatively constant for the fiscal year ended December 31, 2018 compared to the fiscal year ended December 31, 2017. Research and Development Research and development expense increased by $30.4 million, or 123%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. This increase was primarily due to an increase of $21.7 million in personnel costs for our engineering, product and design teams as a result of increased headcount and an increase of $8.7 million in cloud infrastructure related investments and in allocated overhead costs necessary for supporting the growth of the business. Sales and Marketing Sales and marketing expense increased by $44.6 million, or 101%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. This increase was primarily due to an increase of $26.1 million in personnel costs for our sales and marketing organization as a result of increased headcount and increased variable compensation for our sales personnel, an increase of $11.6 million in marketing and promotional activities, and an increase of $6.9 million in allocated overhead costs as a result of an increase in overall costs necessary to support the growth of the business and related infrastructure. General and Administrative General and administrative expense increased by $7.2 million, or 63%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. This increase was primarily due to an increase of $4.7 million in personnel expenses as a result of increased headcount, an increase of $0.9 million related to outside professional fees primarily related to legal and accounting services, an increase of $1.6 million in allocated overhead expenses related to an increase in overall costs necessary to support the growth of the business and related infrastructure. 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 the same basis as our audited annual consolidated financial statements and reflect, in the opinion of management, all adjustments of a normal, recurring nature that are 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 included in “Part II, Item 8. Financial Statements” of this Annual Report on Form 10-K. Historical results are not necessarily indicative of the results that may be expected for the full fiscal year or any other period. (1) Includes stock-based compensation expense as follows: (2) Includes amortization of acquired intangibles expense as follows: (3) Includes a $2.3 million, $0.4 million and $2.3 million benefit within Research and development, Sales and marketing and General and administrative expenses, respectively, related to the release of a non-income tax liability for the three months ended June 30, 2019. See Note 9 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for further discussion. Quarterly Revenue Trends Total revenue increased sequentially in each of the quarters presented primarily due to the growth from existing customers and the addition of new customers. We recognize revenue ratably over the terms of our subscription contracts. As a result, a substantial portion of the revenue we report in a period is attributable to orders we received during prior periods. Therefore, increases or decreases in new sales, customer expansion or renewals in a period may not be immediately reflected in revenue for the period. Quarterly Cost of Revenue Trends Our quarterly cost of revenue has generally increased quarter-over-quarter in each period presented above primarily as a result of third-party cloud infrastructure hosting and software costs, as well as increased headcount, which resulted in increased personnel expenses. Quarterly Gross Margin Trends Our quarterly gross margins have fluctuated between 73% and 79% in each period presented. Our gross margins increased in the last three quarters ended December 31, 2019 as a result of better optimization of cloud spend. Quarterly Operating Expense Trends Operating expenses have generally increased in each sequential quarter presented above primarily due to the increased headcount, infrastructure and related costs to support our growth. We intend to continue to make significant investments in research and development as we add features and enhance our platform. We also intend to invest in our sales and marketing organization to drive future revenue growth. Quarterly Other Income, Net Trends Other income, net stayed flat over the seven quarters ended September 30, 2019. During the last quarter ended December 31, 2019, we earned interest income from investments in money market funds and marketable securities. Liquidity and Capital Resources Since inception, we have financed operations primarily through sales of subscriptions and the net proceeds we have received from sales of equity securities as further detailed below. Our cash and cash equivalents primarily consist of bank deposits and money market funds. Our marketable securities consist of U.S. government treasury securities, commercial paper and corporate bonds. As of December 31, 2019, we had cash and cash equivalents of $597.3 million and marketable securities of $176.7 million. In September 2019, we closed our IPO of 27,600,000 shares of our Class A common stock at an offering price of $27.00 per share, including 3,600,000 shares pursuant to the underwriters’ option to purchase shares of our Class A common stock, resulting in aggregate net proceeds to us of $705.9 million after deducting underwriting discounts and commissions of $37.3 million and net offering expenses of $2.0 million. We believe that our existing cash and cash equivalents, marketable securities and cash flow from operations will be sufficient to support working capital and capital expenditure requirements for at least the next 12 months. Our future capital requirements will depend on many factors, including our subscription growth rate, subscription renewal activity, including the timing and the amount of cash received from customers, the expansion of sales and marketing activities, the timing and extent of spending to support development efforts, the introduction of new and enhanced products, and the continuing market adoption of our platform. We may, in the future, enter into arrangements to acquire or invest in complementary businesses, products, and technologies. We may be required to seek additional equity or debt financing. In the event that we require additional financing, we may not be able to raise such financing on terms acceptable to us or at all. If we are unable to raise additional capital or generate cash flows necessary to expand our operations and invest in continued innovation, we may not be able to compete successfully, which would harm our business, operations and financial condition. A substantial source of our cash from operations is from our deferred revenue, which is included in the liabilities section of our consolidated balance sheet. Deferred revenue consists of the unearned portion of customer billings, which is recognized as revenue in accordance with our revenue recognition policy. As of December 31, 2019, we had deferred revenue of $138.5 million, of which $134.1 million was recorded as a current liability and expected to be recognized as revenue in the next 12 months, provided all other revenue recognition criteria have been met. The following table shows a summary of our cash flows for the periods presented: Operating Activities Our largest source of operating cash is cash collection from sales of subscriptions to our customers. Our primary uses of cash from operating activities are for personnel expenses, marketing expenses, hosting expenses and overhead expenses. We have generated positive cash flows and have supplemented working capital requirements through net proceeds from the sale of equity securities. Cash provided by operating activities for the fiscal year ended December 31, 2019 of $24.2 million was primarily related to our net loss of $16.7 million, adjusted for non-cash charges of $50.5 million and net cash outflows of $9.5 million provided by changes in our operating assets and liabilities. Non-cash charges primarily consisted of stock-based compensation, depreciation and amortization of property and equipment, amortization of capitalized software, amortization of acquired intangibles and amortization of deferred contract costs. The main drivers of the changes in operating assets and liabilities were related to a $67.8 million increase in deferred revenue, resulting primarily from increased billings for subscriptions, a $6.4 million increase in accrued expenses and other liabilities, and a $2.5 million increase in accounts payable. These amounts were partially offset by a $47.5 million increase in accounts receivable, net, due to increases in sales, a $20.1 million increase in deferred contract costs related to commissions paid on new bookings, a $10.0 million increase in prepaid expenses and other current assets, primarily driven by prepaid hosting services, and a $8.5 million increase in other assets. Cash provided by operating activities for the fiscal year ended December 31, 2018 of $10.8 million was primarily related to our net loss of $10.8 million, adjusted for non-cash charges of $14.4 million and net cash inflows of $7.2 million provided by changes in our operating assets and liabilities. Non-cash charges primarily consisted of stock-based compensation, net of amounts capitalized, depreciation and amortization of property and equipment, amortization of capitalized software, and amortization of acquired intangibles. The main drivers of the changes in operating assets and liabilities were related to a $31.6 million increase in deferred revenue, resulting primarily from increased billings for subscriptions, a $7.2 million increase in accounts payable, and a $10.9 million increase in accrued expenses and other liabilities, due to an increase in headcount. These amounts were partially offset by a $25.3 million increase in accounts receivable, net, due to increases in sales, a $1.3 million increase in prepaid expenses and other current assets, primarily driven by prepaid hosting services, an $8.9 million increase in deferred contract costs related to commissions paid on new bookings, and a $7.0 million increase in other assets. Cash provided by operating activities for the fiscal year ended December 31, 2017 of $13.8 million was primarily related to our net loss of $2.6 million, adjusted for non-cash charges of $7.4 million and net cash inflows of $9.0 million provided by changes in our operating assets and liabilities. Non-cash charges primarily consisted of stock-based compensation, net of amounts capitalized, depreciation and amortization of property and equipment, amortization of capitalized software, and amortization of acquired intangibles. The main drivers of the changes in operating assets and liabilities were related to a $29.8 million increase in deferred revenue, resulting primarily from increased billings for subscriptions, a $4.6 million increase in accounts payable, and a $2.9 million increase in accrued expenses and other liabilities, due to an increase in headcount. These amounts were partially offset by a $19.3 million increase in accounts receivable, net, due to increases in sales, a $4.3 million increase in prepaid expenses and other current assets, a $3.4 million increase in deferred contract costs related to commissions paid on new bookings, and a $1.5 million increase in other assets. Investing Activities Cash used in investing activities for the years ended December 31, 2019, 2018 and 2017 was $202.2 million, $17.5 million and $12.8 million, respectively, and was primarily the result of investment in marketable securities, increases in capital expenditures to purchase property and equipment to support additional office space and site operations, increases in capitalization of software development costs and increases in acquired intangibles. Financing Activities Cash provided by financing activities for the year ended December 31, 2019 was $714.2 million and was primarily the result of aggregate net proceeds from our IPO in the amount of $706.3 million and proceeds from the exercise of stock options in the amount of $7.9 million. Cash provided by financing activities for the fiscal years ended December 31, 2018 and 2017 was $7.8 million and $0.5 million, respectively, and was primarily the result of proceeds from the exercise of stock options. Non-GAAP Free Cash Flow We report our financial results in accordance with U.S. GAAP. To supplement our consolidated financial statements, we provide investors with the amount of free cash flow, which is a non-GAAP financial measure. Free cash flow represents net cash used in operating activities, reduced by capital expenditures and capitalized software development costs, if any. Free cash flow is a measure used by management to understand and evaluate our liquidity and to generate future operating plans. The reduction of capital expenditures and amounts capitalized for software development facilitates comparisons of our liquidity on a period-to-period basis and excludes items that we do not consider to be indicative of our liquidity. We believe that free cash flow is a measure of liquidity that provides useful information to our management, board of directors, investors and others in understanding and evaluating the strength of our liquidity and future ability to generate cash that can be used for strategic opportunities or investing in our business. Nevertheless, our use of free cash flow has limitations as an analytical tool, and you should not consider it in isolation or as a substitute for analysis of our financial results as reported under GAAP. Further, our definition of free cash flow may differ from the definitions used by other companies and therefore comparability may be limited. You should consider free cash flow alongside our other GAAP-based financial performance measures, such as net cash used in operating activities, and our other GAAP financial results. The following table presents a reconciliation of free cash flow to net cash used in operating activities, the most directly comparable GAAP measure, for each of the periods indicated. The following table presents our cash flows for the periods presented and a reconciliation of free cash flow to net cash provided by operating activities, the most directly comparable financial measure calculated in accordance with GAAP: Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2019: The commitment amounts in the table above are associated with contracts that are enforceable and legally binding and that specify all significant terms, including fixed or minimum services to be used, fixed, minimum or variable price provisions, and the approximate timing of the actions under the contracts. Our operating lease commitments relate primarily to our office space. The significant operating lease obligations relate to leases for our New York, Boston, Paris and Dublin office spaces. Purchase commitments relate mainly to hosting agreements as well as computer software used to facilitate our operations at the enterprise level. In January 2020, we entered into an agreement with Microsoft Azure, pursuant to which we are required to purchase an aggregate of at least $21.0 million of cloud services through January 2023. This agreement is not reflected in the table above. We have also excluded unrecognized tax benefits from the contractual obligations table above. A variety of factors could affect the timing of payments for the liabilities related to unrecognized tax benefits. Therefore, we cannot reasonably estimate the timing of such payments. We believe that these matters will likely not be resolved in the next 12 months and accordingly we have classified the estimated liability as non-current in the consolidated balance sheet. For further information see Note 12 in our Notes to Consolidated Financial Statements included in “Part II, Item 8. Financial Statements” of this Annual Report on Form 10-K. Off-Balance Sheet Arrangements As of December 31, 2019 we did not have any off-balance sheet financing arrangements or any relationships with unconsolidated entities or financial partnerships, including entities sometimes referred to as structured finance or special purpose entities, that were established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Critical Accounting Policies and Estimates Our financial statements are 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, 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. Our actual results could differ from these estimates. We believe that the accounting policies described below involve a greater degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of operations. Revenue Recognition We generate revenue from the sale of subscriptions to customers using our cloud-based platform. The terms of our subscription agreements are primarily monthly or annual, with the majority of our revenue coming from annual subscriptions. Our customers can enter into a subscription for a committed contractual amount of usage that is apportioned ratably on a monthly basis over the term of the subscription period, a subscription for a committed contractual amount of usage that is delivered as used, or a monthly subscription based on usage. To the extent that our customers’ usage exceeds the committed contracted amounts under their subscriptions, either on a monthly basis in the case of a ratable subscription or once the entire commitment is used in the case of a delivered-as-used subscription, they are charged for their incremental usage. We elected to early adopt Financial Accounting Standards Board, Accounting Standards Codification Topic 606, Revenue from Contracts with Customers, or Topic 606, effective January 1, 2017, using the full retrospective method of adoption. As such, the consolidated financial statements present revenue in accordance with Topic 606 for the period presented. We account for revenue contracts with customers through the following steps: • identify the contract with a customer; • identify the performance obligations in the contract; • determine the transaction price; • allocate the transaction price to the performance obligations in the contract; and • recognize revenue when or as, we satisfy a performance obligation. Our subscriptions are generally non-cancellable. Once we have determined the transaction price, the total transaction price is allocated to each performance obligation in the contract on a relative stand-alone selling price basis, or SSP. The determination of a relative stand-alone SSP for each distinct performance obligation requires judgment. We determine SSP for performance obligations based on overall pricing objectives, which take into consideration market conditions and customer-specific factors. This includes a review of internal discounting tables, the service(s) being sold, and customer demographics. Revenue is recognized when control of these services is transferred to customers, in an amount that reflects the consideration we expect to be entitled to receive in exchange for those services. We determined an output method to be the most appropriate measure of progress because it most faithfully represents when the value of the services are simultaneously received and consumed by the customer, and control is transferred. For committed contractual amounts of usage, revenue is recognized ratably over the term of the subscription agreement generally beginning on the date that the platform is made available to a customer. For committed contractual amount of usage that is delivered as used, a monthly subscription based on usage, or usage in excess of a ratable subscription, we recognize revenue as the services are rendered. Stock-Based Compensation We account for stock-based compensation expense related to stock-based awards based on the estimated fair value of the award on the grant date. We historically issued options to purchase shares of our common stock under our 2012 equity incentive plan, or the 2012 Plan. Following the IPO, we ceased granting awards under the 2012 Plan, and all shares that remained available for issuance under the 2012 Plan at that time were transferred to our 2019 equity incentive plan, or the 2019 Plan. Under the 2019 Plan, we may grant stock options, stock appreciation rights, restricted stock awards, restricted stock units, or RSUs, and performance-based and other awards, each valued or based on our Class A common stock, to our employees, directors, consultants, and advisors. Through December 31, 2019, we have only issued stock options and RSUs in connection with the 2012 Plan and 2019 Plan. For further information see Note 11 in our Notes to Consolidated Financial Statements included in “Part II, Item 8. Financial Statements” of this Annual Report on Form 10-K. Compensation expense related to stock-based transactions, including employee, consultant, and non-employee director stock option awards, is measured and recognized in the consolidated financial statements based on fair value. The fair value of each option award is estimated on the grant date using the Black Scholes option-pricing model. Expense is recognized on a straight-line basis over the vesting period of the award. Forfeitures are accounted for in the period in which the awards are forfeited. Our option-pricing model requires the input of highly subjective assumptions, including the fair value of the underlying common stock, the expected term of the option, the expected volatility of the price of our common stock, risk-free interest rates, and the expected dividend yield of our common stock. The assumptions used in our option-pricing model represent management’s best estimates. These estimates involve inherent uncertainties and the application of management’s judgment. If factors change and different assumptions are used, our stock-based compensation expense could be materially different in the future. These assumptions are estimated as follows: • Fair value. Prior to our IPO, the fair value of common stock underlying the stock options had historically been determined by our Board of Directors, with input from our management. Our Board of Directors previously determined the fair value of the common stock at the time of grant of the options by considering a number of objective and subjective factors, including the results of contemporaneous independent third-party valuations of our common stock, the prices, rights, preferences, and privileges of our redeemable convertible Preferred Stock relative to those of our common stock, the prices of common or convertible preferred stock sold to third-party investors by us and in secondary transactions or repurchased by us in arm’s-length transactions, the lack of marketability of our common stock, actual operating and financial results, current business conditions and projections, the likelihood of achieving a liquidity event, such as an initial public offering or a merger or acquisition of our company given prevailing market conditions. Subsequent to our IPO, the fair value of the underlying common stock is determined by the closing price, on the date of grant, of our Class A common stock, as reported by the Nasdaq. • Expected volatility. Expected volatility is a measure of the amount by which the stock price is expected to fluctuate. Since we do not have sufficient trading history of our common stock, we estimate the expected volatility of our stock options at the grant date by taking the average historical volatility of a group of comparable publicly traded companies over a period equal to the expected life of the options. • Expected term. We determine the expected term based on the average period the stock options are expected to remain outstanding using the simplified method, generally calculated as the midpoint of the stock options’ vesting term and contractual expiration period, as we do not have sufficient historical information to develop reasonable expectations about future exercise patterns and post-vesting employment termination behavior. • Risk-free rate. We use the U.S. Treasury yield for our risk-free interest rate that corresponds with the expected term. • Expected dividend yield. We utilize a dividend yield of zero, as we do not currently issue dividends, nor do we expect to do so in the future. The following assumptions were used to calculate the fair value of stock options granted to employees: Assumptions used in valuing non-employee stock options are generally consistent with those used for employee stock options with the exception that the expected term is over the contractual life, or 10 years. Prior to January 1, 2018, we estimated a forfeiture rate to calculate stock-based compensation. We adopted ASU No. 2016-09, Compensation-Stock Compensation (Topic 718), effective January 1, 2018, and elected to account for forfeitures as they occur, rather than estimating expected forfeitures over the course of a vesting period. We recognized a cumulative effect of $0.8 million to accumulated deficit as of January 1, 2018 upon adoption. For further information see Note 2 in our Notes to Consolidated Financial Statements included in “Part II, Item 8. Financial Statements” of this Annual Report on Form 10-K. 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. Internal Use Software Development Costs We capitalize certain costs related to the development of our platform and other software applications for internal use. In accordance with authoritative guidance, we begin to capitalize our costs to develop software when preliminary development efforts are successfully completed, management has authorized and committed project funding, and it is probable that the project will be completed and the software will be used as intended. We stop capitalizing these costs when the software is substantially complete and ready for its intended use, including the completion of all significant testing. These costs are amortized on a straight-line basis over the estimated useful life of the related asset, generally estimated to be two years. We also capitalize costs related to specific upgrades and enhancements when it is probable the expenditure will result in additional functionality and expense costs incurred for maintenance and minor upgrades and enhancements. Costs incurred prior to meeting these criteria together with costs incurred for training and maintenance are expensed as incurred and recorded within research and development expenses in our consolidated statements of operations. We exercise judgment in determining the point at which various projects may be capitalized, in assessing the ongoing value of the capitalized costs and in determining the estimated useful lives over which the costs are amortized. To the extent that we change the manner in which we develop and test new features and functionalities related to our platform, assess the ongoing value of capitalized assets or determine the estimated useful lives over which the costs are amortized, the amount of internal-use software development costs we capitalize and amortize could change in future periods. Recently Adopted Accounting Pronouncements See Note 2, in our Notes to Consolidated Financial Statements included in “Part II, Item 8. Financial Statements” of this Annual Report on Form 10-K for a discussion of recent accounting pronouncements. JOBS Act Accounting Election We are an emerging growth company, as defined in the JOBS Act. The JOBS Act provides that an emerging growth company can take advantage of an extended transition period for complying with new or revised accounting standards. This provision allows an emerging growth company to delay the adoption of some accounting standards until those standards would otherwise apply to private companies. We have elected to use the extended transition period under the JOBS Act until the earlier of the date we (1) are no longer an emerging growth company or (2) 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.

<s>[INST] Overview Datadog is the monitoring and analytics platform for developers, IT operations teams and business users in the cloud age. Our SaaS platform integrates and automates infrastructure monitoring, application performance monitoring and log management to provide unified, realtime observability of our customers’ entire technology stack. Datadog is used by organizations of all sizes and across a wide range of industries to enable digital transformation and cloud migration, drive collaboration among development, operations and business teams, accelerate time to market for applications, reduce time to problem resolution, understand user behavior and track key business metrics. We generate revenue from the sale of subscriptions to customers using our cloudbased platform. Our paid subscriptions are available in Pro and Enterprise tiers. The terms of our subscription agreements are primarily monthly or annual. Customers also have the option to purchase additional products, such as additional containers to monitor, custom metrics packages, anomaly detection and app analytics. Professional services are generally not required for the implementation of our products and revenue from such services has been immaterial to date. We employ a landandexpand business model centered around offering products that are easy to adopt and have a very short time to value. Our customers can expand their footprint with us on a selfservice basis. Our customers often significantly increase their usage of the products they initially buy from us and expand their usage to other products we offer on our platform. We grow with our customers as they expand their workloads in the public and private cloud. As of December 31, 2019, we had $601.2 million in cash, cash equivalents and restricted cash and $176.7 million in marketable securities. We have grown rapidly in recent periods, with revenues for the fiscal years ended December 31, 2019, 2018 and 2017 of $362.8 million, $198.1 million, and $100.8 million, respectively, representing yearoveryear growth of 83% from the fiscal year ended December 31, 2018 to the fiscal year ended December 31, 2019 and 97% from the fiscal year ended December 31, 2017 to the fiscal year ended December 31, 2018. Substantially all of our revenue is subscription software sales. We expect that the rate of growth in our revenue will decline as our business scales, even if our revenue continues to grow in absolute terms. We have continued to make significant expenditures and investments, including in personnelrelated costs, sales and marketing, infrastructure and operations, and have incurred net loss in each period since our inception, including net loss of $(16.7) million, $(10.8) million and $(2.6) million for the fiscal years ended December 31, 2019, 2018 and 2017, respectively. Our operating cash flow was $24.2 million, $10.8 million and $13.8 million for the years ended December 31, 2019, 2018 and 2017 respectively. Our free cash flow was $0.8 million, $(5.0) million and $6.0 million for the years ended December 31, 2019, 2018 and 2017 respectively. See the section titled “Liquidity and Capital ResourcesNonGAAP Free Cash Flow” below. Our employee headcount has increased to 1,403 employees as of December 31, 2019 from 886 as of December 31, 2018. We plan to continue to aggressively invest in the growth of our business to take advantage of our market opportunity. Factors Affecting Our Performance Acquiring New Customers We believe there is substantial opportunity to continue to grow our customer base. We intend to drive new customer acquisition by continuing to invest significantly in sales and marketing to engage our prospective customers, increase brand awareness and drive adoption of our platform and products. We also plan to continue to invest in building brand awareness within the development and operations communities. As of December 31, 2019, we had approximately 10,500 customers spanning organizations of a broad range of sizes and industries. Our ability to attract new customers will depend on a number of factors, including the effectiveness and [/INST] Positive. </s>

Turning Point Therapeutics, Inc.

2020-03-18

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 financial statements and related notes thereto included elsewhere in this Annual Report. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report, 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 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 the comparison of the financial results for the fiscal years ended December 31, 2018 and 2017, see Management’s Discussion and Analysis of Financial Condition and Results of Operations, in our Registration Statement on Form S-1, as amended, originally filed with the SEC on March 21, 2019. References in the following discussion to "we," "our," "us," "Turning Point" or "the Company" refer to Turning Point Therapeutics, Inc. Overview We are a clinical-stage biopharmaceutical company designing and developing novel small molecule, targeted oncology therapies to address key limitations of existing therapies and improve the lives of patients. Our internally developed and wholly owned pipeline of next-generation tyrosine kinase inhibitors (TKIs) targets numerous genetic drivers of cancer in both TKI-naïve and TKI-pretreated patients. The pervasive challenges of intrinsic and acquired treatment resistance often limit the response rate and durability of existing therapies. One of these challenges is the emergence of solvent front mutations, which are a common cause of acquired resistance to currently approved therapies for ROS1, TRK and ALK kinases. We have developed a macrocycle platform enabling us to design proprietary small, compact TKIs with rigid three-dimensional structures that potentially bind to their targets with greater precision and affinity than other kinase inhibitors. We believe the TKIs generated from our drug discovery platform have the potential to be best-in-class. Our lead drug candidate, repotrectinib, is being evaluated in an ongoing Phase 1/2 trial called TRIDENT-1 for the treatment of patients with ROS1+ advanced non-small-cell lung cancer (NSCLC) and patients with NTRK+ advanced solid tumors. We initiated the multi-cohort Phase 2 registrational portion of TRIDENT-1 in June 2019 and we anticipate reporting interim data from initial patients from some of the registrational cohorts within the Phase 2 portion of TRIDENT-1 in the second half of 2020. We plan to conduct the Phase 2 portion of the trial in approximately 100 sites in the United States, Europe and Asia-Pacific regions, and to enroll a total of approximately 320 patients. The Phase 2 portion of TRIDENT-1 is a registrational trial for potential approval in ROS1+ advanced NSCLC and NTRK+ advanced solid tumors. We also commenced a Phase 1/2 study of repotrectinib in pediatric and young adult patients with ROS1+, TRK+ or ALK+ advanced solid tumors in November 2019. In addition to repotrectinib, our pipeline includes two clinical-stage multi-targeted kinase inhibitors, TPX-0022 (a novel MET/CSF1R/SRC inhibitor) and TPX-0046 (a novel RET/SRC inhibitor), and a preclinical ALK inhibitor, TPX-0131, which is entering IND-enabling studies. We initiated our Phase 1 clinical trial of TPX-0022 in patients with advanced solid tumors harboring genetic alterations in MET in July 2019. The Phase 1 trial is designed to evaluate the overall safety profile, pharmacokinetics and preliminary efficacy of TPX-0022 and includes a dose-escalation portion starting at 20 mg daily, or QD, followed by dose expansion cohorts with a targeted enrollment of 120 patients at sites in the United States, Europe, and Asia-Pacific regions. The dose expansion cohorts are planned to enroll MET therapy-naïve and pretreated NSCLC patients with MET exon 14 skipping mutations; patients with MET-amplified NSCLC, hepatocellular, gastric or gastroesophageal cancer; and patients with other solid tumors harboring MET kinase domain mutations or MET fusions. We anticipate reporting early interim data from initial patients treated with TPX-0022 in this Phase 1 trial in the second half of 2020. We initiated our Phase 1/2 clinical trial of TPX-0046 in patients with advanced solid tumors harboring RET genetic alterations in the fourth quarter of 2019. The trial is designed to enroll TKI-naïve and TKI-pretreated patients with RET-altered non-small-cell lung, thyroid, and other advanced cancers in multiple cohorts to assess safety, tolerability, pharmacokinetics and preliminary clinical activity of TPX-0046, with a targeted enrollment of approximately 50 patients in the Phase 1 dose escalation portion, and approximately 300 patients in the Phase 2 expansion portion at sites in the United States, Europe and Asia-Pacific regions. The study design allows intra-patient dose escalation based on tolerability in both RET TKI-treatment naïve and pretreated patients. As we advance our clinical programs with site activations and patient enrollment across our three clinical stage drug candidates, we are in close contact with our CROs and clinical sites as we navigate and assess the impact of COVID-19 on our studies and current timelines. Our fourth drug candidate, TPX-0131 is a next-generation preclinical ALK inhibitor. TPX-0131 has been designed with a compact macrocyclic structure and in preclinical studies has been shown to potently inhibit wildtype ALK and numerous ALK mutations, in particular the clinically observed G1202R solvent front mutation and G1202R/L1196M compound mutation. Pending successful completion of IND-enabling studies, we anticipate submitting an IND for TPX-0131 in early 2021. 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 drug candidates. As of December 31, 2019, we had an accumulated deficit of $122.9 million and we incurred net losses of approximately $72.1 million for the year ended December 31, 2019. We expect to continue to incur significant expenses and increasing operating losses for at least the next several years. We will not generate revenue from product sales unless we successfully complete clinical development and obtain regulatory approval for our drug candidates. If we obtain regulatory approval for any of our drug candidates and do not enter into a commercialization partnership, we expect to incur significant expenses related to developing our internal commercialization capability to support product sales, marketing and distribution. We also 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 we may have to significantly delay, scale back or discontinue the development and commercialization of one or more of our drug candidates. On April 22, 2019, we completed an initial public offering whereby we sold an aggregate of 10,637,500 shares of our common stock at a price of $18.00 per share, resulting in net proceeds of $175.2 million after deducting underwriting discounts, commissions and other offering costs. On September 10, 2019, we completed an additional public offering of our common stock which resulted in the issuance and sale of 4,500,000 shares of common stock at a price of $45.00 per share, resulting in net proceeds of $189.5 million after deducting underwriting discounts and commissions and other offering costs. Components of Our Results of Operations Revenue To date, we have not generated any revenue from product sales, licenses or collaborations and do not expect to generate any revenue from the sale of products in the foreseeable future. If our development efforts for our drug candidates are successful and result in regulatory approval, we may generate revenue from future product sales. If we enter into license or collaboration agreements for any of our drug candidates or intellectual property, we may generate revenue in the future from payments as a result of such license or collaboration agreements. We cannot predict if, when, or to what extent we will generate revenue from the commercialization and sale of our drug candidates. We may never succeed in obtaining regulatory approval for any of our drug candidates. Operating Expenses Research and Development Expenses Research and development expenses include: • employee-related expenses, including salaries, related benefits, travel 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 drug candidates, including expenses incurred under agreements with contract research organizations (CROs); • the cost of consultants and contract manufacturing organizations (CMOs) that manufacture drug products for use in our preclinical studies and clinical trials; and • facilities, depreciation and other expenses, which include allocated expenses for rent and maintenance of facilities, insurance and supplies. We expense research and development costs to operations as incurred. Nonrefundable advance payments for goods or services to be received in the future for use in research and development activities are recorded as prepaid assets. Our prepaid assets are expensed as the related goods are delivered or the services are performed. 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 consultants, central laboratories, contractors, CMOs and CROs in connection with our preclinical and clinical development activities. We allocate indirect expenses, such as employee salaries, fringe benefits, facilities, travel and other miscellaneous expenses, based on an estimated percentage of time worked on programs. The table below summarizes our research and development expenses incurred by development program for the periods presented (in thousands): Drug 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 clinical and preclinical development activities in the near term and in the future. 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 drug candidates. The successful development of our drug candidates is highly uncertain. This is due to the numerous risks and uncertainties, including the following: • successful completion of preclinical studies and clinical trials; • 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; • the number and location of clinical sites included in the trials; • raising additional funds necessary to complete clinical development of our drug candidates; • obtaining and maintaining patent, trade secret and other intellectual property protection and regulatory exclusivity for our drug candidates; • making arrangements with third-party manufacturers, or establishing manufacturing capabilities, for clinical supplies of our drug candidates; • the ability to obtain clearance or approval of companion diagnostic tests, if required, on a timely basis, or at all; • the results of our clinical trials; • protecting and enforcing our rights in our intellectual property portfolio; and • maintaining a continued acceptable safety profile of the products following approval. A change in the outcome of any of these variables with respect to the development of our drug candidates may significantly impact the costs and timing associated with the development of our drug candidates. We may never succeed in obtaining regulatory approval for any of our drug candidates. Research and development activities are central to our business model. There are numerous factors associated with the successful commercialization of any of our drug candidates, including future trial design and various regulatory requirements, many of which cannot be determined with accuracy at this time based on our stage of development. In addition, future regulatory factors beyond our control may impact our clinical development programs. General and Administrative Expenses General and administrative expenses consist primarily of salaries and related costs for personnel in executive, finance and administrative functions, including stock-based compensation. General and administrative expenses also include travel expenses and direct and allocated facility-related costs, as well as professional fees for legal, accounting and tax-related services and insurance costs. We anticipate that our general and administrative expenses 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. Other income, net Interest income consists of interest earned on cash and cash equivalents and our marketable securities. Income Taxes We are subject to typical corporate U.S. federal and state income taxation. As of December 31, 2019, we had federal and state net operating loss carryforwards of approximately $105.8 million and $111.6 million, respectively. Portions of the federal and state net operating loss carryforwards will begin to expire in 2033 if not utilized. The $86.1 million of the federal net operating loss carryforwards generated post 2017 is limited to 80% of taxable income generated in any given year and can be carried forward indefinitely. As of December 31, 2019, we had federal and state research and development tax credits of approximately $1.0 million and $1.7 million, respectively. As of December 31, 2019, we had federal Orphan Drug tax credits of approximately $12.9 million. If not utilized, the federal research tax credit will begin to expire in 2035 and the Orphan Drug credit will begin to expire in 2037. The California research tax credit 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 Section 382 of the Code and similar provisions of state law. The annual limitations in Sections 382 and 383 of the Code may result in the expiration of our net operating loss and tax credit carryforwards before utilization. We have not performed an analysis to determine whether our net operating loss and credit carryforwards are subject to an annual limitation under Sections 382 or 383 of the Code. Critical Accounting Policies and Significant Judgments and Estimates Our management’s discussion and analysis of our financial condition and results of operations are based on our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of our financial statements and related disclosures requires us to make estimates and judgments that affect the reported amounts of assets and liabilities, related disclosure of contingent liabilities at the date of the financial statements, and the reported amounts of expenses and other income during the reporting period. We continually evaluate our estimates and judgments, the most critical of which are those related to preclinical and clinical study accruals and stock-based compensation costs. We base our estimates and judgments on historical experience and other factors that we believe to be reasonable under the circumstances. Materially different results can occur as circumstances change and additional information becomes known. While our significant accounting policies are described in more detail in Note 2 to our financial statements appearing in this Annual Report, we believe that the following accounting policies are those most critical to the judgments and estimates used in the preparation of our financial statements. 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 drug candidates, which include: • employee-related expenses, including salaries, related benefits, travel 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 drug candidates, including expenses incurred under agreements with contract research organizations (CROs); • the cost of consultants and contract manufacturing organizations (CMOs) that manufacture drug products for use in our preclinical studies and clinical trials; and • facilities, depreciation and other expenses, which include allocated expenses for rent and maintenance of facilities, insurance and supplies. We expense research and development costs to operations as incurred. Nonrefundable advance payments for goods or services to be received in the future for use in research and development activities are recorded as prepaid assets. Our prepaid assets are expensed as the related goods are delivered or the services are performed. 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 consultants, central laboratories, contractors, CMOs and CROs in connection with our preclinical and clinical development activities. We allocate indirect expenses, such as employee salaries, fringe benefits, facilities, travel and other miscellaneous expenses, based on an estimated percentage of time worked on programs. Stock-Based Compensation Expense For purposes of calculating stock-based compensation, we estimate the fair value of stock options issued using a Black-Scholes option-pricing model. The determination of the fair value of stock-based payment awards utilizing the Black-Scholes model is affected by the Company’s stock price and a number of assumptions, including expected volatility, expected life, risk-free interest rate and expected dividends. Expected Term-We have opted to use the “simplified method” for estimating the expected term of employee options, whereby the expected term equals the arithmetic average of the vesting term and the original contractual term of the option (generally 10 years). Expected Volatility-Due to our limited operating history 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 data was computed using the daily closing prices for the selected companies’ shares during the equivalent period of the calculated expected term of the stock-based awards. Risk-Free Interest Rate-The risk-free rate assumption is based on the U.S. Treasury instruments with maturities similar to the expected term of our stock options. Expected Dividend-We have not issued any dividends and do not expect to issue dividends over the life of the options. As a result, we have estimated the dividend yield to be zero. The estimated fair value of stock options granted to employees and non-employee service providers are expensed over the requisite service period (generally the vesting term) on a straight-line basis. We account for the impact of forfeitures as they occur. 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. 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): Research and development expenses Research and development expenses increased by $36.9 million from $21.1 million during 2018 to $57.9 million during 2019. The increase was primarily attributable to the 2019 commencements of the Phase 2 registrational portion of TRIDENT-1, the Phase 1 trial for TPX-0022 and the Phase 1/2 trial TPX-0046. General and administrative expenses General and administrative expenses increased by $15.2 million from $4.6 million during 2018 to $19.8 million during 2019. The increase was primarily attributable to higher personnel-related expenses as a result of increased employee head count and professional fees for legal and accounting services, which supported our transition to becoming a public company in 2019. In January 2020, we entered into a Transition Separation and Consulting Agreement with Jingrong Jean Cui, in connection with Dr. Cui’s resignation from her position as Chief Scientific Officer effective January 31, 2020. In accordance with the terms of the agreement with Dr. Cui we will record an expense in the amount of $1.2 million during fiscal year 2020 for cash severance that will be paid to Dr. Cui during 2020. In addition, we anticipate recording non-cash stock-based compensation expense in fiscal year 2020 related to the modification of Dr. Cui’s outstanding stock option grants. Other income, net Other income, net increased by $4.7 million from $0.9 million during 2018 to $5.6 million during 2019. The increase was primarily driven by an increase in interest earned on our higher marketable securities and money market account balances resulting from our public offerings in 2019. Liquidity and Capital Resources; Plan of Operations Based on our current and anticipated level of operations, we believe that our cash and cash equivalents and marketable securities will be sufficient to fund current operations for at least one year from the date that this Annual Report on Form 10-K is filed with the SEC. At December 31, 2019, we had $409.2 million of cash and cash equivalents and marketable securities. Our cash and cash equivalents and marketable securities include money market funds, government agency securities, corporate debt and commercial paper. We maintain established guidelines relating to diversification and maturities of our investments to preserve principal and maintain liquidity. Since inception, our operations have been financed primarily through the sale of equity and convertible preferred stock. Through December 31, 2019, we received net proceeds of approximately $512.0 million from the issuance of common stock and convertible preferred stock. Most recently, on April 22, 2019, we completed our initial public offering whereby we sold an aggregate of 10,637,500 shares of our common stock at a price of $18.00 per share, resulting in net proceeds of $175.2 million after deducting underwriting discounts, commissions and offering costs payable by us. In addition, on September 10, 2019, we completed an additional public offering of our common stock, which resulted in the issuance and sale of an aggregate of 4,500,000 shares of common stock at a price of $45.00 per share, resulting in net proceeds of $189.5 million after deducting underwriting discounts and commissions and other offering costs. Since inception, we have primarily devoted our resources to funding research and development programs, including discovery research, preclinical and clinical development activities. To fund future operations, we will need to raise significant additional capital. The amount and timing of future funding requirements will depend on many factors, including the timing and results of our ongoing development activities, the potential expansion of our current development programs, potential new development programs and related general and administrative support. We may seek to obtain additional financing in the future through equity or debt financings or other sources, such as potential collaboration agreements. We cannot make assurances that anticipated additional financing will be available to us on favorable terms, or at all. Although we have previously been successful in obtaining financing through our equity securities offerings, there can be no assurance that we will be able to do so in the future. Cash Flows The following table summarizes our sources and uses of cash for each of the periods presented (in thousands): Operating Activities During the year ended December 31, 2019, operating activities used approximately $57.8 million primarily due to the 2019 commencements of the Phase 2 registrational portion of TRIDENT-1, the Phase 1 trial for TPX-0022 and Phase 1/2 trial for TPX-0046 in 2019. During the year ended December 31, 2018, operating activities used approximately $23.5 million due to increases in headcount to support the development of our pipeline. During the year ended December 31, 2017, operating activities used approximately $12.6 million due to increases in headcount to support the development of our pipeline. Investing Activities During the year ended December 31, 2019, investing activities used approximately $361.1 million primarily resulting from the purchase (net of sales and maturities) of marketable securities using the proceeds from our public offerings during 2019 totaling $359.4 million. In addition, we purchased property and equipment totaling $1.7 million during 2019. During the year ended December 31, 2018, investing activities used approximately $0.3 million primarily resulting from the purchases of property and equipment. During the year ended December 31, 2017, investing activities was related to purchases of property and equipment, primarily laboratory equipment. Financing Activities During the year ended December 31, 2019, financing activities provided approximately $366.0 million of cash, primarily resulting from the net proceeds from our April 2019 initial public offering and September 2019 public offering and from option exercises. During the year ended December 31, 2018, financing activities provided approximately $79.8 million in net proceeds from the sale and issuance of our Series D convertible preferred stock. During the year ended December 31, 2017, financing activities provided approximately $44.9 million in net proceeds from the sale and issuance of our Series C convertible preferred stock. Contractual Obligations and Commitments The following table summarizes our contractual obligations, excluding interest, as of December 31, 2019: We enter into contracts in the normal course of business with various third parties for clinical trials, preclinical research studies and testing, manufacturing and other services and products for operating purposes. These contracts provide for termination upon notice. 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 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 in the rules and regulations of the Securities and Exchange Commission.

<s>[INST] References in the following discussion to "we," "our," "us," "Turning Point" or "the Company" refer to Turning Point Therapeutics, Inc. Overview We are a clinicalstage biopharmaceutical company designing and developing novel small molecule, targeted oncology therapies to address key limitations of existing therapies and improve the lives of patients. Our internally developed and wholly owned pipeline of nextgeneration tyrosine kinase inhibitors (TKIs) targets numerous genetic drivers of cancer in both TKInaïve and TKIpretreated patients. The pervasive challenges of intrinsic and acquired treatment resistance often limit the response rate and durability of existing therapies. One of these challenges is the emergence of solvent front mutations, which are a common cause of acquired resistance to currently approved therapies for ROS1, TRK and ALK kinases. We have developed a macrocycle platform enabling us to design proprietary small, compact TKIs with rigid threedimensional structures that potentially bind to their targets with greater precision and affinity than other kinase inhibitors. We believe the TKIs generated from our drug discovery platform have the potential to be bestinclass. Our lead drug candidate, repotrectinib, is being evaluated in an ongoing Phase 1/2 trial called TRIDENT1 for the treatment of patients with ROS1+ advanced nonsmallcell lung cancer (NSCLC) and patients with NTRK+ advanced solid tumors. We initiated the multicohort Phase 2 registrational portion of TRIDENT1 in June 2019 and we anticipate reporting interim data from initial patients from some of the registrational cohorts within the Phase 2 portion of TRIDENT1 in the second half of 2020. We plan to conduct the Phase 2 portion of the trial in approximately 100 sites in the United States, Europe and AsiaPacific regions, and to enroll a total of approximately 320 patients. The Phase 2 portion of TRIDENT1 is a registrational trial for potential approval in ROS1+ advanced NSCLC and NTRK+ advanced solid tumors. We also commenced a Phase 1/2 study of repotrectinib in pediatric and young adult patients with ROS1+, TRK+ or ALK+ advanced solid tumors in November 2019. In addition to repotrectinib, our pipeline includes two clinicalstage multitargeted kinase inhibitors, TPX0022 (a novel MET/CSF1R/SRC inhibitor) and TPX0046 (a novel RET/SRC inhibitor), and a preclinical ALK inhibitor, TPX0131, which is entering INDenabling studies. We initiated our Phase 1 clinical trial of TPX0022 in patients with advanced solid tumors harboring genetic alterations in MET in July 2019. The Phase 1 trial is designed to evaluate the overall safety profile, pharmacokinetics and preliminary efficacy of TPX0022 and includes a doseescalation portion starting at 20 mg daily, or QD, followed by dose expansion cohorts with a targeted enrollment of 120 patients at sites in the United States, Europe, and AsiaPacific regions. The dose expansion cohorts are planned to enroll MET therapynaïve and pretreated NSCLC patients with MET exon 14 skipping mutations; patients with METamplified NSCLC, hepatocellular, gastric or gastroesophageal cancer; and patients with other solid tumors harboring MET kinase domain mutations or MET fusions. We anticipate reporting early interim data from initial patients treated with TPX0022 in this Phase 1 trial in the second half of 2020. We initiated our Phase 1/2 clinical trial of TPX0046 in patients with advanced solid tumors harboring RET genetic alterations in the fourth quarter of 2019. The trial is designed to enroll TKInaïve and TKIpretreated patients with RETaltered nonsmallcell lung, thyroid, and other advanced cancers in multiple cohorts to assess safety [/INST] Positive. </s>

STERIS plc

2019-05-30

2019-03-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INTRODUCTION In Management’s Discussion and Analysis (“MD&A”), we explain the general financial condition and the results of operations for STERIS and its subsidiaries including: • what factors affect our business; • what our earnings and costs were; • why those earnings and costs were different from the year before; • where our earnings came from; • how this affects our overall financial condition; • what our expenditures for capital projects were; and • where cash will come from to fund future debt principal repayments, growth outside of core operations, repurchase ordinary shares, pay cash dividends and fund future working capital needs. The MD&A also analyzes and explains the annual changes in the specific line items in the Consolidated Statements of Income. As you read the MD&A, it may be helpful to refer to information in Item 1, “Business,” Item 6, “Selected Financial Data,” and our consolidated financial statements, which present the results of our operations for fiscal 2019, 2018 and 2017, as well as Part I, Item 1A, “Risk Factors” and Note 10 of our consolidated financial statements titled, "Commitments and Contingencies" for a discussion of some of the matters that can adversely affect our business and results of operations. This information, discussion, and disclosure may be important to you in making decisions about your investments in STERIS. FINANCIAL MEASURES In the following sections of the MD&A, we may, at times, refer to financial measures that are not required to be presented in the consolidated financial statements under U.S. GAAP. We sometimes use the following financial measures in the context of this report: backlog; debt-to-total capital; and days sales outstanding. We define these financial measures as follows: • Backlog - We define backlog as the amount of unfilled capital equipment purchase orders at a point in time. We use this figure as a measure to assist in the projection of short-term financial results and inventory requirements. • Debt-to-total capital - We define debt-to-total capital as total debt divided by the sum of total debt and shareholders’ equity. We use this figure as a financial liquidity measure to gauge our ability to borrow and fund growth. • Days sales outstanding (“DSO”) - We define DSO as the average collection period for accounts receivable. It is calculated as net accounts receivable divided by the trailing four quarters’ revenues, multiplied by 365 days. We use this figure to help gauge the quality of accounts receivable and expected time to collect. We, at times, may also refer to financial measures which are considered to be “non-GAAP financial measures” under SEC rules. We have presented these financial measures because we believe that meaningful analysis of our financial performance is enhanced by an understanding of certain additional factors underlying that performance. These financial measures should not be considered an alternative to measures required by accounting principles generally accepted in the United States. Our calculations of these measures may differ from calculations of similar measures used by other companies and you should be careful when comparing these financial measures to those of other companies. Additional information regarding these financial measures, including reconciliations of each non- GAAP financial measure, is available in the subsection of MD&A titled, "Non-GAAP Financial Measures." REVENUES- DEFINED As required by Regulation S-X, we separately present revenues generated as either product revenues or service revenues on our Consolidated Statements of Income for each period presented. When we discuss revenues, we may, at times, refer to revenues summarized differently than the Regulation S-X requirements. The terminology, definitions, and applications of terms that we use to describe revenues may be different from terms used by other companies. We use the following terms to describe revenues: • Revenues - Our revenues are presented net of sales returns and allowances. • Product Revenues - We define product revenues as revenues generated from sales of consumable and capital equipment products. • Service Revenues - We define service revenues as revenues generated from parts and labor associated with the maintenance, repair, and installation of our capital equipment. Service revenues also include hospital sterilization services, instrument and scope repairs, and linen management as well as revenues generated from contract sterilization and laboratory services offered through our Applied Sterilization Technologies segment. Linen management services were divested in fiscal 2017. • Capital Equipment Revenues - We define capital equipment revenues as revenues generated from sales of capital equipment, which includes steam sterilizers, low temperature liquid chemical sterilant processing systems, including SYSTEM 1 and 1E, washing systems, VHP® technology, water stills, and pure steam generators; surgical lights and tables; and integrated OR. • Consumable Revenues - We define consumable revenues as revenues generated from sales of the consumable family of products, which includes SYSTEM 1 and 1E consumables, V-PRO consumables, gastrointestinal endoscopy accessories, sterility assurance products, skin care products, cleaning consumables, barrier product solutions and surgical instruments. • Recurring Revenues - We define recurring revenues as revenues generated from sales of consumable products and service revenues. GENERAL OVERVIEW AND EXECUTIVE SUMMARY STERIS plc is a leading provider of infection prevention and other procedural products and services. Our MISSION IS TO HELP OUR CUSTOMERS CREATE A HEALTHIER AND SAFER WORLD by providing innovative healthcare and life science product and service solutions around the globe. We offer our Customers a unique mix of innovative consumable products, such as detergents, gastrointestinal ("GI") endoscopy accessories, barrier product solutions, and other products and services, including: equipment installation and maintenance, microbial reduction of medical devices, instrument and scope repair solutions, laboratory testing services, on-site and off-site reprocessing, and capital equipment products, such as sterilizers and surgical tables, and connectivity solutions such as operating room (“OR”) integration. On March 28, 2019, STERIS plc, a public limited company organized under the laws of England and Wales (“STERIS UK”), completed a redomiciliation from the United Kingdom to Ireland (the “Redomiciliation”). The Redomiciliation was achieved through the insertion of a new Irish public limited holding company (“STERIS Ireland”) on top of STERIS UK pursuant to a court-approved scheme of arrangement under English law (the “Scheme”). Following the Scheme effectiveness, STERIS UK was re-registered as a private limited company with the name STERIS Limited, and STERIS Emerald IE Limited, a company established in Ireland and a wholly-owned direct subsidiary of STERIS Ireland, was interposed as the direct parent company of STERIS UK. We operate and report in four reportable business segments: Healthcare Products, Healthcare Specialty Services, Life Sciences, and Applied Sterilization Technologies. We describe our business segments in Note 11 to our consolidated financial statements, titled "Business Segment Information." The bulk of our revenues are derived from the healthcare and pharmaceutical industries. Much of the growth in these industries is driven by the aging of the population throughout the world, as an increasing number of individuals are entering their prime healthcare consumption years, and is dependent upon advancement in healthcare delivery, acceptance of new technologies, government policies, and general economic conditions. The pharmaceutical industry has been impacted by increased regulatory scrutiny of cleaning and validation processes, mandating that manufacturers improve their processes. Within healthcare, there is increased concern regarding the level of hospital acquired infections around the world; increased demand for medical procedures, including preventive screenings such as endoscopies and colonoscopies; and a desire by our Customers to operate more efficiently, all which are driving increased demand for many of our products and services. We completed several acquisitions and asset purchases in fiscal 2019, 2018 and 2017 that expanded our product and service offerings to our Customers. During fiscal 2018, we divested our Synergy Health Healthcare Consumable Solutions ("HCS") business with annual revenues of approximately $40 million. During fiscal 2017, we divested our Applied Infection Control ("AIC") product line and four businesses acquired in the acquisition of Synergy Health including: all of the linen management services businesses and Synergy Health Laboratory Services. We continue to invest in manufacturing in-sourcing projects and lean process improvements for the purpose of improving quality, cost and delivery of our products to our Customers. U.S. Tax Reform. On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (the “TCJA”). The TCJA made broad and complex changes to the U.S. tax code including, but not limited to, (1) reduction of the U.S. federal corporate income tax rate; (2) elimination of the corporate alternative minimum tax ("AMT"); (3) the creation of the base erosion anti-abuse tax ("BEAT"), a new minimum tax; (4) a general elimination of U.S. federal income taxes on dividends from non-U.S. subsidiaries; (5) a new provision designed to tax global intangible low-taxed income ("GILTI"), which allows for the possibility of using foreign tax credits ("FTCs") and a deduction of up to 50 percent to offset the income tax liability (subject to some limitations); (6) a new limitation on deductible interest expense; (7) the repeal of the domestic production activity deduction; (8) limitations on the deductibility of certain executive compensation; (9) limitations on the use of FTCs to reduce the U.S. income tax liability; and (10) limitations on net operating losses ("NOLs") generated after December 31, 2017, to 80.0 percent of taxable income. Fiscal 2019 Restructuring Plan. During the third quarter of fiscal year 2019, we adopted and announced a targeted restructuring plan (the “Fiscal 2019 Restructuring Plan”), which included the closure of two manufacturing facilities, one in Brazil and one in England, as well as other actions including, the rationalization of certain products. Fewer than 200 positions are being eliminated. The Company will relocate the production of certain impacted products to other existing manufacturing operations during fiscal 2020. These restructuring actions are designed to enhance profitability and improve efficiency. For additional information on restructuring see the subsection titled "Restructuring Expenses", located in the Results of Operations section of this MD&A, or Note 2 of our Consolidated Financial Statements, titled "Restructuring". Highlights. Revenues increased $162.2 million, or 6.2%, to $2,782.2 million for the year ended March 31, 2019, as compared to $2,620.0 million for the year ended March 31, 2018. This increase reflects organic growth in all business segments, which was partially offset by the impact of our fiscal 2018 divestiture of HCS and unfavorable fluctuations in currencies. Fiscal 2019 operating income increased 2.9% to $411.5 million over fiscal 2018 operating income of $399.9 million. The increase is attributable to increased volume and fluctuations in currencies and the positive impact from our fiscal 2018 divestiture of HCS, which were partially offset by costs associated with our Fiscal 2019 Restructuring Plan. Net cash flows from operations were $539.5 million and free cash flow was $355.4 million in fiscal 2019 compared to net cash flows from operations of $457.6 million and free cash flow of $294.3 million in fiscal 2018 (see subsection of MD&A titled, "Non-GAAP Financial Measures" for additional information and related reconciliation of non-GAAP financial measures to the most comparable GAAP measures). The improvement in free cash flow was primarily due to the improved cash from operations, which was partially offset by higher capital expenditures. Our debt-to-total capital ratio was 27.1% at March 31, 2019. During the year, we increased our quarterly dividend for the thirteenth consecutive year to $0.34 per share per quarter. Outlook. Fluctuations in currency rates can impact revenues and costs outside of the United States, creating variability in our results for fiscal 2020 and beyond. In fiscal 2020 and beyond, we expect to continue to manage our costs, grow our business with internal product and service development, invest in greater capacity, and augment these value creating methods with potential acquisitions of additional products and services. NON-GAAP FINANCIAL MEASURES We, at times, refer to financial measures which are considered to be “non-GAAP financial measures” under SEC rules. We, at times, also refer to our results of operations excluding certain transactions or amounts that are non-recurring or are not indicative of future results, in order to provide meaningful comparisons between the periods presented. These non-GAAP financial measures are not intended to be, and should not be, considered separately from or as an alternative to the most directly comparable GAAP financial measures. These non-GAAP financial measures are presented with the intent of providing greater transparency to supplemental financial information used by management and the Board of Directors in their financial analysis and operational decision-making. These amounts are disclosed so that the reader has the same financial data that management uses with the belief that it will assist investors and other readers in making comparisons to our historical operating results and analyzing the underlying performance of our operations for the periods presented. We believe that the presentation of these non-GAAP financial measures, when considered along with our GAAP financial measures and the reconciliation to the corresponding GAAP financial measures, provide the reader with a more complete understanding of the factors and trends affecting our business than could be obtained absent this disclosure. It is important for the reader to note that the non-GAAP financial measure used may be calculated differently from, and therefore may not be comparable to, a similarly titled measure used by other companies. We define free cash flow as net cash provided by operating activities as presented in the Consolidated Statements of Cash Flows less purchases of property, plant, equipment, and intangibles plus proceeds from the sale of property, plant, equipment, and intangibles, which are also presented within investing activities in the Consolidated Statements of Cash Flows. We use this as a measure to gauge our ability to pay cash dividends, fund growth outside of core operations, fund future debt principal repayments, and repurchase shares. The following table summarizes the calculation of our free cash flow for the years ended March 31, 2019, 2018 and 2017: RESULTS OF OPERATIONS In the following subsections, we discuss our earnings and the factors affecting them. We begin with a general overview of our operating results and then separately discuss earnings for our operating segments. FISCAL 2019 AS COMPARED TO FISCAL 2018 Revenues. The following table compares our revenues, in total and by type and geography, for the year ended March 31, 2019 to the year ended March 31, 2018: Revenues increased $162.2 million, or 6.2%, to $2,782.2 million for the year ended March 31, 2019, as compared to $2,620.0 million for the year ended March 31, 2018. This increase reflects organic growth in all business segments, which was partially offset by the impact of our fiscal 2018 divestiture of HCS and unfavorable fluctuations in currencies. Service revenues for fiscal 2019 increased $86.8 million, or 6.2% over fiscal 2018, reflecting growth in all business segments. Consumable revenues for fiscal 2019 increased $24.1 million, or 4.1%, over fiscal 2018, reflecting growth in all business segments which was partially offset by the impact of our fiscal 2018 divestiture of HCS. Capital equipment revenues for fiscal 2019 increased by $51.3 million, or 8.0%, as compared to fiscal 2018, reflecting strong shipment volumes in the Healthcare Products and Life Science business units. Ireland revenues for fiscal 2019 were $56.8 million, an increase of $8.5 million, or 17.7%, over fiscal 2018 revenues of $48.2 million, reflecting growth in service, consumable and capital equipment revenues. United States revenues for fiscal 2019 were $1,976.8 million, an increase of $140.4 million, or 7.6%, over fiscal 2018 revenues of $1,836.4 million, reflecting growth in service, consumable and capital equipment revenues. Revenues from other foreign locations for fiscal 2019 were $748.6 million, an increase of 1.8% over the fiscal 2018 revenues of $735.3 million, reflecting growth in Canada and in the Asia Pacific and Latin America regions, which was partially offset by a decline in the Europe, Middle East and Africa ("EMEA") region. Gross Profit. The following table compares our gross profit for the year ended March 31, 2019 to the year ended March 31, 2018: Our gross profit is affected by the volume, pricing and mix of sales of our products and services, as well as the costs associated with the products and services that are sold. Our gross profit increased $82.7 million and gross profit percentage increased 50 basis points to 42.2% for fiscal 2019 as compared to 41.7% for fiscal 2018. This increase was attributable to the positive impacts of pricing (40 basis points), our recent divestitures (20 basis points), fluctuations in currencies (10 basis points) and other factors, which were offset by costs associated with our Fiscal 2019 Restructuring Plan (40 basis points). Operating Expenses. The following table compares our operating expenses for the year ended March 31, 2019 to the year ended March 31, 2018: NM - Not meaningful Selling, General, and Administrative Expenses. Significant components of total selling, general, and administrative expenses (“SG&A”) are compensation and benefit costs, fees for professional services, travel and entertainment, facilities costs, gains or losses from divestitures, and other general and administrative expenses. SG&A increased 6.0% in fiscal 2019 over fiscal 2018, largely due to additional expenses associated with our Fiscal 2019 Restructuring Plan. Additionally, during the third quarter of fiscal 2019, we adopted a branding strategy that included phasing out the usage of a tradename associated with certain products in the Healthcare Products business segment, which resulted in an impairment charge of $16.2 million. Research and Development. Research and development expenses increased $2.3 million during fiscal 2019, as compared to fiscal 2018, due primarily to increased spending within the Healthcare Products segment. Research and development expenses are influenced by the number and timing of in-process projects and labor hours and other costs associated with these projects. Our research and development initiatives continue to emphasize new product development, product improvements, and the development of new technological platform innovations. During fiscal 2019, our investments in research and development continued to be focused on, but were not limited to, enhancing capabilities of sterile processing combination technologies, procedural products and accessories, and devices and support accessories used in gastrointestinal endoscopy procedures. Restructuring Expenses. During the third quarter of fiscal 2019, we adopted and announced a targeted restructuring plan (the "Fiscal 2019 Restructuring Plan"), which included the closure of two manufacturing facilities, one in Brazil and one in England, as well as other actions including, the rationalization of certain products. Fewer than 200 positions are being eliminated. The Company will relocate the production of certain impacted products to other existing manufacturing operations during fiscal 2020. These restructuring actions are designed to enhance profitability and improve efficiency. We have incurred pre-tax expenses totaling $40.7 million related to these restructuring actions, of which $31.0 million was recorded as restructuring expenses and $9.7 million was recorded in cost of revenues, with a total of $28.4 million, $2.5 million, $0.7 million, and $7.8 million related to the Healthcare Products, Healthcare Specialty Services, Life Sciences, and Applied Sterilization Technologies segments, respectively. Corporate related restructuring charges were $1.3 million. We expect to incur additional restructuring expenses related to this plan of approximately $3.0 million in fiscal 2020 and beyond. The following table summarizes our total pre-tax restructuring expenses for fiscal 2019: (1) Recorded in cost of revenues on the Consolidated Statements of Income. Non-Operating Expenses, Net. Non-operating expense (income), net consists of interest expense on debt, offset by interest earned on cash, cash equivalents, short-term investment balances, and other miscellaneous expense. The following table compares our non-operating expense (income), net for the year ended March 31, 2019 to the year ended March 31, 2018: Interest expense decreased $5.6 million during fiscal 2019, as compared to 2018. This decrease was primarily due to: (i) reduced interest rates on our 2008 and 2012 Private Placement Notes, (ii) replacement of higher cost fixed rate debt with lower cost floating rate debt as a result of $85.0 million of 2008 Private Placement Notes maturing during the second quarter of fiscal 2019 and (iii) overall lower debt levels (refer to our Note 6 to our consolidated financial statements, titled "Debt", for more information). Interest income and miscellaneous expense decreased by $2.7 million during fiscal 2019 as compared to fiscal 2018, primarily due to unrealized losses on our equity investments (refer to our Note 17 to our consolidated financial statements, titled "Fair Value Measurements" for more information). Additional information regarding our outstanding debt is included in Note 6 to our consolidated financial statements titled, “Debt,” and in the subsection of this MD&A titled, “Liquidity and Capital Resources.” Income Tax Expense. The following table compares our income tax expense and effective income tax rates for the years ended March 31, 2019 and March 31, 2018: The effective income tax rate for fiscal 2019 was 17.4% as compared to 17.8% for fiscal 2018. The fiscal 2019 effective tax rate decreased when compared to fiscal 2018 primarily due the reduction in the US statutory tax rate from a blended rate of 31.5% to 21%. This was offset unfavorably by non-recurring TCJA impacts benefiting fiscal 2018. Additional information regarding our income tax expense is included in Note 8 to our consolidated financial statements titled, “Income Taxes.” Business Segment Results of Operations. We operate and report in four reportable business segments: Healthcare Products, Healthcare Specialty Services, Life Sciences, and Applied Sterilization Technologies. Non-allocated operating costs that support the entire Company and items not indicative of operating trends are excluded from segment operating income. Our Healthcare Products segment offers infection prevention and procedural solutions for healthcare providers worldwide, including consumable products, equipment maintenance and installation services, and capital equipment. Our Healthcare Specialty Services segment provides a range of specialty services for healthcare providers including hospital sterilization services and instrument and scope repairs. Our Life Sciences segment offers consumable products, equipment maintenance, specialty services and capital equipment primarily for pharmaceutical manufacturers. Our Applied Sterilization Technologies segment offers contract sterilization and laboratory services primarily for medical device and pharmaceutical Customers. We disclose a measure of segment income that is consistent with the way management operates and views the business. The accounting policies for reportable segments are the same as those for the consolidated Company. In fiscal 2019, we ceased the allocation of certain corporate costs to our segments to align with internal management measures. The prior period operating income measures have been recast for comparability. For more information regarding our segments please refer to Note 11 to our consolidated financial statements titled “Business Segment Information,” and Item 1, “Business”. The following table compares business segment and Corporate and other revenues and operating income for the year ended March 31, 2019 to the year ended March 31, 2018: (1) For more information regarding our recent acquisitions and divestitures see Note 18 titled, "Business Acquisitions and Divestitures". Amortization of purchased intangible assets fiscal 2019 total includes an impairment charge of $16.2 million, see Note 3 titled, "Goodwill and Intangible Assets", for more information. (2) Acquisition and integration related charges include transaction costs and integration expenses associated with acquisitions. (3) Represents a one-time special employee bonus paid to most U.S. employees and associated professional fees. (4) Costs incurred in connection with the decision to redomicile. (5) See Note 2 titled, "Restructuring", for more information. Healthcare Products revenues increased 4.9% in fiscal 2019, as compared to fiscal 2018, reflecting growth in consumable, service revenues and capital equipment revenues of 0.6%, 5.5% and 7.9%, respectively. The increase was attributable to organic growth which was partially offset by the negative impact of fluctuations in currencies and the fiscal 2018 divestiture of HCS, which directly impacted the consumables revenue growth. At March 31, 2019, the Healthcare Products segment’s backlog amounted to $154.5 million, increasing $21.5 million, or 16.1%, compared to the backlog of $133.0 million at March 31, 2018. Healthcare Specialty Services revenues increased 8.7% in fiscal 2019, as compared to fiscal 2018. The increase was attributable to organic growth which was partially offset by the negative impact of fluctuations in currencies. Life Sciences revenues increased 4.7% in fiscal 2019, as compared to fiscal 2018, reflecting growth in consumable, service revenues and capital equipment revenues of 7.4%, 3.3% and 2.1%, respectively. The increase was attributable to organic growth which was partially offset by the negative impact of fluctuations in currencies. Life Sciences backlog at March 31, 2019 amounted to $60.7 million, essentially flat as compared to backlog of $60.8 million at March 31, 2018. Applied Sterilization Technologies revenues increased 8.2% in fiscal 2019, as compared to fiscal 2018. Revenues in fiscal 2019 were favorably impacted by increased volume from our core medical device Customers which was partially offset by the negative impact of fluctuations in currencies. The Healthcare Products segment’s operating income increased $29.5 million to $323.7 million for fiscal year 2019 as compared to $294.2 million in fiscal year 2018. The segment's operating margin was 24.2% for fiscal year 2019 compared to 23.1% for fiscal year 2018. The increase in operating income in fiscal 2019 was primarily due to increased volumes and operating efficiencies, which were partially offset by continued investment in research and development spending. The Healthcare Specialty Services segment’s operating income increased $5.8 million to $64.2 million for fiscal year 2019 as compared to $58.5 million in fiscal year 2018. The segment’s operating margin was 12.6% for fiscal year 2019 compared to 12.5% for fiscal year 2018. The increase in operating income in fiscal 2019 resulted from leveraging the investments made over the past several quarters in the United States and higher volumes. The Life Sciences business segment’s operating income increased $8.2 million to $132.1 million for fiscal year 2019 as compared to $123.9 million in fiscal year 2018. The segment’s operating margin was 34.9% for fiscal year 2019 compared to 34.3% for fiscal year 2018. The segment’s operating income increase in fiscal 2019 was primarily driven by increased volumes. The Applied Sterilization Technologies segment’s operating income increased $25.5 million to $221.8 million for fiscal year 2019 as compared to $196.3 million for fiscal year 2018. The Applied Sterilization Technologies segment's operating margin was 40.0% for fiscal year 2019 compared to 38.2% for fiscal year 2018. The segment’s operating income increase in fiscal 2019 was primarily driven by revenue growth. FISCAL 2018 AS COMPARED TO FISCAL 2017 Revenues. The following table compares our revenues, in total and by type and geography, for the year ended March 31, 2018 to the year ended March 31, 2017: Revenues increased $7.2 million, or 0.3%, to $2,620.0 million for the year ended March 31, 2018, as compared to $2,612.8 million for the year ended March 31, 2017. This increase is primarily attributable to organic growth within all business segments, favorable pricing, the benefit of acquisitions and the positive impact of fluctuations in currencies. These increases were largely offset by the impact of our recent divestitures. Service revenues for fiscal 2018 decreased $15.1 million, or 1.1%, over fiscal 2017, as the impact of recent divestitures more than offset increases in other service offerings. Consumable revenues increased $22.7 million, or 4.1%, during fiscal 2018 over fiscal 2017, reflecting growth within the Healthcare Products and Life Sciences business segments, which more than offset the impact of the divestitures of the AIC product line and HCS business within the Healthcare Products segment. Capital equipment revenues decreased by $0.4 million, or 0.1%, during fiscal 2018 as compared to fiscal 2017, reflecting a decline in revenues from the Healthcare Products segment, which was offset by growth in revenues from the Life Sciences segment. Ireland revenues for fiscal 2018 were $48.2 million, an increase of $5.5 million, or 12.9%, over fiscal 2017 revenues of $42.7 million, reflecting increases in consumable and service revenues, which were partially offset by decline in capital equipment revenues. United States revenues for fiscal 2018 were $1,836.4 million, an increase of $33.0 million, or 1.8%, over fiscal 2017 revenues of $1,803.5 million. Strength in Life Sciences capital equipment and strength in service offerings within the Healthcare Products, Life Sciences and Applied Sterilization Technologies segments more than offset the negative impact of the decline in capital equipment revenues within the Healthcare Products segment and the recent divestitures. Revenues from other foreign locations for fiscal 2018 were $735.3 million, a decrease of 4.1% over the fiscal 2017 revenues of $766.6 million, primarily due to the fiscal 2017 divestiture of the Netherlands Linen Management Services, which more than offset growth in Canada and in the Asia Pacific and Latin America regions. Gross Profit. The following table compares our gross profit for the year ended March 31, 2018 to the year ended March 31, 2017: Our gross profit is affected by the volume, pricing and mix of sales of our products and services, as well as the costs associated with the products and services that are sold. Our gross profit increased $66.5 million and gross profit percentage increased 240 basis points to 41.7% for fiscal 2018 as compared to 39.3% for fiscal 2017. The increase in our gross profit percentage was due to the favorable impact of the divestiture of lower margin operations (190 basis points), favorable mix (50 basis points), and favorable pricing (30 basis points) which were partially offset by the negative impact of currencies (30 basis points). Operating Expenses. The following table compares our operating expenses for the year ended March 31, 2018 to the year ended March 31, 2017: NM - Not meaningful Selling, General, and Administrative Expenses. Significant components of total selling, general, and administrative expenses (“SG&A”) are compensation and benefit costs, fees for professional services, travel and entertainment, facilities costs, gains or losses from divestitures, and other general and administrative expenses. SG&A decreased 7.3% in fiscal 2018 over fiscal 2017. The decline was primarily attributable to a lower net loss on divestitures and lower acquisition and integration costs incurred in fiscal 2018, as compared to fiscal 2017. Goodwill impairment loss. Goodwill impairment loss of $58.4 million was recorded during fiscal 2017 as a result of our annual goodwill impairment review in the third quarter relative to the Synergy Health Netherlands linen management reporting unit. Research and Development. Research and development expenses increased $1.4 million during fiscal 2018, as compared to fiscal 2017. Research and development expenses are influenced by the number and timing of in-process projects and labor hours and other costs associated with these projects. Our research and development initiatives continue to emphasize new product development, product improvements, and the development of new technological platform innovations. During fiscal 2018, our investments in research and development continued to be focused on, but were not limited to, enhancing capabilities of sterile processing combination technologies, procedural products and accessories, and devices and support accessories used in gastrointestinal endoscopy procedures. Non-Operating Expenses, Net. Non-operating expense (income), net consists of interest expense on debt, offset by interest earned on cash, cash equivalents, short-term investment balances, and other miscellaneous expense. The following table compares our non-operating expense (income), net for the year ended March 31, 2018 to the year ended March 31, 2017: Interest expense increased $6.1 million during fiscal 2018 as compared to 2017. This increase was primarily due to an increase in the proportion of higher-cost, fixed rate debt following the issuance and sale of senior notes in a private placement to certain investors on February 27, 2017. The increase in Interest income and miscellaneous expense was primarily due to our retrospective adoption of ASU 2017-07, "Compensation - Retirement Benefits - Improving the Presentation of Net Periodic Pension and Net Periodic Postretirement Benefit Cost". Additional information regarding the standard can be found in Note 1 to our consolidated financial statements titled, "Nature of Operations and Summary of Significant Accounting Policies." Additional information regarding our outstanding debt is included in Note 6 to our consolidated financial statements titled, “Debt,” and in the subsection of this MD&A titled, "Liquidity and Capital Resources." Income Tax Expense. The following table compares our income tax expense and effective income tax rates for the years ended March 31, 2018 and March 31, 2017: The effective income tax rate for fiscal 2018 was 17.8% as compared to 40.1% for fiscal 2017. The fiscal 2018 effective tax rate decreased when compared to fiscal 2017 primarily due to the TCJA impact and non-recurring nondeductible costs related to divestitures. Additional information regarding our income tax expense is included in Note 8 to our consolidated financial statements titled, “Income Taxes.” On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (the “TCJA”). The SEC staff issued Staff Accounting Bulletin No.118 (“SAB 118”), which provides guidance on accounting for the tax effects of the TCJA. SAB 118, provides a measurement period that should not extend beyond one year from the TCJA enactment date for companies to complete the accounting under Accounting Standards Codification (“ASC”) Topic 740, Income Taxes. Our accounting for the various elements of the TCJA was incomplete at March 31, 2018. However, in accordance with SAB 118 guidance, we were able to make what we believed to be reasonable estimates of certain effects and therefore recorded a provisional net tax benefit of approximately $18.9 million related to the reduction of the U.S. federal corporate income tax rate and the deemed repatriation transition tax. During fiscal 2019, the Company completed its accounting for the tax effects of the TCJA. During fiscal 2019, the Company recorded an immaterial favorable adjustment to the provisional amounts recorded as of March 31, 2018 for remeasurement of the Company’s deferred tax balances and the one-time transition tax. Business Segment Results of Operations. We operate and report in four reportable business segments: Healthcare Products, Healthcare Specialty Services, Life Sciences, and Applied Sterilization Technologies. Non-allocated operating costs that support the entire Company and items not indicative of operating trends are excluded from segment operating income. Our Healthcare Products segment offers infection prevention and procedural solutions for healthcare providers worldwide, including consumable products, equipment maintenance and installation services, and capital equipment. Our Healthcare Specialty Services segment provides a range of specialty services for healthcare providers including hospital sterilization services and instrument and scope repairs. Our Life Sciences segment offers consumable products, equipment maintenance, specialty services and capital equipment primarily for pharmaceutical manufacturers. Our Applied Sterilization Technologies segment offers contract sterilization and laboratory services primarily for medical device and pharmaceutical Customers. We disclose a measure of segment income that is consistent with the way management operates and views the business. The accounting policies for reportable segments are the same as those for the consolidated Company. In fiscal 2019, we ceased the allocation of certain corporate costs to our segments to align with internal management measures. The prior period operating income measures have been recast for comparability. For more information regarding our segments please refer to Note 11 to our consolidated financial statements titled “Business Segment Information,” and Item 1, “Business.” The following table compares business segment and Corporate and other revenues and operating income for the year ended March 31, 2018 to the year ended March 31, 2017: (1) For more information regarding our goodwill impairment loss see Note 3 to our consolidated financial statements titled, "Goodwill and Intangible Assets". (2) For more information regarding our recent acquisitions and divestitures see Note 18 to our consolidated financial statements titled, "Business Acquisitions and Divestitures". (3) Acquisition and integration related charges include transaction costs and integration expenses associated with acquisitions. (4) Represents a one-time special employee bonus paid to most U.S. employees and associated professional fees. Healthcare Products revenues increased 0.8% in fiscal 2018, as compared to fiscal 2017, reflecting growth in consumable and service revenues of 2.2% and 7.2%, respectively, which were partially offset by a 4.0% decline in capital equipment revenues. The increase was attributable to organic growth, acquisitions and the positive impact of fluctuations in currencies, and was partially offset by divestitures. At March 31, 2018, the Healthcare Products segment’s backlog amounted to $133.0 million, increasing $23.3 million, or 21.3%, compared to the backlog of $109.7 million at March 31, 2017. Healthcare Specialty Services revenues decreased 13.1% in fiscal 2018, as compared to fiscal 2017. The negative impact of the divestitures was partially offset by organic growth and the positive impact of fluctuations in currencies. Life Sciences revenues increased 10.0% in fiscal 2018, as compared to fiscal 2017, reflecting growth of 19.6%, 5.2% and 8.6% in capital equipment, consumable and service revenues, respectively. The increase was primarily attributable to organic growth and the positive impact of fluctuations in currencies. Life Sciences backlog at March 31, 2018 amounted to $60.8 million, increasing $7.7 million compared to the backlog of $53.2 million at March 31, 2017. Applied Sterilization Technologies revenues increased 7.4% in fiscal 2018, as compared to fiscal 2017. Revenues in fiscal 2018 were favorably impacted by increased volume from our core medical device Customers and the positive impact of fluctuations in currencies, which was partially offset by the impact of the divestitures. The Healthcare Products segment’s operating income increased $9.0 million to $294.2 million in fiscal year 2018, as compared to $285.2 million in fiscal year 2017. The segment's operating margin was 23.1% for fiscal year 2018 compared to 22.5% for fiscal year 2017. The increase in operating income in fiscal 2018 was primarily due to organic growth which was partially offset by increased spending on research and development and negative fluctuations in currencies. The Healthcare Specialty Services segment’s operating income increased $17.4 million to $58.5 million for fiscal year 2018 as compared to $41.0 million in fiscal year 2017. The segment’s operating margin was 12.5% for fiscal year 2018 compared to 7.6% for fiscal year 2017. The increase in operating income in fiscal 2018 was primarily due to the divestiture of the low margin Linen Management Services operations and growth in retained businesses. The Life Sciences business segment’s operating income increased $13.9 million to $123.9 million for fiscal year 2018 as compared to $110.0 million in fiscal year 2017. The segment’s operating margin was 34.3% for fiscal year 2018 compared to 33.4% for fiscal year 2017. The increase in operating income in fiscal 2018 was primarily attributable to higher volume which was partially offset by unfavorable product mix. The Applied Sterilization Technologies segment’s operating income increased $19.9 million to $196.3 million for fiscal year 2018 as compared to $176.4 million for fiscal year 2017. The Applied Sterilization Technologies segment's operating margin was 38.2% for fiscal year 2018 compared to 36.9% for fiscal year 2017. The segment’s operating income increase in fiscal 2018 over fiscal 2017 was primarily due to increased volume from the segment’s core medical device Customers. LIQUIDITY AND CAPITAL RESOURCES The following table summarizes significant components of our cash flows for the years ended March 31, 2019, 2018 and 2017: Net Cash Provided By Operating Activities - The net cash provided by our operating activities was $539.5 million for the year ended March 31, 2019 compared to $457.6 million for the year ended March 31, 2018 and $424.1 million for the year ended March 31, 2017. The following discussion summarizes the significant changes in our operating cash flows for the years ended March 31, 2019, 2018 and 2017: • Net cash provided by operating activities increased in fiscal 2019 by 17.9%, as compared to fiscal 2018. Net cash provided by operating activities increased 7.9% in fiscal 2018 compared to fiscal 2017. The improvement in both years was primarily due to higher earnings and lower requirements to fund operating assets and liabilities. Net Cash Used In Investing Activities - The net cash used in our investing activities was $213.2 million for the year ended March 31, 2019, compared to $203.8 million for the year ended March 31, 2018 and $104.3 million for the year ended March 31, 2017. The following discussion summarizes the significant changes in our investing cash flows for the years ended March 31, 2019, 2018 and 2017: • Purchases of property, plant, equipment, and intangibles, net - Capital expenditures totaled $189.7 million during fiscal 2019, $165.5 million during fiscal 2018 and $172.9 million during fiscal 2017. • Proceeds from the sale of property, plant, equipment and intangibles - During fiscal 2019, 2018 and 2017 we received $5.6 million, $2.1 million and $4.8 million, respectively, for proceeds from the sale of property, plant, equipment and intangibles. • Proceeds from the sale of business - During fiscal 2019, 2018 and 2017 we received $2.5 million, $8.9 million and $135.7 million, respectively, for proceeds from the sale of certain non-core businesses. For more information, refer to our Note 18 to our consolidated financial statements, titled "Business Acquisitions and Divestitures". • Purchases of investments - During fiscal 2019, we completed an equity investment for approximately $5.0 million. During fiscal 2017, we invested an additional $6.4 million in the common stock of Servizi Italia, S.p.A., a leading provider of integrated linen washing and outsourced sterile processing services to hospital Customers. • Investments in business, net of cash acquired - During fiscal 2019, 2018 and 2017, we used $13.3 million, $46.3 million and $65.6 million respectively, for acquisitions. For more information on these acquisitions refer to Note 18 to our consolidated financial statements titled, "Business Acquisitions and Divestitures". • Other - During fiscal 2019 and 2018 we provided approximately $13.4 and $3.1 million, respectively under borrowing agreements. For more information on these agreements. For more information, refer to our Note 18 to our consolidated financial statements, titled "Business Acquisitions and Divestitures". Net Cash Used In Financing Activities - Net cash used in financing activities was $294.8 million for the year ended March 31, 2019, compared to net cash used in financing activities of $356.2 million, and $267.1 million for the years ended March 31, 2018 and March 31, 2017, respectively. The following discussion summarizes the significant changes in our financing cash flows for the years ended March 31, 2019, 2018 and 2017: • Proceeds from the issuance of long-term obligations - On February 27, 2017, we issued and sold to various institutional investors fixed-rate Series A Senior Notes, in the aggregate principal amount of $95.0 million, €99.0 million, and £75.0 million or a total of approximately $293.7 million. We provide additional information about our debt structure in Note 6 to our consolidated financial statements titled, “Debt,” and in this section of the MD&A titled, “Liquidity and Capital Resources” in the subsection titled, “Sources of Credit.” • Payments on long-term obligations - During fiscal 2019 we repaid $85.0 million in private placement notes that matured on August 15, 2018. During fiscal 2018 and fiscal 2017 we repaid $222.5 million and $172.5 million, respectively on our bank term loan. • Proceeds under credit facilities, net - At the end of fiscal 2019, $301.8 million of debt was outstanding under our bank credit facility, compared to $331.2 million and $521.6 million of debt outstanding under this facility at the end of fiscal 2018 and 2017, respectively. We provide additional information about our bank credit facility including the fiscal 2018 refinancing in Note 6 to our consolidated financial statements titled, “Debt”. • Repurchases of shares - During fiscal 2019, we purchased 659,393 of our ordinary shares in the aggregate amount of $73.2 million, which included $0.4 million of taxes and commissions. We also obtained 112,356 of our ordinary shares in connection with our stock-based compensation award programs in the amount of $8.3 million during fiscal 2019. During fiscal 2018, we purchased 656,663 of our ordinary shares in the aggregate amount of $58.5 million, which included $0.3 million of taxes and commissions. We also obtained 127,903 of our ordinary shares in connection with our stock-based compensation award programs in the amount $7.0 million. During fiscal 2017, we purchased 1,286,183 of our ordinary shares in the aggregate amount of $90.5 million, which included $0.5 million of taxes and commissions. We also obtained 168,906 of our ordinary shares in connection with our stock-based compensation award programs in the amount $7.0 million. We provide additional information about our share repurchases in Note 13 to our consolidated financial statements titled, “Repurchases of Ordinary Shares.” • Deferred financing fees and debt issuance costs - We paid $0.5 million, $2.0 million and $1.1 million in fiscal 2019, 2018 and 2017, respectively, for financing fees and debt issuance costs related to our Credit Agreement and Private Placement debt. For more information on our debt refer to Note 6 to our consolidated financial statements titled, "Debt". • Cash dividends paid to ordinary shareholders - During fiscal 2019, we paid cash dividends totaling $112.5 million or $1.33 per outstanding share. During fiscal 2018, we paid cash dividends totaling $102.9 million or $1.21 per outstanding share. During fiscal 2017, we paid cash dividends totaling $93.2 million, or $1.09 per outstanding share. • Stock option and other equity transactions, net - We generally receive cash for issuing shares upon the exercise of options under our employee stock option program. During fiscal 2019, fiscal 2018 and fiscal 2017, we received cash proceeds totaling $13.3 million, $11.1 million, and $5.0 million, respectively, under these programs. During fiscal 2018 we also paid dividends in the amount of $1.4 million to minority interest shareholders. Cash Flow Measures. Free cash flow was $355.4 million in fiscal 2019 compared to $294.3 million in fiscal 2018. The improvement in cash flow was primarily due to improved cash from operations, which was partially offset by higher capital expenditures. Our debt-to-total capital ratio was 27.1% at March 31, 2019 and 29.1% at March 31, 2018. Cash Requirements. We intend to use our existing cash and cash equivalent balances and cash generated from operations to fund capital expenditures and meet our other liquidity needs. Our capital requirements depend on many uncertain factors, including our rate of sales growth, our Customers’ acceptance of our products and services, the costs of obtaining adequate manufacturing capacities, the timing and extent of our research and development projects, changes in our operating expenses and other factors. To the extent that existing and anticipated sources of cash are not sufficient to fund our future activities, we may need to raise additional funds through additional borrowings or the sale of equity securities. There can be no assurance that our financing arrangements will provide us with sufficient funds or that we will be able to obtain any additional funds on terms favorable to us or at all. Sources of Credit. Our sources of credit as of March 31, 2019 are summarized in the following table: (1) At March 31, 2019, there was $4.8 million of letters of credit outstanding under the Credit Agreement. Our sources of funding from credit as of March 31, 2019 are summarized below: • On March 23, 2018, STERIS UK and certain of its subsidiaries entered into a Credit Agreement (the "Credit Agreement") with various financial institutions as lenders, and JPMorgan Chase Bank, N.A., as Administrative Agent. STERIS Ireland subsequently became a borrower and guarantor under the Credit Agreement. The Credit Agreement replaced a bank credit facility dated March 31, 2015. The Credit Agreement provides up to $1.0 billion of credit, in the form of a revolver facility, which may be utilized for revolving credit borrowings, swing line borrowings and letters of credit, with sublimits for swing line borrowings and letters of credit. The revolver facility may be increased in specified circumstances by up to $500.0 million. The Credit Agreement will mature on March 23, 2023, and all unpaid borrowings, together with accrued and unpaid interest thereon, are repayable on that date. The Credit Agreement contains leverage and interest coverage covenants. Borrowings may be taken in U.S. dollars, euros, and pounds sterling and certain other specified currencies and bear interest at our option based upon either the Base Rate or the Eurocurrency Rate, plus the Applicable Margin in effect from time to time under the Credit Agreement. The Applicable Margin is determined based on the ratio of Consolidated Total Debt to Consolidated EBITDA (as such terms are defined in the Credit Agreement). Interest on Base Rate Advances is payable quarterly in arrears and interest on Eurocurrency Rate Advances is payable at the end of the relevant interest period therefor, but in no event less frequently than every three months. Borrowings at closing were used to repay outstanding balances of debt outstanding under the former bank credit facility dated March 31, 2015 that was scheduled to mature on March 31, 2020 and for other general corporate purposes. • The Credit Agreement was amended in March 2019, in connection with the Redomiciliation to permit the Redomiciliation. The amendments did not effect any material changes in the terms of the Credit Agreement regarding borrowings or the issuance of letters of credit. Our outstanding Senior Notes at March 31, 2019 were as follows: • On February 27, 2017, STERIS UK issued and sold an aggregate principal amount of $95.0 million, €99.0 million, and £75.0 million, of senior notes in a private placement to certain institutional investors in an offering that was exempt from the registration requirements of the Securities Act of 1933. These notes have maturities of between 10 and 15 years from the issue date. The agreement governing these notes contains leverage and interest coverage covenants. • On May 15, 2015, STERIS Corporation issued and sold $350.0 million of senior notes, in a private placement to certain institutional investors in an offering that was exempt from the registration requirements of the Securities Act of 1933. These notes have maturities of 10 to 15 years from the issue date. The agreement governing these notes contains leverage and interest coverage covenants. • The agreements governing certain senior notes issued and sold in February 2013, December 2012, and August 2008, were amended and restated in their entirety on March 31, 2015. All of these notes were issued and sold in private placements to certain institutional investors in offerings that were exempt from the registration requirements of the Securities Act of 1933. The amended and restated agreements, which have been consolidated into a single agreement for the 2013 and 2012 notes, and a separate single agreement for the 2008 notes, contain leverage and interest coverage covenants. • All of the note agreements were amended in March 2019, in connection with the Redomiciliation. The amendments waived certain repurchase rights of the note holders and increased the size of certain baskets to more closely align with Credit Agreement baskets. As of March 31, 2019, a total of $301.8 million was outstanding under the Credit Agreement, based on currency exchange rates as of March 31, 2019. At March 31, 2019, we had $693.4 million of unused funding available under the Credit Agreement. The Credit Agreement includes a sub-limit that reduces the maximum amount available to us by letters of credit outstanding. At March 31, 2019, there was $4.8 million in letters of credit outstanding under the Credit Agreement. At March 31, 2019, we were in compliance with all financial covenants associated with our indebtedness. We provide additional information regarding our debt structure and payment obligations in the section of the MD&A titled, “Liquidity and Capital Resources” in the subsection titled, “Contractual and Commercial Commitments” and in Note 6 to our consolidated financial statements titled, “Debt.” CAPITAL EXPENDITURES Our capital expenditure program is a component of our long-term strategy. This program includes, among other things, investments in new and existing facilities, business expansion projects, radioisotope (cobalt-60), and information technology enhancements and research and development advances. During fiscal 2019, our capital expenditures amounted to $189.7 million. We use cash provided by operating activities and our cash and cash equivalent balances to fund capital expenditures. We expect fiscal 2020 capital expenditures to increase to approximately $280.0 million, reflecting continued facility expansions, particularly within the Applied Sterilization Technologies segment and general maintenance for existing facilities. CONTRACTUAL AND COMMERCIAL COMMITMENTS At March 31, 2019, we had commitments under non-cancelable operating leases totaling $162.4 million. Our contractual obligations and commercial commitments as of March 31, 2019 are presented in the following tables. Commercial commitments include standby letters of credit, letters of credit required as security under our self-insured risk retention policies, and other potential cash outflows resulting from events that require us to fulfill commitments. The table above includes only the principal amounts of our contractual obligations. We provide information about the interest component of our long-term debt in the subsection of MD&A titled, “Liquidity and Capital Resources,” and in Note 6 to our consolidated financial statements titled, “Debt.” Purchase obligations shown in the table above relate to minimum purchase commitments with suppliers for materials purchases and long term construction contracts. The table above excludes contributions we make to our defined contribution plans. Our future contributions to the defined contribution plans depend on uncertain factors, such as the amount and timing of employee contributions and discretionary employer contributions. We provide additional information about our defined benefit pension plans, defined contribution plan, and other post-retirement benefits plan in Note 9 to our consolidated financial statements titled, “Benefit Plans." CRITICAL ACCOUNTING POLICIES, ESTIMATES, AND ASSUMPTIONS The following subsections describe our most critical accounting policies, estimates, and assumptions. Our accounting policies are more fully described in Note 1 to our consolidated financial statements titled, “Nature of Operations and Summary of Significant Accounting Policies.” Estimates and Assumptions. Our discussion and analysis of financial condition and results of operations is based on our consolidated financial statements that were prepared in accordance with United States generally accepted accounting principles. We make certain estimates and assumptions that we believe to be reasonable when preparing these financial statements. These estimates and assumptions involve judgments with respect to numerous factors that are difficult to predict and are beyond management’s control. As a result, actual amounts could be materially different from these estimates. We periodically review these critical accounting policies, estimates, assumptions, and the related disclosures with the Audit Committee of the Company’s Board of Directors. Revenue Recognition. Revenue is recognized when obligations under the terms of the contract are satisfied and control of the promised products or services has transferred to the Customer. Revenues are measured at the amount of consideration that we expect to be paid in exchange for the products or services. Product revenue is recognized when control passes to the Customer, which is generally based on contract or shipping terms. Service revenue is recognized when the Customer benefits from the service, which occurs either upon completion of the service or as it is provided to the Customer. Our Customers include end users as well as dealers and distributors who market and sell our products. Our revenue is not contingent upon resale by the dealer or distributor, and we have no further obligations related to bringing about resale. Our standard return and restocking fee policies are applied to sales of products. Shipping and handling costs charged to Customers are included in Product revenues. The associated expenses are treated as fulfillment costs and are included in Cost of revenues. Revenues are reported net of sales and value-added taxes collected from Customers. We have individual Customer contracts that offer discounted pricing. Dealers and distributors may be offered sales incentives in the form of rebates. We reduce revenue for discounts and estimated returns, rebates, and other similar allowances in the same period the related revenues are recorded. The reduction in revenue for these items is estimated based on historical experience and trend analysis to the extent that it is probable that a significant reversal of revenue will not occur. Estimated returns are recorded gross on the Consolidated Balance Sheets. In transactions that contain multiple performance obligations, such as when products, maintenance services, and other services are combined, we recognize revenue as each product is delivered or service is provided to the Customer. We allocate the total arrangement consideration to each performance obligation based on its relative standalone selling price, which is the price for the product or service when it is sold separately. Payment terms vary by the type and location of the Customer and the products or services offered. Generally, the time between when revenue is recognized and when payment is due is not significant. We do not evaluate whether the selling price contains a financing component for contracts that have a duration of less than one year. We do not capitalize sales commissions as substantially all of our sales commission programs have an amortization period of one year or less. Certain costs to fulfill a contract are capitalized and amortized over the term of the contract if they are recoverable, directly related to a contract and generate resources that we will use to fulfill the contract in the future. At March 31, 2019 assets related to costs to fulfill a contract were not material to our Consolidated Financial Statements. Allowance for Doubtful Accounts Receivable. We maintain an allowance for uncollectible accounts receivable for estimated losses in the collection of amounts owed by Customers. We estimate the allowance based on analyzing a number of factors, including amounts written off historically, Customer payment practices, and general economic conditions. We also analyze significant Customer accounts on a regular basis and record a specific allowance when we become aware of a specific Customer’s inability to pay. As a result, the related accounts receivable are reduced to an amount that we reasonably believe is collectible. These analyses require a considerable amount of judgment. If the financial condition of our Customers worsens, or economic conditions change, we may be required to make changes to our allowance for doubtful accounts receivable. Allowance for Sales Returns. We maintain an allowance for sales returns based upon known returns and estimated returns for both capital equipment and consumables. We estimate returns of capital equipment and consumables based upon historical experience. Inventories and Reserves. Inventories are stated at the lower of their cost or market value. We determine cost based upon a combination of the last-in, first-out (“LIFO”) and first-in, first-out (“FIFO”) cost methods. We determine the LIFO inventory value at the end of the year based on inventory levels and costs at that time. For inventories valued using the LIFO method, we believe that the use of the LIFO method results in a matching of current costs and revenues. Inventories valued using the LIFO method represented approximately 25.2% and 26.0% of total inventories at March 31, 2019 and 2018, respectively. Inventory costs include material, labor, and overhead. If we had used only the FIFO method of inventory costing, inventories would have been $16.8 million and $17.3 million higher than those reported at March 31, 2019 and 2018, respectively. We review inventory on an ongoing basis, considering factors such as deterioration and obsolescence. We record an allowance for estimated losses when the facts and circumstances indicate that particular inventories will not be usable. If future market conditions vary from those projected, and our estimates prove to be inaccurate, we may be required to write-down inventory values and record an adjustment to cost of revenues. Asset Impairment Losses. Property, plant, equipment, and identifiable intangible assets are reviewed for impairment when events and circumstances indicate that the carrying value of such assets may not be recoverable. Impaired assets are recorded at the lower of carrying value or estimated fair value. We conduct this review on an ongoing basis and, if impairment exists, we record the loss in the Consolidated Statements of Income during that period. When we evaluate assets for impairment, we make certain judgments and estimates, including interpreting current economic indicators and market valuations, evaluating our strategic plans with regards to operations, historical and anticipated performance of operations, and other factors. If we incorrectly anticipate these factors, or unexpected events occur, our operating results could be materially affected. Asset Retirement Obligations. We incur retirement obligations for certain assets. We record an initial liability for the asset retirement obligations (ARO) at fair value. Accounting for the ARO at inception and in subsequent periods includes the determination of the present value of a liability and offsetting asset, the subsequent accretion of that liability and depletion of the asset, and a periodic review of the ARO liability estimates and discount rates used in the analysis. We provide additional information about our asset retirement obligations in Note 5 to our consolidated financial statements titled, “Property, Plant and Equipment.” Restructuring. We record specific accruals in connection with plans for restructuring elements of our business. These accruals include estimates principally related to employee separation costs, the closure and/or consolidation of facilities, and contractual obligations. Actual amounts could differ from the original estimates. We review our restructuring-related accruals on a quarterly basis and changes to plans are appropriately recognized in the Consolidated Statements of Income in the period the change is identified. Purchase Accounting and Goodwill. Assets and liabilities of the business acquired are accounted for at their estimated fair values as of the acquisition date. Any excess of the cost of the acquisition over the fair value of the net tangible and intangible assets acquired is recorded as goodwill. We supplement management expertise with valuation specialists in performing appraisals to assist us in determining the fair values of assets acquired and liabilities assumed. These valuations require us to make estimates and assumptions, especially with respect to intangible assets. We generally amortize our intangible assets over their useful lives with the exception of indefinite lived intangible assets. We do not amortize goodwill, but we evaluate it annually for impairment. Therefore, the allocation of the purchase price to intangible assets and goodwill has a significant impact on future operating results. We evaluate the recoverability of recorded goodwill amounts annually, or when evidence of potential impairment exists. We may consider qualitative indicators of the fair value of a reporting unit when it is unlikely that a reporting unit has impaired goodwill. We may also utilize a discounted cash flow analysis that requires certain assumptions and estimates be made regarding market conditions and our future profitability. In those circumstances, we test goodwill for impairment by reviewing the book value compared to the fair value at the reporting unit level. We calculate the fair value of our reporting units based on the present value of estimated future cash flows. Considerable management judgment is necessary to evaluate the impact of operating and macroeconomic changes and to estimate future cash flows to measure fair value. Assumptions used in our impairment evaluations, such as forecasted growth rates and cost of capital, are consistent with internal projections and operating plans. We believe such assumptions and estimates are also comparable to those that would be used by other marketplace participants. As a result of our annual impairment review for goodwill and other indefinite lived intangible assets for fiscal year 2019 and fiscal year 2018, no indicators of impairment were identified. As a result of our annual goodwill impairment review for fiscal year 2017, we concluded that the carrying value of one of our reporting units exceeded its fair value. Prior to its divestiture in fiscal 2017, the Synergy Health Netherlands linen management unit was reported within our Healthcare Specialty Services segment. Financial forecasts prepared for the annual assessment reflected pricing pressures, volume declines driven by overcapacity in the market, and a decline in the overall market size. These factors resulted in further degradation of the already low operating margin and cash flows of this unit. We incurred a goodwill impairment charge of $58.4 million as a result, which was recorded within Goodwill impairment loss in the Consolidated Statements of Income. The fair market value of the reporting unit was determined under an income approach using discounted cash flows and estimated fair market values. Fair value calculated using a discounted cash flow analysis is classified within level 3 of the fair value hierarchy and requires several assumptions including risk adjusted discount rates and financial forecasts. We evaluate indefinite lived intangible assets annually, or when evidence of potential impairment exists. We evaluate several qualitative indicators and assumptions, and trends that influence the valuation of the assets to determine if any evidence of potential impairment exists. During the third quarter of fiscal 2019, management adopted a branding strategy that included phasing out the usage of a tradename associated with certain products in the Healthcare Products business segment. As a result, management recorded an impairment charge of $16.2 million, which is included within the Selling, general, and administrative line of the Consolidated Statements of Income. The remaining fair value of the asset was calculated using an income approach (the relief from royalty method). The remaining fair value was not material and will be amortized over the asset's remaining useful life. Fair value calculated using this approach is classified within Level 3 of the fair value hierarchy and requires several assumption. During the third quarter of fiscal 2017, we adopted a new branding strategy change as part of the integration of certain Synergy Health operations into the Healthcare Specialty Services Segment. Under this new branding strategy, hospital sterilization services and instrument repair services will utilize the STERIS Instrument Management Services brand name. The Synergy Health trade name was phased out during the fourth quarter of fiscal 2017. As a result, we shortened the estimated useful life of the Synergy Health trade name and accelerated the corresponding amortization expense over the remainder of fiscal 2017, which totaled $14.4 million and was recorded within the Selling, general and administrative expense line on the Consolidated Statements of Income. Income Taxes. Our provision for income taxes is based on our current period income, changes in deferred income tax assets and liabilities, income tax rates, changes in uncertain tax benefits, and tax planning opportunities available to us in the various jurisdictions in which we operate. Tax laws are complex and subject to different interpretations by the taxpayer and the respective governmental taxing authorities. We use significant judgment in determining our annual effective income tax rate and evaluating our tax positions. We prepare and file tax returns based on our interpretation of tax laws and regulations, and we record estimates based on these judgments and interpretations. We cannot be sure that the tax authorities will agree with all of the tax positions taken by us. The actual income tax liability for each jurisdiction in any year can, in some instances, ultimately be determined be several years after the tax return is filed and the financial statements are published. We evaluate our tax positions using the recognition threshold and measurement attribute in accordance with current accounting guidance. We determine whether it is more-likely-than-not that a tax position will be sustained upon examination, including resolution of related appeals or litigation processes, based on the technical merits of the position. In evaluating whether a tax position has met the more-likely-than-not recognition threshold, we presume that the position will be examined by the appropriate taxing authority and that the taxing authority will have full knowledge of all relevant information. A tax position that meets the more-likely-than-not recognition threshold is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. The appropriate unit of account for determining what constitutes an individual tax position, and whether the more-likely-than-not recognition threshold is met for a tax position, is a matter of judgment based on the individual facts and circumstances of that position evaluated in light of all available evidence. We review and adjust our tax estimates periodically because of ongoing examinations by and settlements with the various taxing authorities, as well as changes in tax laws, regulations and precedent. We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax basis of assets and liabilities. We regularly review our deferred tax assets for recoverability and establish a valuation allowance based on historical taxable income, projected future taxable income, the expected timing of the reversals of existing temporary differences, and the implementation of tax planning strategies. If we are unable to generate sufficient future taxable income in certain tax jurisdictions, or if there is a material change in the effective income tax rates or time period within which the underlying temporary differences become taxable or deductible, we could be required to increase our valuation allowance, which would increase our effective income tax rate and could result in an adverse impact on our consolidated financial position, results of operations, or cash flows. We believe that adequate accruals have been made for income taxes. Differences between the estimated and actual amounts determined upon ultimate resolution, individually or in the aggregate, are not expected to have a material adverse effect on our consolidated financial position, but could possibly be material to our consolidated results of operations or cash flows for any one period. Additional information regarding income taxes is included in Note 8 to our consolidated financial statements titled, “Income Taxes.” Self-Insurance Liabilities. We record a liability for self-insured risks that we retain for general and product liabilities, workers’ compensation, and automobile liabilities based on actuarial calculations. We use our historical loss experience and actuarial methods to calculate the estimated liability. This liability includes estimated amounts for both losses and incurred but not reported claims. We review the assumptions used to calculate the estimated liability at least annually to evaluate the adequacy of the amount recorded. We maintain insurance policies to cover losses greater than our estimated liability, which are subject to the terms and conditions of those policies. The obligation covered by insurance contracts will remain on the balance sheet as we remain liable to the extent insurance carriers do not meet their obligation. Estimated amounts receivable under the contracts are included in the "Prepaid expenses and other current assets" line, and the "Other assets" line of our consolidated balance sheets. Our accrual for self-insured risk retention as of March 31, 2019 and 2018 was $19.7 million and $20.9 million, respectively. We are also self-insured for employee medical claims. We estimate a liability for incurred but not reported claims based upon recent claims experience. Our self-insured liabilities contain uncertainties because management must make assumptions and apply judgments to estimate the ultimate cost to settle reported claims and claims incurred but not reported as of the balance sheet date. If actual results are not consistent with these assumptions and judgments, we could be exposed to additional costs in subsequent periods. Contingencies. We are, and will likely continue to be, involved in a number of legal proceedings, government investigations, and claims, which we believe generally arise in the course of our business, given our size, history, complexity, and the nature of our business, products, Customers, regulatory environment, and industries in which we participate. These legal proceedings, investigations and claims generally involve a variety of legal theories and allegations, including, without limitation, personal injury (e.g., slip and falls, burns, vehicle accidents), product liability or regulation (e.g., based on product operation or claimed malfunction, failure to warn, failure to meet specification, or failure to comply with regulatory requirements), product exposure (e.g., claimed exposure to chemicals, asbestos, contaminants, radiation), property damage (e.g., claimed damage due to leaking equipment, fire, vehicles, chemicals), commercial claims (e.g., breach of contract, economic loss, warranty, misrepresentation), financial (e.g., taxes, reporting), employment (e.g., wrongful termination, discrimination, benefits matters), and other claims for damage and relief. We record a liability for such contingencies to the extent we conclude that their occurrence is both probable and estimable. We consider many factors in making these assessments, including the professional judgment of experienced members of management and our legal counsel. We have made estimates as to the likelihood of unfavorable outcomes and the amounts of such potential losses. In our opinion, the ultimate outcome of these proceedings and claims is not anticipated to have a material adverse affect on our consolidated financial position, results of operations, or cash flows. However, the ultimate outcome of proceedings, government investigations, and claims is unpredictable and actual results could be materially different from our estimates. We record expected recoveries under applicable insurance contracts when we are assured of recovery. Refer to Note 10 of our consolidated financial statements titled, "Commitments and Contingencies" for additional information. We are subject to taxation from federal, state and local, and foreign jurisdictions. Tax positions are settled primarily through the completion of audits within each individual tax jurisdiction or the closing of a statute of limitation. Changes in applicable tax law or other events may also require us to revise past estimates. The IRS of the United States routinely conducts audits of our federal income tax returns. Additional information regarding our commitments and contingencies is included in Note 10 to our consolidated financial statements titled, “Commitments and Contingencies.” Benefit Plans. We provide defined benefit pension plans for certain employees and retirees. In addition, we sponsor an unfunded post-retirement benefits plan for two groups of United States retirees. Benefits under this plan include retiree life insurance and retiree medical insurance, including prescription drug coverage. Employee pension and post-retirement benefits plans are a cost of conducting business and represent obligations that will be settled in the future and therefore, require us to use estimates and make certain assumptions to calculate the expense and liabilities related to the plans. Changes to these estimates and assumptions can result in different expense and liability amounts. Future actual experience may be significantly different from our current expectations. We believe that the most critical assumptions used to determine net periodic benefit costs and projected benefit obligations are the expected long-term rate of return on plan assets and the discount rate. A summary of significant assumptions used to determine the March 31, 2019 projected benefit obligations and the fiscal 2019 net periodic benefit costs is as follows: NA - Not applicable. We develop our expected long-term rate of return on plan assets assumptions by evaluating input from third-party professional advisors, taking into consideration the asset allocation of the portfolios, and the long-term asset class return expectations. Generally, net periodic benefit costs increase as the expected long-term rate of return on plan assets assumption decreases. Holding all other assumptions constant, lowering the expected long-term rate of return on plan assets assumption for our funded defined benefit pension plans by 50 basis points would have increased the fiscal 2019 benefit costs by less than $0.1 million. We develop our discount rate assumptions by evaluating input from third-party professional advisers, taking into consideration the current yield on country specific investment grade long-term bonds which provide for similar cash flow streams as our projected benefit obligations. Generally, the projected benefit obligations and the net periodic benefit costs both increase as the discount rate assumption decreases. Holding all other assumptions constant, lowering the discount rate assumption for our defined benefit pension plans and for the other post-retirement benefits plan by 50 basis points would have decreased the fiscal 2019 net periodic benefit costs by less than $0.1 million and would have increased the projected benefit obligations by approximately $11.8 million at March 31, 2019. We have made assumptions regarding healthcare costs in computing our other post-retirement benefit obligation. The assumed rates of increase generally decline ratably over a five year-period from the assumed current year healthcare cost trend rate of 6.8% to the assumed long-term healthcare cost trend rate. A 100 basis point change in the assumed healthcare cost trend rate (including medical, prescription drug, and long-term rates) would have had the following effect at March 31, 2019: We recognize an asset for the overfunded status or a liability for the underfunded status of defined benefit pension and post-retirement benefit plans in our balance sheets. This amount is measured as the difference between the fair value of plan assets and the benefit obligation (the projected benefit obligation for pension plans and the accumulated post-retirement benefit obligation for other post-retirement benefit plans). Changes in the funded status of the plans are recorded in other comprehensive income in the year they occur. We measure plan assets and obligations as of the balance sheet date. Note 9 to our consolidated financial statements titled, “Benefit Plans,” contains additional information about our pension and other post-retirement welfare benefits plans. Share-Based Compensation. We measure the estimated fair value for share-based compensation awards, including grants of employee stock options, at the grant date and recognize the related compensation expense over the period in which the share-based compensation vests. We selected the Black-Scholes-Merton option pricing model as the most appropriate method for determining the estimated fair value of our share-based stock option compensation awards. This model involves assumptions that are judgmental and affect share-based compensation expense. Share-based compensation expense was $24.0 million in fiscal 2019, $22.2 million in fiscal 2018 and $18.8 million in fiscal 2017. Note 14 to our consolidated financial statements titled, “Share-Based Compensation,” contains additional information about our share-based compensation plans. RECENTLY ISSUED ACCOUNTING STANDARDS IMPACTING THE COMPANY Recently issued accounting standards that are relevant to us are presented in Note 1 to our consolidated financial statements titled, “Nature of Operations and Summary of Significant Accounting Policies.” INFLATION Our business has not been significantly impacted by the overall effects of inflation. We monitor the prices we charge for our products and services on an ongoing basis and plan to adjust those prices to take into account future changes in the rate of inflation. However, we may not be able to completely offset the impact of inflation. FORWARD-LOOKING STATEMENTS This Form 10-K may contain statements concerning certain trends, expectations, forecasts, estimates, or other forward-looking information affecting or relating to STERIS or its industry, products or activities that are intended to qualify for the protections afforded “forward-looking statements” under the Private Securities Litigation Reform Act of 1995 and other laws and regulations. Forward-looking statements speak only as to the date the statement is made and may be identified by the use of forward-looking terms such as “may,” “will,” “expects,” “believes,” “anticipates,” “plans,” “estimates,” “projects,” “targets,” “forecasts,” “outlook,” “impact,” “potential,” “confidence,” “improve,” “optimistic,” “deliver,” “orders,” “backlog,” “comfortable,” “trend”, and “seeks,” or the negative of such terms or other variations on such terms or comparable terminology. Many important factors could cause actual results to differ materially from those in the forward-looking statements including, without limitation, disruption of production or supplies, changes in market conditions, political events, pending or future claims or litigation, competitive factors, technology advances, actions of regulatory agencies, and changes in laws, government regulations, labeling or product approvals or the application or interpretation thereof. Other risk factors are described herein and in STERIS’s other securities filings, including Item 1A of this Annual Report on Form 10-K. Many of these important factors are outside of STERIS’s control. No assurances can be provided as to any result or the timing of any outcome regarding matters described in STERIS’s securities filings or otherwise with respect to any regulatory action, administrative proceedings, government investigations, litigation, warning letters, cost reductions, business strategies, earnings or revenue trends or future financial results. References to products are summaries only and should not be considered the specific terms of the product clearance or literature. Unless legally required, STERIS does not undertake to update or revise any forward-looking statements even if events make clear that any projected results, express or implied, will not be realized. Other potential risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements include, without limitation, (a) STERIS's ability to achieve the expected benefits regarding the accounting and tax treatments of the Redomiciliation transaction, (b) operating costs, Customer loss and business disruption (including, without limitation, difficulties in maintaining relationships with employees, Customers, clients or suppliers) being greater than expected following the Redomiciliation, (c) STERIS’s ability to meet expectations regarding the accounting and tax treatment of the Tax Cuts and Jobs Act (“TCJA”) or the possibility that anticipated benefits resulting from the TCJA will be less than estimated, (d) changes in tax laws or interpretations that could increase our consolidated tax liabilities, including changes in tax laws that would result in STERIS being treated as a domestic corporation for United States federal tax purposes, (e) the potential for increased pressure on pricing or costs that leads to erosion of profit margins, (f) the possibility that market demand will not develop for new technologies, products or applications or services, or business initiatives will take longer, cost more or produce lower benefits than anticipated, (g) the possibility that application of or compliance with laws, court rulings, certifications, regulations, regulatory actions, including without limitation those relating to FDA warning notices or letters, government investigations, the outcome of any pending FDA requests, inspections or submissions, or other requirements or standards may delay, limit or prevent new product introductions, affect the production and marketing of existing products or services or otherwise affect STERIS’s performance, results, prospects or value, (h) the potential of international unrest, economic downturn or effects of currencies, tax assessments, tariffs and/or other trade barriers, adjustments or anticipated rates, raw material costs or availability, benefit or retirement plan costs, or other regulatory compliance costs, (i) the possibility of reduced demand, or reductions in the rate of growth in demand, for STERIS’s products and services, (j) the possibility of delays in receipt of orders, order cancellations, or delays in the manufacture or shipment of ordered products or in the provision of services, (k) the possibility that anticipated growth, cost savings, new product acceptance, performance or approvals, or other results may not be achieved, or that transition, labor, competition, timing, execution, regulatory, governmental, or other issues or risks associated with STERIS’s businesses, industry or initiatives including, without limitation, those matters described in this Form 10-K and other securities filings, may adversely impact STERIS’s performance, results, prospects or value, (l) the impact on STERIS and its operations, or tax liabilities, of Brexit or the exit of other member countries from the EU, and the Company’s ability to respond to such impacts, (m) the impact on STERIS and its operations of any legislation, regulations or orders, including but not limited to any new trade or tax legislation, regulations or orders, that may be implemented by the U.S. administration or Congress, or of any responses thereto, (n) the possibility that anticipated financial results or benefits of recent acquisitions, or of STERIS’s restructuring efforts, or of recent divestitures, or of the targeted restructuring plan will not be realized or will be other than anticipated, and (o) the effects of contractions in credit availability, as well as the ability of STERIS’s Customers and suppliers to adequately access the credit markets when needed.

<s>[INST] INTRODUCTION In Management’s Discussion and Analysis (“MD&A”), we explain the general financial condition and the results of operations for STERIS and its subsidiaries including: what factors affect our business; what our earnings and costs were; why those earnings and costs were different from the year before; where our earnings came from; how this affects our overall financial condition; what our expenditures for capital projects were; and where cash will come from to fund future debt principal repayments, growth outside of core operations, repurchase ordinary shares, pay cash dividends and fund future working capital needs. The MD&A also analyzes and explains the annual changes in the specific line items in the Consolidated Statements of Income. As you read the MD&A, it may be helpful to refer to information in Item 1, “Business,” Item 6, “Selected Financial Data,” and our consolidated financial statements, which present the results of our operations for fiscal 2019, 2018 and 2017, as well as Part I, Item 1A, “Risk Factors” and Note 10 of our consolidated financial statements titled, "Commitments and Contingencies" for a discussion of some of the matters that can adversely affect our business and results of operations. This information, discussion, and disclosure may be important to you in making decisions about your investments in STERIS. FINANCIAL MEASURES In the following sections of the MD&A, we may, at times, refer to financial measures that are not required to be presented in the consolidated financial statements under U.S. GAAP. We sometimes use the following financial measures in the context of this report: backlog; debttototal capital; and days sales outstanding. We define these financial measures as follows: Backlog We define backlog as the amount of unfilled capital equipment purchase orders at a point in time. We use this figure as a measure to assist in the projection of shortterm financial results and inventory requirements. Debttototal capital We define debttototal capital as total debt divided by the sum of total debt and shareholders’ equity. We use this figure as a financial liquidity measure to gauge our ability to borrow and fund growth. Days sales outstanding (“DSO”) We define DSO as the average collection period for accounts receivable. It is calculated as net accounts receivable divided by the trailing four quarters’ revenues, multiplied by 365 days. We use this figure to help gauge the quality of accounts receivable and expected time to collect. We, at times, may also refer to financial measures which are considered to be “nonGAAP financial measures” under SEC rules. We have presented these financial measures because we believe that meaningful analysis of our financial performance is enhanced by an understanding of certain additional factors underlying that performance. These financial measures should not be considered an alternative to measures required by accounting principles generally accepted in the United States. Our calculations of these measures may differ from calculations of similar measures used by other companies and you should be careful when comparing these financial measures to those of other companies. Additional information regarding these financial measures, including reconciliations of each non GAAP financial measure, is available in the subsection of MD&A titled, "NonGAAP Financial Measures." REVENUES DEFINED As required by Regulation SX, we separately present revenues generated as either product revenues or service revenues on our Consolidated Statements of Income for each period presented. When we discuss revenues, we may, at times, refer to revenues summarized differently than the Regulation SX requirements. The terminology, definitions, and applications of terms that we use to describe revenues may be different from terms used by other companies. We use the following terms to describe revenues: Revenues Our revenues are presented net of sales returns and allowances. Product Revenues We define product revenues as revenues generated from sales of consumable and capital equipment products. Service Revenues We define service revenues as revenues generated from parts and labor associated with the maintenance, repair, and installation of our capital equipment. Service revenues also include hospital sterilization services, instrument and scope repairs, and linen management as well as revenues generated from contract sterilization and laboratory services offered through our Applied Sterilization Technologies segment. Linen management services were divested in fiscal 2017. [/INST] Positive. </s>

Livongo Health, Inc.

2020-03-24

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 the related notes thereto included elsewhere in this Annual Report on Form 10-K. As discussed in the section titled "Note Regarding Forward-Looking Statements," the following discussion and analysis contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below and those discussed in the section titled “Risk Factors” under Part I, Item 1A in this Annual Report on Form 10-K. Pursuant to the FAST Act Modernization and Simplification of Regulation S-K, discussions related to the changes in results of operations from fiscal year 2018 to fiscal year 2017 have been omitted. Such omitted discussion can be found in our Form S-1, filed December 9, 2019 with the SEC. Overview Our mission is to empower people with chronic conditions to live better and healthier lives. The advancement of technology and data science has transformed nearly every industry except healthcare to create new, consumer-first experiences that are both personalized and empowering. Livongo is pioneering a new category in healthcare, called Applied Health Signals, which is transforming the management of chronic conditions. Our platform, which leverages data science and technology, creates a new kind of personalized experience for people with chronic conditions (our members). This empowers our members to make sustainable behavior changes that lead to better outcomes and lower costs. The Livongo experience makes it easier for our members to stay healthy. We fit into the way our members live, put them in control of managing their condition, and give them an experience that they don’t just like, but love (evidenced by our average Livongo for Diabetes member NPS of +64 as of December 31, 2019). We currently offer Livongo for Diabetes, which has historically accounted for a substantial portion of our revenue, and we expect that to continue for the next several years, as well as Livongo for Hypertension, Livongo for Prediabetes and Weight Management, and Livongo for Behavioral Health by myStrength. Our solutions include a smart, cellular-connected device and related testing materials, if applicable, that are sent directly to the member, and member access to a suite of personalized feedback and remote monitoring and coaching services on our platform. We invoice our clients monthly on a per-member or per-solution basis, depending on the solution, and may also charge an upfront fee for the devices. We do not sell member support services separately. As a result, member enrollment and continued usage drives our revenue and we primarily generate revenue not through the upfront fee for our devices, but from the ongoing subscription revenue for our members to access to our integrated solution. Our agreements have fixed and variable pricing components based on the number of members. This results in a highly predictable revenue stream, which helps us plan for growth and scale. Furthermore, over time, many of our clients make our solutions available to a greater percentage of their employee population, allowing us to both increase enrollment within our existing clients, which we refer to as product intensity, and for the sale of additional solutions to existing clients, which we refer to as product density. Beginning in 2020, we introduced pricing options that provide members with access to multiple solutions in order to enable us to more fully address the health of the whole person. We typically enter into a higher percentage of agreements with new clients, as well as renewal agreements with existing clients, in our third and fourth quarters, which results in higher enrollment launch rates in the first quarter. We believe that this results in part from the timing of open enrollment periods of many of our clients. We sell to companies of all sizes, including employers, from small businesses to Fortune 500 enterprises, hospital payors government entities, and labor unions. We currently derive a high concentration of our revenue from sales to clients that are self-insured employers, with hospital payors, government entities, and labor unions accounting for a smaller portion of our revenue. As of December 31, 2019 and December 31, 2018, we served 804 and 413 clients, respectively. As of December 31, 2019 and December 31, 2018, we had approximately 222,700 and 113,900 members, respectively, enrolled in our Livongo for Diabetes solution. In addition, we have a growing number of members enrolled in our hypertension, prediabetes and weight management, and behavioral health solutions. Our client and member base are located in the United States. See Note 2 under Part II, Item 8 of this report for information about significant customers and partners which represent 10% or more of our net accounts receivable balance or revenue during the period at each respective consolidated balance sheet date. We have experienced significant growth since our inception. Our revenue increased $101.8 million, or 149%, to $170.2 million for the year ended December 31, 2019, compared to $68.4 million for the year ended December 31, 2018. We have made significant investments to grow our business, particularly in research and development and sales and marketing. As a result, we have incurred net losses of $55.3 million and $33.4 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $164.2 million. In July 2019, we completed our IPO and issued and sold 14,590,050 shares at an offering price of $28.00 per share, including 1,903,050 shares pursuant to the exercise in full of the underwriters' option to purchase additional shares. We raised net proceeds of $377.5 million, after deducting underwriting discounts and commissions of $28.6 million and offering costs of approximately $2.4 million. Immediately prior to the closing of our IPO, all 58,615,488 shares of our then-outstanding redeemable convertible preferred shares automatically converted into 58,615,488 shares of common stock and we reclassified $237.0 million from temporary equity to additional paid-in capital and into common stock par value on our consolidated balance sheet. In December 2019, a novel strain of coronavirus was reported in Wuhan, China. The extent of the impact of the coronavirus outbreak on our operational and financial performance will depend on certain developments, including the duration and spread of the outbreak, impact on our clients and our sales cycles, impact on our marketing efforts, and effect on our suppliers, all of which are uncertain and cannot be predicted. At this point, the extent to which the coronavirus outbreak may materially impact our financial condition, liquidity or results of operations is uncertain. Due to our subscription-based business model, the effect of the coronavirus outbreak may not be fully reflected in our results of operations until future periods, if at all. Factors Affecting Our Performance New Client Acquisition. We believe there are significant opportunities for growth as enterprises and individuals seek better ways to manage chronic conditions. We believe our ability to add new clients is a key indicator of our increasing market adoption and future revenue potential. Our client count grew from 413 as of December 31, 2018 to 804 clients as of December 31, 2019, including 120 clients we acquired in connection with our acquisition of myStrength, Inc. completed in February 2019, representing an increase of 95%. Our channel partners, PBMs and resellers play an important role in marketing to and contracting with our clients. They often speed up the process of contracting and increase our access to clients. Under our agreements with our channel partners, PBMs and resellers, we are obligated to pay such third parties an administrative or a marketing fee. While these relationships carry up-front costs, they significantly expand the distribution channels through which we may capture new clients and enroll new members. Our growth and financial results will depend in part on our ability to acquire new clients, particularly as we pursue Medicare Advantage, Managed Medicare, Fee for Service Medicare, Medicaid, and other fully-insured employers. Our ability to increase our total number of clients also increases our future opportunities for product intensity through expansion of members within an existing client using a solution, renewals, and product density through sales of additional solutions for other chronic conditions. Product Intensity and Enrollment. An important component of our revenue growth strategy is to retain our existing clients and members, as well as increase product intensity through growing member enrollment within our client base. We believe we are well-positioned to continue our relationships with existing clients due to the quality of our solutions and member satisfaction with our solutions. Members see real value in our solutions and are satisfied with our offering, which is demonstrated with our average Livongo for Diabetes member NPS of +64 as of December 31, 2019. We work to continually improve our enrollment rate through the use of our AI+AI engine, which provides feedback on successful outreach and engagement strategies. The ability to enroll additional members with chronic conditions represents a significant opportunity for us within our existing clients. Once a client is onboarded, we leverage our AI+AI engine to target and engage with potential new members in an informed manner that drives rapid enrollment and increases our product intensity in these new clients. We believe that our ability to grow the subscription revenue generated from our existing clients is an indicator of the long-term value of our client relationships for Livongo as a whole. We typically enjoy a high rate of client retention and expansion. We track our performance in this area by measuring our dollar-based net expansion rate, which for clients who had been clients for at least one year was 111.5% and 113.8% for the years ended December 31, 2019 and 2018, respectively. Our dollar-based net expansion rate compares our monthly service revenue from the same set of clients across comparable periods. Our dollar-based net expansion rate equals: (1) the monthly service revenue at the end of a period for a base set of clients from which we generated monthly service revenue two years prior to the date of calculation, divided by (2) the monthly service revenue one year prior to the date of calculation for the same set of clients. Monthly service revenue is calculated as the monthly per participant rate for our Livongo for Diabetes and our Livongo for Hypertension solutions multiplied by the number of members who were active on or used our solution within a certain period of time, as specified in the applicable client’s agreement. Our dollar-based net expansion rate reflects clients who have ceased using our solution. We began tracking dollar-based net expansion rate annually in 2018. Our retention rate for clients who have been with us for at least one year as of December 31, 2019 and 2018 was 94.2% and 95.9%, respectively. Product Density. While Livongo for Diabetes was our first solution, there is significant overlap in the target members for each of our solutions and we see significant cross-selling opportunities. We currently offer solutions focused on diabetes, hypertension, prediabetes and weight management and behavioral health. We are continuing to invest in expanding our solutions, as well as developing solutions that address other chronic conditions. As we continue to add solutions that address additional chronic conditions to our platform and deepen our product density, we see increased sales opportunities as members often experience multiple chronic conditions simultaneously and could benefit from access to multiple Livongo solutions. Additionally, we see significant opportunities to add new clients and members to our platform as we offer an increasing number of solutions. Beginning in 2020, we introduced pricing options that provide members with access to multiple solutions in order to enable us to more fully address the health of the whole person. Enhancing and Extending Our Platform. We offer web and mobile resources, empowering members to be active participants in their journey to becoming and staying physically and mentally healthy. Our AI+AI engine constantly assesses which approaches are most effective in helping our members, and we will continue to add to our repertoire as we receive further data and feedback. We expect to continue to invest in research and development to enhance our platform by improving our existing solutions and furthering product density by expanding into solutions for other chronic conditions. Our platform is highly scalable and is built to treat the whole person. We believe our platform can be expanded to address a range of chronic conditions, and we are constantly reviewing areas of improvement and potential density expansion. We are continuing to evaluate other chronic conditions, as well as solutions that are compatible with other payors such as government programs, including Medicare Advantage, Managed Medicaid, Fee for Service Medicare, and Medicaid. In addition to our ongoing investment in research and development, we may also pursue acquisitions of businesses, technologies and assets that complement and expand the functionality of our solutions to other chronic conditions, add to our technology or security expertise, or bolster our leadership position by gaining access to new clients or markets. Investing in Growth. We expect to continue to focus on long-term revenue growth through investments in sales and marketing and research and development. While we offer our own devices that are compatible with our solutions, we are also working to enhance our offering to integrate existing health monitoring devices and incorporate new technology. We also believe our solutions are well suited for people living with chronic conditions around the globe, and we view international expansion as a longer-term opportunity. In addition, we expect our general and administrative expenses to increase in absolute dollars for the foreseeable future to support our growth. We plan to balance these investments in future growth with a continued focus on managing our expenditures and investing judiciously. Accordingly, in the short term we expect these activities to increase our net losses, but in the long term we anticipate that these investments will positively impact our business and results of operations. Timing of Sales. While we sell to and implement our solutions to clients year-round, we experience some seasonality in terms of when we enter into agreements with our clients and when we launch our solutions to members. We typically enter into a higher percentage of agreements with new clients, as well as renewal agreements with existing clients, in our third and fourth quarters, which coincide with typical employee benefit enrollment periods, with higher implementation rates in the first quarter. Regardless of when the agreement is entered into, we can typically complete client implementation in an average of approximately three months. Any downturn in sales, however, may negatively affect our revenue in future periods. Accordingly, the effect of downturns in sales and potential changes in our rate of renewals may not be fully reflected in our results of operations until future periods. Key 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. We believe the following metrics are useful in evaluating our business: (1) Previously referred to as total contract value. Clients. We define our clients as business entities that have at least one active paid contract with us at the end of a particular period. Entities that access our platform through our channel partners, PBMs, and resellers are counted as individual clients. We do not count our channel partners, PBMs, or resellers as clients, unless they also separately have active paid contracts for our solutions. If business units or subsidiaries of the same entity enter into separate agreements with us, they are counted as separate clients. However, entities that have purchased multiple solutions through different contracts are treated as a single client. Enrolled Diabetes Members. We believe our ability to grow the number of enrolled diabetes members is an indicator of penetration of our flagship solution, Livongo for Diabetes. We define our enrolled diabetes members as all individuals that are enrolled in Livongo for Diabetes at the end of a given period. This number excludes: (i) employees or dependents of a client that has ceased using our solution, (ii) employees who no longer have an employment relationship with an active client, and their dependents, and (iii) employees and dependents who have not been active on or used our solution for a period of time as specified in the applicable client’s agreement, which is typically between four and six months. Estimated Value of Agreements. Estimated value of agreements, which we previously referred to as Total Contract Value, is helpful in evaluating our business because it provides some visibility into future revenue. Our new client subscriptions typically have a term of one to three years, and we generally invoice our clients in monthly installments at the end of each month in the subscription period based on the number of members in such month who were active on or used our solution within a certain period of time, as specified in the applicable client’s agreement. We define estimated value of agreements as contractually committed orders to be invoiced under agreements initially entered into during the relevant period. Estimated value of agreements includes agreements entered into with new clients or expansion opportunities entered into with existing clients. Agreements are only counted in estimated value of agreements in the period in which they are entered into, and for purposes of this calculation, we assume an average member enrollment rate. Our estimates include assumptions regarding the total recruitable individuals at a client, commencement of enrollment period, enrollment method, starting enrollment rates, monthly increases to enrollment rates over time, contract length, and client size and industry. Estimates also assume the agreement will not be terminated early and will be serviced for the full term, there are no changes to the total recruitable individuals at a client during the relevant period, and no changes to the per participant per month fee, or PPPM, during the relevant period. Until such time as these amounts are invoiced, which occurs at the end of each month of service, they are not recorded in revenue, deferred revenue, or elsewhere in our consolidated financial statements. Non-GAAP Financial Measures We believe that, in addition to our financial results determined in accordance with GAAP, adjusted gross profit, adjusted gross margin, and adjusted EBITDA, all of which are non-GAAP financial measures, are useful in evaluating our business, results of operations, and financial condition. We adopted the Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASC 606”) on January 1, 2019 by applying the modified retrospective transition method to all active contracts at the adoption date. Results for the reporting period beginning January 1, 2019 are reported in accordance with ASC 606; however, prior year results were not adjusted and are presented in accordance with ASC 605, Revenue Recognition. As a result of the adoption of the new revenue standard, our adjusted EBITDA for the year ended December 31, 2019 decreased by $0.6 million, primarily attributable to the deferral and amortization of incremental costs to obtain client contracts. The adoption of ASC 606 did not have a material impact on our revenue for the year ended December 31, 2019. See Note 3 under Part II, Item 8 of this report for further disclosure related to ASC 606. Adjusted Gross Profit and Adjusted Gross Margin Adjusted gross profit and adjusted gross margin are key performance measures that our management uses to assess our overall performance. We define adjusted gross profit as GAAP gross profit, excluding stock-based compensation expense and amortization of intangible assets. We define adjusted gross margin as our adjusted gross profit divided by our revenue. We believe adjusted gross profit and adjusted gross margin provide our management and investors consistency and comparability with our past financial performance and facilitate period-to-period comparisons of operations, as these metrics eliminate the effects of stock-based compensation and amortization of intangible assets from period-to-period as factors unrelated to overall operating performance. The following table presents a reconciliation of adjusted gross profit from the most comparable GAAP measure, gross profit, for the periods presented: 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 adjusted to exclude (i) depreciation and amortization, (ii) amortization of intangible assets, (iii) stock-based compensation expense, (iv) acquisition-related expenses, (v) secondary offering costs, (vi) secondary offering related payroll taxes, (vii) change in fair value of contingent consideration, (viii) other income, net, and (ix) provision for (benefit from) income taxes. The following table presents a reconciliation of adjusted EBITDA from the most comparable GAAP measure, net loss, for the periods presented: ______________ (1) Depreciation and amortization includes depreciation of property and equipment, amortization of debt discount, and amortization of capitalized internal-use software costs. (2) Acquisition-related expenses primarily consist of transaction and transition related fees and expenses, including legal, accounting, and other professional fees. (3) Secondary offering costs primarily consist of transaction related fees and expenses incurred in connection with our secondary transaction. We did not receive any proceeds from this offering. (4) Secondary offering costs consist of employer portion of payroll taxes associated with the release of equity awards for the secondary offering. (5) Other income, net includes interest income, interest expense, and other income (expense). Some of the limitations of adjusted EBITDA include (i) adjusted EBITDA does not properly reflect capital commitments to be paid in the future, and (ii) although depreciation and amortization are non-cash charges, the underlying assets may need to be replaced and adjusted EBITDA does not reflect these capital expenditures. Our adjusted EBITDA may not be comparable to similarly titled measures of other companies because they may not calculate adjusted EBITDA in the same manner as we calculate the measure, limiting its usefulness as a comparative measure. In evaluating adjusted EBITDA, you should be aware that in the future we will incur expenses similar to the adjustments in this presentation. Our presentation of adjusted EBITDA should not be construed as an inference that our future results will be unaffected by these expenses or any unusual or non-recurring items. When evaluating our performance, you should consider adjusted EBITDA alongside other financial performance measures, including our net loss and other GAAP results. Components of Statements of Operations We adopted the new revenue standard on January 1, 2019 by applying the modified retrospective transition method to all active contracts at the adoption date. Results for the reporting period beginning January 1, 2019 are reported in accordance with ASC 606; however, prior periods were not adjusted and are presented in accordance with ASC 605. As a result of the adoption of the new revenue standard, our sales and marketing expense increased by $0.7 million, primarily due to the amortization of incremental costs to obtain client contracts. The adoption of ASC 606 did not have a material impact on our revenue for the year ended December 31, 2019. See Note 2 and Note 3 under Part II, Item 8 of this report for further information related to the adoption of ASC 606. Revenue The substantial majority of our revenue is derived from monthly subscription fees that are charged based on a PPPM basis, which is determined based on number of active enrolled members each month. Our Livongo for Diabetes, Livongo for Prediabetes and Weight Management, and Livongo for Behavioral Health solutions incorporate the integration of devices used to monitor members’ chronic conditions, supplies and services, including access to our platform. The contract term is generally one to three years, with one year auto-renewal terms. There is usually a six-month minimum enrollment period within our contracts. Many of our customers can stop their monthly recurring subscription but will be required to pay an early termination fee if the termination occurs during the minimum enrollment period. Additionally, certain of our contracts are subject to pricing adjustments based on various performance metrics including member satisfaction scores, cost savings guarantees and health outcome guarantees. In most agreements associated with our Livongo for Diabetes, Livongo for Hypertension, and Livongo for Prediabetes and Weight Management solutions, clients primarily pay monthly subscription fees based on a per participant per month model, based on the number of active enrolled members each month. In addition, clients can choose to pay an upfront amount with a lower per participant per month fee. We have determined that access to our solution is a single continuous service comprised of a series of distinct services that are substantially the same and have the same pattern of transfer (i.e. distinct days of service). These services are consumed as they are received and we recognize revenue each month using the variable consideration allocation exception. We apply this exception because we concluded that the nature of our obligations and the variability of the payment being based on the number of active members are aligned. In most agreements associated with our Livongo for Behavioral Health by myStrength solution, clients either pay a fixed upfront fee or a monthly fee based on the number of members to whom the solution is available. The contract term is generally one to three years, with one year auto-renewal terms. We have determined that access to our solution is a single continuous service comprised of a series of distinct services that are substantially the same and have the same pattern of transfer (i.e. distinct days of service). These services are consumed as they are received and we recognize revenue each month using the variable consideration allocation exception. We apply this exception because we concluded that the nature of our obligations and the variability of the payment terms based on the number of available members are aligned and uncertainty related to the consideration is resolved on a monthly basis as we satisfy our obligations. For certain arrangements where the per-member fee varies as the number of available members changes, we estimate the expected transaction price based on the number of expected members over the term of the arrangement. In certain legacy arrangements, we derive revenue from the sale of our cellular-connected weight scale and access to the Livongo for Prediabetes and Weight Management solution through the Retrofit platform. When an agreement contains multiple performance obligations, we allocate the transaction price to each performance obligation based on the relative SSP. The determination of SSP is judgmental and is based on the price an entity charges for the same good or service, sold separately in a standalone sale, and sold to similar clients in similar circumstances. We typically price the devices and services within a narrow range to represent SSP. Amounts allocated to the connected device are recognized at a point in time upon delivery of the device. Amounts allocated to the services are recognized as the service is performed. Although we are in the early stages of selling our newer solutions, we are experiencing client demand to broaden their relationship with Livongo and are seeing add-on orders as well as contracts being executed with multiple solutions. Our contracts are negotiated directly with the customer or through a partner. We are the principal that controls the transfer of promised goods and services to members with respect to the contracts originated through partners, we have latitude in establishing pricing, and we have inventory risk. In these situations, revenue is recognized on a gross basis and fees paid to partners are recorded as commission expenses as a component of sales and marketing expenses. Cost of Revenue Cost of revenue consists of expenses that are closely correlated or directly related to delivery of our solutions and monthly subscription fees, including product costs, data center costs, client support costs, credit card processing fees, allocated overhead costs, amortization of developed technology, and amortization of deferred costs. For our Livongo for Diabetes, Hypertension and Prediabetes and Weight Management solutions, which offer the cellular-connected devices, device costs are deferred and amortized over the shorter of the expected member enrollment period or the expected device life. Certain personnel expenses associated with supporting these functions, such as salaries, bonuses, stock-based compensation expense and benefits, including allocated overhead expenses for facilities, information technology and depreciation expense, are included in cost of revenue. We expect cost of revenue to increase in the foreseeable future in absolute dollars, but decrease as a percentage of revenue over the long term. Gross Profit and Gross Margin Gross profit and gross margin, or gross profit as a percentage of revenue, has been and will continue to be affected by various factors, including the timing of our acquisition of new clients, renewals of our existing agreements, sales of additional solutions to our existing clients, our product life cycle as we transition into new products, our introduction of new solutions for other chronic conditions, including the costs associated with bringing such new solutions to market, the extent to which we expand our coaching and monitoring features, and the extent to which we can increase the efficiency of our technology through ongoing improvements, cost reduction, and operational efficiency. We expect our gross margin to increase over the long term, although it could fluctuate from period to period depending on the interplay of these and other factors. Operating Expenses Our operating expenses primarily consist of sales and marketing, research and development and general and administrative expenses. For each of these categories, personnel costs are the most significant component, which include salaries, bonuses, stock-based compensation expense and benefits. Operating expenses also include overhead costs for facilities, information technology, and depreciation expense. As a result of stock-based compensation expense related to stock awards, we expect our research and development, sales and marketing, and general and administrative expenses to increase significantly in absolute dollars. Research and Development. Our research and development expenses support our efforts to add new features to our existing solutions and to ensure the reliability and scalability of our existing solutions. Research and development expenses consist of personnel expenses, including salaries, bonuses, stock-based compensation expense and benefits for employees and contractors for our engineering, product, and design teams, and allocated overhead costs. We have expensed our research and development costs as they were incurred, except those costs that have been capitalized as software development costs. We plan to hire employees for our engineering team to support our research and development efforts. We expect that research and development expenses will increase on an absolute dollar basis in the foreseeable future as we continue to increase investments in our technology architecture. However, we expect our research and development expenses to decrease as a percentage of revenue over the long term, although our research and development expenses may fluctuate as a percentage of revenue from period to period due to the timing and amount of these expenses. Sales and Marketing. Sales and marketing expenses consist of personnel expenses, sales commissions for our direct sales force and our channel partners’ commission expenses, as well as communication, promotional, client conferences, public relations, other marketing events, and allocated overhead costs. Personnel expenses include salaries, bonuses, stock-based compensation expense and benefits for employees and contractors. Prior to the adoption of ASC 606, we expensed sales commissions in the period of sale. Upon our adoption of ASC 606, incremental sales commissions and stock-based compensation associated with costs to acquire clients are amortized to sales and marketing expense over the estimated period of benefit. We intend to continue to make significant investment in our sales and marketing organization to increase our brand awareness, drive additional revenue and expand into new markets. As a result, we expect our sales and marketing expenses to continue to increase in absolute dollars in the foreseeable future. However, we expect our sales and marketing expenses to decrease as a percentage of revenue over the long term, although our sales and marketing expenses may fluctuate as a percentage of revenue from period to period due to the timing and amount of these expenses. General and Administrative. General and administrative expenses consist of personnel expenses and related expenses for our executive, finance, human resources and legal organizations. In addition, general and administrative expenses include external legal, accounting and other professional fees, and allocated overhead costs. We expect our general and administrative expenses to increase in absolute dollars in the foreseeable future. However, we anticipate general and administrative expenses to decrease as a percentage of revenue over the long term, although they may fluctuate as a percentage of revenue from period to period due to the timing and amount of these expenses. In addition, we expect to incur additional general and administrative expenses as a result of operating as a public company, including expenses related to compliance with the rules and regulations of the SEC and the listing standards of Nasdaq, additional corporate and director and officer insurance expenses, greater investor relations expenses and increased legal, audit and consulting fees. Other Income, Net Other income, net primarily consists of interest income earned from our cash, cash equivalents and short-term investments. Provision for (Benefit from) Income Taxes The income tax provision and benefit were primarily due to state and foreign income tax expense, and benefit related to release of the valuation allowance as a result of our acquisitions. Deferred tax assets are reduced by a valuation allowance to the extent management believes it is not more likely than not to be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income. Management makes estimates and judgments about future taxable income based on assumptions that are consistent with our plans and estimates. Results of Operations The following tables set forth consolidated statements of operations for the periods indicated and such data as a percentage of revenue for the periods indicated: ______________ (1) Includes stock-based compensation expense as follows: ______________ (2) Includes amortization of intangible assets as follows: ______________ (3) Includes acquisition-related expenses as follows: ______________ (4) Includes secondary offering costs as follows: ______________ (5) Includes secondary offering related payroll taxes as follows: Comparison of Years Ended December 31, 2019 and 2018 Revenue Revenue was $170.2 million for the year ended December 31, 2019 compared to $68.4 million for the year ended December 31, 2018, an increase of $101.8 million, or 149%. The increase in revenue was primarily due to increases in monthly subscription revenue. Total monthly subscription revenue represents approximately 98% of revenue, for the year ended December 31, 2019, compared to 94% of revenue for the year ended December 31, 2018. Growth in revenue is primarily due to growth in enrolled diabetes members, which increased by approximately 109,000 enrolled diabetes members, or 96%, to approximately 222,700 enrolled diabetes members as of December 31, 2019 from approximately 113,900 enrolled diabetes members as of December 31, 2018, along with the addition of monthly subscription revenue from Livongo for Hypertension. Additionally, the growth of Livongo for Prediabetes and Weight Management program and Livongo for Behavioral Health by myStrength solution, from our acquisition of myStrength in February 2019, contributed to the growth of our revenue during the year ended December 31, 2019. Cost of Revenue Cost of revenue was $46.2 million for the year ended December 31, 2019, compared to $20.3 million for the year ended December 31, 2018, an increase of $25.9 million, or 128%. The increase in cost of revenue was primarily due to a $16.5 million increase in devices, supplies, cellular and fulfillment costs as a result of growth and increased shipments of Livongo for Diabetes, Livongo for Prediabetes and Weight Management, and Livongo for Hypertension welcome kits. The increase was also driven by a $6.1 million increase in member coaching and support costs to support the growth in enrolled diabetes members, a $1.2 million increase in amortization of intangible assets from the Retrofit and myStrength acquisitions, and a $0.4 million increase in overhead allocation costs. Gross Profit and Gross Margin Gross profit was $124.0 million for the year ended December 31, 2019 compared to $48.2 million for the year ended December 31, 2018, an increase of $75.9 million, or 158%. The increase in gross profit was the result of an increase in monthly subscription revenue due to the continued addition of new enrolled diabetes members and the expansion into new offerings including Livongo for Behavioral Health by myStrength and Livongo for Prediabetes and Weight Management program. Gross margin was 72.9% for the year ended December 31, 2019 compared to 70.4% for the year ended December 31, 2018. The increase in gross margin was primarily due to better economies of scale, an increase in revenue from the Livongo for Behavioral Health by myStrength solution and our deferral and capitalization of our device costs for hypertension and scales, which will be amortized in future periods. Operating Expenses Research and Development Research and development expenses were $49.8 million for the year ended December 31, 2019 compared to $24.9 million for the year ended December 31, 2018, an increase of $25.0 million, or 100%. The increase in research and development expenses was primarily due to a $11.0 million increase in personnel expenses as a result of increases in headcount, a $6.0 million increase in stock-based compensation expense largely due to the satisfaction of the performance-based vesting condition upon the completion of our IPO in July 2019, a $3.7 million increase in development costs to support the development of new product offerings, a $1.6 million increase in amortization of capitalized internal-use software development costs, and a $1.6 million increase in allocated overhead costs. Sales and Marketing Sales and marketing expenses were $78.1 million for the year ended December 31, 2019 compared to $36.4 million for the year ended December 31, 2018, an increase of $41.6 million, or 114%. The increase in sales and marketing expenses was primarily due to a $14.0 million increase in personnel expenses, which is attributable to department headcount growth and a $0.7 million increase as a result of the adoption of ASC 606, partially offset by the capitalization of sales commissions associated with initial contract costs, which will be amortized in future periods. Other increases consisted of a $9.6 million increase in partner commissions due to increased sales activities through our channel partners, a $7.6 million increase in expenses due to marketing campaigns and member outreach efforts, a $6.7 million increase in stock-based compensation expense largely due to the satisfaction of the performance-based vesting condition upon the completion of our IPO in July 2019, a $1.9 million increase in overhead allocation costs, a $1.2 million increase in travel and related expenses, and a $0.8 million increase in amortization expense related to acquired intangible assets. General and Administrative General and administrative expenses were $55.7 million for the year ended December 31, 2019 compared to $23.1 million for the year ended December 31, 2018, an increase of $32.6 million, or 141%. The increase in general and administrative expenses was primarily due to a $13.4 million increase in stock-based compensation expense largely driven by the satisfaction of the performance-based vesting condition upon the completion of our IPO in July 2019, a $7.9 million increase in personnel expenses as a result of department headcount growth, a $7.5 million increase in professional and consulting costs to support our growth and preparation to become a public company, a $2.0 million increase in insurance costs largely attributable to higher premium for public companies, a $1.0 million increase in allocated overhead costs, and a $0.3 million secondary offering costs. Change in Fair Value of Contingent Consideration The change in fair value of contingent consideration recorded for the year ended December 31, 2019 was attributable to a $1.7 million increase in the fair value of the earn-out contingent consideration associated with the myStrength acquisition, partially offset by a $0.9 million decrease in the fair value of the earn-out contingent consideration associated with the Retrofit acquisition. Other Income, Net Other income, net increased by $2.1 million for the year ended December 31, 2019, compared to the same period ended December 31, 2018, primarily due to additional interest earned on higher cash, cash equivalent, and short-term investments balances as we raised net proceeds of $377.5 million from our IPO in July 2019. Provision for (Benefit from) Income Taxes ______________ * Percentage not meaningful We had a benefit from income taxes of $1.4 million for the year ended December 31, 2019, compared to a provision for income taxes for the year ended December 31, 2018, primarily due to the partial release of a valuation allowance in connection with the myStrength acquisition. The deferred tax liability provided an additional source of taxable income to support the realizability of pre-existing deferred tax assets. Some of the information required by this Item is set forth under the heading “Comparison of Year Ended December 31, 2017 and 2018” in our Form S-1 filed with the SEC on December 9, 2019, and is incorporated herein by reference. Liquidity and Capital Resources As of December 31, 2019, we had cash and cash equivalents of $241.7 million and short-term investments of $150.0 million. Our cash and cash equivalents primarily consist of highly liquid investments in money market funds and cash. Our short-term investments consist of certificates of deposit with an initial maturity of twelve months or less. Since our inception, we have generated significant operating losses from our operations as reflected in our accumulated deficit of $164.2 million as of December 31, 2019 and negative cash flows from operations. In July 2019, we completed our IPO and issued and sold 14,590,050 shares at an offering price of $28.00 per share, including 1,903,050 shares pursuant to the exercise in full of the underwriters' option to purchase additional shares. We received net proceeds of $377.5 million, after deducting underwriting discounts and commissions of $28.6 million and offering costs of approximately $2.4 million. Immediately prior to the closing of the IPO, all 58,615,488 shares of our then-outstanding redeemable convertible preferred stock automatically converted into 58,615,488 shares of common stock and we reclassified $237.0 million from redeemable convertible preferred stock to additional paid-in capital and into common stock on our consolidated balance sheet. Prior to our IPO, we financed our operations principally through private placements of our equity securities and payments received from clients whose employees and dependents access our solutions. In July 2019, we entered into a loan and security agreement with SVB. The agreement provides a secured revolving loan facility in an aggregate principal amount of up to $30.0 million. Revolving loans under this facility bear interest at a floating rate equal to the greater of (i) 5.25% or (ii) the prime rate published in the Wall Street Journal, minus 0.25%. Interest on the revolving loans is due and payable monthly in arrears. The maturity date of any revolving loan is July 2022. Our obligations under the loan and security agreement are secured by a security interest on substantially all of our assets, excluding our intellectual property. The loan and security agreement contains a financial covenant along with covenants limiting our ability to, among other things, dispose of assets, undergo a change in control, merge or consolidate, make acquisitions, incur debt, incur liens, pay dividends, repurchase stock, and make investments, in each case subject to certain exceptions. The loan and security agreement also contains customary events of default, upon which SVB may declare all or a portion of our outstanding obligations payable to be immediately due and payable. There were no amounts outstanding under the loan and security agreement as of December 31, 2019. We expect to continue to incur operating losses and generate negative cash flows from operations for the foreseeable future due to the investments we intend to continue to make in research and development and sales and marketing and due to additional general and administrative costs we expect to incur in connection with operating as a public company. As a result, we may require additional capital resources to execute strategic initiatives to grow our business. We believe that our existing cash and cash equivalents will be sufficient to fund our operating and capital needs for at least the next 12 months. Our assessment of the period of time through which our financial resources will be adequate to support our operations is a forward-looking statement and involves risks and uncertainties. Our actual results could vary because of, and our future capital requirements will depend on, many factors, including our growth rate, the timing and extent of spending to support our research and development efforts, the expansion of sales and marketing activities, the timing of introductions of new solutions or features, and the continued market adoption of our solutions. We may in the future enter into arrangements to acquire or invest in complementary businesses, services and technologies, including intellectual property rights. We have based this estimate on assumptions that may prove to be wrong, and we could use our available capital resources sooner than we currently expect. 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, or if we cannot expand our operations or otherwise capitalize on our business opportunities because we lack sufficient capital, our business, results of operations, and financial condition would be adversely affected. Cash Flows The following table summarizes our cash flows for the periods indicated: Cash Flows from Operating Activities Our largest source of operating cash flows is cash collections from our clients for access to our solutions. Our primary use of cash from operating activities is for personnel-related expenditures to support the growth of our business. Net cash used in operating activities during the year ended December 31, 2019 of $59.4 million was attributable to a $55.3 million net loss, adjusted for $38.8 million of non-cash adjustments and $43.0 million of net cash outflow from changes in operating assets and liabilities. The non-cash adjustments primarily consist of $32.6 million of stock-based compensation expense, $3.3 million of depreciation and amortization, $2.6 million of amortization of intangible assets, $0.9 million in change of accounts receivable allowance, and $0.8 million of change in fair value of contingent consideration, partially offset by $1.4 million of deferred income taxes related benefit. The net cash outflow from changes in operating assets and liabilities is primarily the result of an increase of $23.8 million in accounts receivable due to more billings and timing of collections, an increase in inventory of $20.0 million driven by enrollment growth, an increase of $8.6 million in deferred costs largely due to the capitalization and amortization of our device costs, and a $4.5 million increase in prepaid and other assets largely due to insurance prepayments, partially offset by an increase of $10.0 million in accounts payable, accrued expenses and other liabilities, an increase of $2.8 million in advance payments from a partner, and a $1.1 million increase in deferred revenue. Net cash used in operating activities during the year ended December 31, 2018 of $33.0 million was attributable to a $33.4 million net loss, adjusted for $7.5 million of non-cash adjustments and $7.1 million of net cash outflow from changes in operating assets and liabilities. The non-cash adjustments primarily consist of $6.3 million of stock-based compensation expense and $1.9 million of depreciation and amortization, partially offset by a $1.2 million change in fair value of contingent consideration. The net cash outflow from changes in operating assets and liabilities is primarily the result of an increase of $9.2 million in accounts receivable due to higher billings and timing of collections, an increase of $6.0 million in inventories due to the launch of our new hypertension devices and to support our revenue growth, an increase of $4.5 million in deferred costs as our upfront device sales have increased, and an increase of $1.9 million of prepaid expenses and other assets, partially offset by an increase of $10.8 million in accounts payable, accrued expenses and other liabilities, and an increase of $3.0 million in advance payments from partner. Cash Flows from Investing Activities Net cash used in investing activities during the year ended December 31, 2019 of $182.9 million was primarily attributable to a purchase of short-term investment of $150.0 million, a $27.4 million net payment for the myStrength acquisition, $5.2 million in capitalized internal-use software costs, and $2.0 million in capital expenditures to support our growth, partially offset by $1.8 million of proceeds from the release of the escrow deposit related to the Retrofit acquisition. Net cash used in investing activities during the year ended December 31, 2018 of $23.8 million was primarily attributable to the $19.3 million net payment for the Retrofit acquisition and the related escrow deposit, $3.6 million in capitalized internal-use software costs, and $1.0 million in capital expenditures for new and upgraded back office systems, including enterprise resource planning software, to support our growth. Cash Flows from Financing Activities Net cash used in financing activities during the year ended December 31, 2019 of $376.2 million was attributable to $377.8 million received from our IPO, net of offering costs paid, net proceeds from exercise of stock options of $3.1 million, partially offset by $3.7 million of contingent-earn out liability payments for the myStrength and Retrofit acquisitions, and $1.0 million of taxes paid related to net share settlement of vested equity awards. Net cash provided by financing activities during the year ended December 31, 2018 of $104.4 million was primarily attributable to $104.8 million of net proceeds from the issuance of our Series E redeemable convertible preferred stock and $1.7 million of proceeds from the exercise of stock options, partially offset by $2.0 million of deferred acquisition payments related to our acquisition of Diabeto Inc. Contractual Obligations and Other Commitments The following table summarizes our contractual obligations as of December 31, 2019: The operating lease obligation amounts above exclude sublease income of $0.2 million as of December 31, 2019. Purchase orders issued in the ordinary course of business are not included in the table above, as our purchase orders are generally fulfilled within short time periods. Non-cancelable purchase commitments as of December 31, 2019 related to our cloud-based software contracts. Off-Balance Sheet Arrangements We did not have, during the periods presented, and we do not currently have, any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities, that would 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 and accompanying notes are prepared in accordance with U.S. GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses, as well as 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 from these estimates. To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected. The critical accounting estimates, assumptions, and judgments that we believe have the most significant impact on our consolidated financial statements are described below. Revenue Recognition The substantial majority of our revenue is derived from monthly subscription fees that are recognized as services are rendered and earned under the subscription agreements with clients. Clients are business entities, such as health plans, self-insured plans, and government entities, that have contracted with us to offer the Livongo solution to their covered lives. Client’s employees or their covered dependents enrolled in the Livongo program are referred to as members. Clients are our customers. There is usually a six-month minimum enrollment period for members. Many of our customers can stop their monthly recurring subscription but will be required to pay an early termination fee if the termination occurs during the minimum enrollment period. We sell to our clients through our direct sales force and through our partners (channel partners, pharmacy benefit managers, and resellers). We are the principal that controls the transfer of promised goods and services to members with respect to contracts originated through partners, that are the subject of the arrangement with the client, we have latitude in establishing pricing, and we have inventory risk. In these situations, revenue is recognized on a gross basis, and fees paid to partners are recorded as commissions expense included in sales and marketing expenses in the consolidated statements of operations. Revenue Recognition Policy from January 1, 2019 On January 1, 2019, we adopted the requirements of Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASC 606”). ASC 606 establishes a principle for recognizing revenue upon the transfer of promised goods or services to customers, in an amount that reflects the expected consideration received in exchange for those goods or services. The adoption of ASC 606 also requires the adoption of ASC Subtopic 340-40, Other Assets and Deferred Costs-Contracts with Customers, which provides for the deferral of certain incremental costs of obtaining a contract with a customer. Collectively, references to ASC 606 used herein refer to both ASC 606 and Subtopic 340-40. The core principle of ASC 606 is to recognize revenue to depict the transfer of promised goods or services to clients in an amount that reflects the consideration the entity expects to be entitled in exchange for those goods or services. This principle is achieved through applying the following five-step approach: • Identification of the contract, or contracts, with a client. • Identification of the performance obligations in the contract. • Determination of the transaction price. • Allocation of the transaction price to the performance obligations in the contract. • Recognition of revenue when, or as, we satisfy a performance obligation. We improve member health results and reduce healthcare costs by providing an overall health management solution through the integration of Livongo devices, supplies, access to our web-based platform, and clinical and data services. We believe that our overall promise to our customers is to improve member health results and reduce healthcare costs, and the delivery of this promise would not be possible without the integration of Livongo devices, supplies, access to our web-based platform, and clinical and data services. The promises to transfer the goods and services are not separately identifiable as we provide a significant service of integrating the goods and services provided by us (i.e. inputs) into a combined output (i.e. member behavior modifications) that result in the fulfillment of our promise to our customers. In most agreements associated with our Livongo for Diabetes, Livongo for Hypertension, and Livongo for Prediabetes and Weight Management solutions, clients primarily pay monthly subscription fees based on a per participant per month model, based on the number of active enrolled members each month. In addition, clients can choose to pay an upfront amount with a lower per participant per month fee. We have determined that access to our solution is a single continuous service comprised of a series of distinct services that are substantially the same and have the same pattern of transfer (i.e. distinct days of service). These services are consumed as they are received and we recognize revenue each month using the variable consideration allocation exception. We apply this exception because we concluded that the nature of our obligations and the variability of the payment being based on the number of active members are aligned and uncertainty related to the consideration is resolved on a monthly basis as we satisfy our obligations. In most agreements associated with our Livongo for Behavioral Health by myStrength solution, clients either pay a fixed upfront fee or a monthly fee based on the number of members to whom the solution is available. The contract term is generally one to three years, with one year auto-renewal terms. We have determined that access to our solution is a single continuous service comprised of a series of distinct services that are substantially the same and have the same pattern of transfer (i.e. distinct days of service). These services are consumed as they are received and we recognize revenue in each month using the variable consideration allocation exception. We apply this exception because we concluded that the nature of our obligations and the variability of the payment based on the number of available members are aligned and uncertainty related to the consideration is resolved on a monthly basis as we satisfy our obligations. For certain arrangements where the per-member fee varies as the number of available members changes, we estimate the expected transaction price based on the number of expected members over the term of the arrangement. In certain legacy arrangements, we derive revenue from the sale of our cellular-connected weight scale and access to the Livongo for Prediabetes and Weight Management solution through the Retrofit platform. When an agreement contains multiple performance obligations, we allocate the transaction price to each performance obligation based on the relative SSP. The determination of SSP is judgmental and is based on the price an entity charges for the same good or service, sold separately in a standalone sale, and sold to similar clients in similar circumstances. We typically price the devices and services within a narrow range and has estimated that contractual amounts to represent SSP. Amounts allocated to the connected device are recognized when control transfers, which is at the point in time upon delivery of the device. Amounts allocated to the services are recognized as the service is performed. Certain of our client contracts are subject to pricing adjustments based on various performance metrics, such as member satisfaction scores, cost savings guarantees and health outcome guarantees, which if not met typically require us to refund a portion of the per participant per month fee paid. We estimate the amount of variable consideration we expect to refund to our clients under these arrangements and defer that estimate over the term of the arrangement. Such estimate is judgmental and the actual refund or amount recognized as revenue may vary from our estimate. Certain of our contractual agreements with clients contain a most-favored nation clause, pursuant to which we represent that the price charged and the terms offered to the client will be no less favorable than those made available to other clients. We historically have not been required to modify the transaction price as a result of these clauses; in the event a most-favored nation clause is expected to be triggered, we will reassess the expected transaction price in accordance with ASC 606. We applied the practical expedient to not disclose information about contracts with original expected duration of one year or less, amounts of variable consideration attributable to the variable consideration allocation exception, or contract renewals that are unexercised. We also applied the practical expedient to exclude sales and other indirect taxes when measuring the transaction price. Deferred Costs and Other Deferred costs and other consist of deferred device costs, deferred contract costs, and deferred execution credits. Deferred device costs consist of cost of inventory incurred in connection with delivery of services that are deferred and amortized over the shorter of the expected member enrollment period or the expected device life which are recorded as cost of revenue. Deferred contract costs represent the incremental costs of obtaining a contract with a client if we expect to recover such costs. The primary example of our costs to obtain a contract include the incremental sales commissions and stock-based compensation to our sales organization. Capitalized contract costs are deferred and then amortized on a straight-line basis over a period of benefit that has been determined to be four years. We determined the period of benefit by taking into consideration the length of client contracts, contract renewal rates, the useful life of developed technology and other factors. Amortization expense is included in sales and marketing expenses in the consolidated statement of operations. Deferred costs and other that are to be amortized with twelve months are recorded to deferred costs and other, current and the remainder is recorded to deferred costs and other, non-current on our consolidated balance sheets. Stock-Based Compensation We account for stock-based compensation awards, including stock options, restricted stock awards, and RSUs, based on their estimated grant date fair value. We estimate the fair value of our stock options using the Black-Scholes option-pricing model. We estimate the fair value of stock options with a market-based vesting condition using the Monte Carlo simulation model. We estimate the fair value of our restricted stock awards and RSUs based on the fair value of the underlying common stock. We recognize fair value of stock options, which vest based on continued service, on a straight-line basis over the requisite service period, which is generally four years. Determining the grant date fair value of options using the Black-Scholes option pricing model requires management to make assumptions and judgments. 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. The assumptions and estimates are as follows: • Fair Value of Common Stock - The absence of an active market for our common stock prior to our IPO required us to estimate the fair value of our common stock. See “Common Stock Valuations” below. • Expected Term - The expected term represents the period that the stock-based awards are expected to be outstanding. We determine the expected term using the simplified method. The simplified method deems the term to be the average of the time-to-vesting and the contractual life of the options. For stock options granted to non-employees, the expected term equals the remaining contractual term of the option from the vesting date. • Expected Volatility - As we had no trading history for our common stock when we granted our option awards prior to our IPO, the expected volatility was estimated by taking the average historic price volatility for industry peers, consisting of several public companies in our industry that are either similar in size, stage, or financial leverage, over a period equivalent to the expected term of the awards. • Risk-Free Interest Rate - The risk-free interest rate is calculated using the average of the published interest rates of U.S. Treasury zero-coupon issues with maturities that are commensurate with the expected term. • Dividend Yield - The dividend yield assumption is zero, as we have no history of, or plans to make, dividend payments. The following assumptions were used for the Black-Scholes option pricing model for the periods presented: No options were granted during the year ended December 31, 2019. For awards granted that contain market-based and service-based vesting conditions, we used a Monte Carlo simulation model which utilizes multiple variables to simulate a range of our possible future enterprise value. The determination of the estimated grant date fair value of these awards is affected by a number of assumptions including our estimated common stock fair value on the grant date, expected volatilities of our common stock, our risk-free interest rate, and dividend yield. We recognize stock-based compensation expense for these awards on an accelerated basis over the longer of the explicit service period or the derived service period. The following assumptions were used for the Monte Carlo simulation model for the periods presented: Restricted Stock Units Prior to our IPO, we granted restricted stock units that contain both service- and performance-based vesting conditions to our executives, employees and consultants (“Performance RSUs”). The service-based vesting condition is generally satisfied (i) over four years with 25% vesting on the one-year anniversary of the award and the remainder vesting monthly over the next 36 months, or (ii) over four years with 1/48 vesting on the one-month anniversary of the award, and remainder vesting monthly over the next 47 months, subject to the grantee’s continued service with us through the vesting dates. The performance-based vesting condition is satisfied upon the earlier of (i) a change in control where the consideration paid to our equity security holders is cash, publicly traded stock, or a combination of both, or (ii) six months and one day following our IPO. The satisfaction of the performance-based vesting condition became probable upon the completion of our IPO in July 2019, at which point we recorded cumulative stock-based compensation expense of $11.9 million using the accelerated attribution method. Subsequent to our IPO in July 2019, we grant restricted stock units to our executives, employees and consultants that only contain service-based vesting conditions ("RSUs"). The service-based vesting condition is generally satisfied over four years on a quarterly basis, with each 1/16 vesting on prefixed quarterly vesting anchor dates, subject to the grantee’s continued service with us through the vesting dates. During the year ended December 31, 2019, $24.1 million of stock-based compensation expense related to performance RSUs and RSUs was recognized in our consolidated statement of operations. In January 2019, we granted restricted stock units covering 982,301 shares to an executive that contain only service-based vesting conditions over a four year period and recognized stock-based compensation expense of $4.1 million during 2019. In addition, we granted restricted stock units covering 491,151 shares that immediately vested on the grant date and recognized $3.8 million of stock-based compensation expense in our consolidated statements of operations for the year ended December 31, 2019. During the year ended December 31, 2019, we issued restricted stock units covering 225,000 shares with only service-based vesting conditions to the board of directors, which will be satisfied in quarterly installments through May 25, 2021. We also issued other performance-based restricted stock units covering 100,000 shares which consist of both service- and performance-based vesting conditions including both the achievement of certain sales milestones and our IPO. The service-based vesting condition will be satisfied over four years from the date the sales milestones are met. The performance-based vesting condition is satisfied upon both the achievement of certain sales milestones and our IPO. Stock-based compensation expense related to these restricted stock units that are expected to vest was $0.3 million during the year ended December 31, 2019. Common Stock Valuations Prior to the completion of our IPO, the fair value of the common stock underlying our stock awards was determined by our board of directors. The valuations of our common stock prior to the completion of our IPO were determined in accordance with the guidelines outlined in the American Institute of Certified Public Accountants Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. In the absence of a public trading market, our board of directors, with input from management, exercised significant judgment and considered numerous objective and subjective factors to determine the fair value of our common stock as of the date of each option grant, including the following factors: • contemporaneous valuations performed by third-party valuation firms; • the prices, rights, preferences, and privileges of our redeemable convertible preferred stock relative to those of our common stock; • the prices of redeemable convertible preferred stock sold by us to third-party investors in arms-length transactions; • the lack of marketability of our common stock; • our actual operating and financial performance; • current business conditions and projections; • our history and the timing of the introduction of new solutions and services; • our stage of development; • the likelihood of achieving a liquidity event, such as an initial public offering or a merger or acquisition of our business given prevailing market conditions; • recent secondary stock transactions; • the market performance of comparable publicly-traded companies; and • U.S. market conditions. For all approaches other than the market approach utilizing secondary transactions in our capital stock, the equity value was allocated among the various classes of our equity securities to derive a per share value of our common stock. We historically performed this allocation using the option pricing method, or OPM, which treats the securities comprising our capital structure as call options with exercise prices based on the liquidation preferences of our various series of redeemable convertible preferred stock and the exercise prices of our options and warrants. We performed this allocation using a probability-weighted expected return method, or PWERM. The PWERM involves the estimation of the value of our company under multiple future potential outcomes for us, and estimates of the probability of each potential outcome. The per share value of our common stock determined using the PWERM is ultimately based upon probability-weighted per share values resulting from the various future scenarios, which primarily included an initial public offering or continued operation as a private company. Additionally, the PWERM was combined with the OPM to determine the value of the securities comprising our capital structure in certain of the scenarios considered in the PWERM. In certain scenarios of the PWERM, the OPM was used to allocate value to the various securities comprising our capital structure. In addition, we also considered any secondary transactions involving our capital stock. In our evaluation of such transactions, we considered the facts and circumstances of each such transaction to determine the extent to which they represented a fair value exchange. Factors considered include transaction volume, timing, whether such transactions occurred among willing and unrelated parties, and whether such transactions involved investors with access to our financial information. After the equity value is determined and allocated to the various classes of shares, a discount for lack of marketability, or DLOM, is applied to arrive at the fair value of the common stock. A DLOM is meant to account for the lack of marketability of a stock that is not traded on public exchanges. For financial reporting purposes, we considered the amount of time between the valuation date and the grant date of our stock options to determine whether to use the latest common stock valuation or a straight-line interpolation between the two valuation dates. This determination included an evaluation of whether the subsequent valuation indicated that any significant change in valuation had occurred between the previous valuation and the grant date. Following our IPO, we rely on the closing price of our common stock as reported on the date of grant to determine the fair value of our common stock, as shares of our common stock are traded in the public market. Business Combinations and Valuation of Goodwill and Other Acquired Intangible Assets We have completed a number of acquisitions of other businesses in the past and may acquire additional businesses or technologies in the future. The results of businesses acquired in a business combination are included in our consolidated financial statements from the date of acquisition. We allocate the purchase price, which is the sum of the consideration provided in a business combination to the identifiable assets and liabilities of the acquired business at their acquisition date fair values. The excess of the purchase price over the amount allocated to the identifiable assets and liabilities, if any, is recorded as goodwill. Determining the fair value of assets acquired and liabilities assumed requires management to use significant judgment and estimates, including the selection of valuation methodologies, estimates of future revenue and cash flows, discount rates and selection of comparable companies. When we issue stock-based or cash awards to an acquired company’s shareholders, we evaluate whether the awards are consideration or compensation for post-acquisition services. The evaluation includes, among other things, whether the vesting of the awards is contingent on the continued employment of the acquired company’s stockholders beyond the acquisition date. If continued employment is required for vesting, the awards are treated as compensation for post-acquisition services and recognized as expense over the requisite service period. To date, the assets acquired, and liabilities assumed in our business combinations have primarily consisted of goodwill and finite-lived intangible assets, consisting primarily of developed technology, customer relationships and trade names. The estimated fair values and useful lives of identifiable intangible assets are based on many factors, including estimates and assumptions of future operating performance and cash flows of the acquired business, the nature of the business acquired, and the specific characteristics of the identified intangible assets. The estimates and assumptions used to determine the fair values and useful lives of identified intangible assets could change due to numerous factors, including market conditions, technological developments, economic conditions and competition. In connection with determination of fair values, we may engage a third-party valuation specialist to assist with the valuation of intangible and certain tangible assets acquired and certain assumed obligations. Acquisition-related transaction costs incurred by us are not included as a component of consideration transferred but are accounted for as an operating expense in the period in which the costs are incurred. Capitalized Internal-Use Software Costs Costs incurred to develop and modify software and our platform for internal use, including costs related to the development of software for our connected devices are capitalized and included in property and equipment on our consolidated balance sheets. We estimate the costs that are related to planning, evaluation, application development stages of our internal-use software development projects. Costs incurred during the preliminary planning and evaluation stage of the project and repairs and maintenance are expensed as incurred. Costs incurred during the application development stage of the project are capitalized. Capitalized internal-use software costs are amortized on a straight-line basis over their estimated useful lives of three years. Income Taxes We report income taxes in accordance with Accounting Standards Codification, or ASC, 740, Income Taxes, which requires us to use the asset and liability method, requiring 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 our 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. Recently Issued Accounting Pronouncements Adopted For more information on recently issued accounting pronouncements, see Note 2 to our consolidated financial statements covered under Part II, Item 8 of this Annual Report on Form 10-K. New Accounting Pronouncements Not Yet Adopted For more information on new accounting pronouncements not yet adopted, see Note 2 to our consolidated financial statements covered under Part II, Item 8 in this Annual Report on Form 10-K. Emerging Growth Company Status We are an emerging growth company, as defined in 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. In particular, 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 elected to avail ourselves of this extended transition period and, as a result, we may not adopt new or revised accounting standards on the relevant dates on which adoption of such standards is required for other public companies until required by private company accounting standards.

<s>[INST] Overview Our mission is to empower people with chronic conditions to live better and healthier lives. The advancement of technology and data science has transformed nearly every industry except healthcare to create new, consumerfirst experiences that are both personalized and empowering. Livongo is pioneering a new category in healthcare, called Applied Health Signals, which is transforming the management of chronic conditions. Our platform, which leverages data science and technology, creates a new kind of personalized experience for people with chronic conditions (our members). This empowers our members to make sustainable behavior changes that lead to better outcomes and lower costs. The Livongo experience makes it easier for our members to stay healthy. We fit into the way our members live, put them in control of managing their condition, and give them an experience that they don’t just like, but love (evidenced by our average Livongo for Diabetes member NPS of +64 as of December 31, 2019). We currently offer Livongo for Diabetes, which has historically accounted for a substantial portion of our revenue, and we expect that to continue for the next several years, as well as Livongo for Hypertension, Livongo for Prediabetes and Weight Management, and Livongo for Behavioral Health by myStrength. Our solutions include a smart, cellularconnected device and related testing materials, if applicable, that are sent directly to the member, and member access to a suite of personalized feedback and remote monitoring and coaching services on our platform. We invoice our clients monthly on a permember or persolution basis, depending on the solution, and may also charge an upfront fee for the devices. We do not sell member support services separately. As a result, member enrollment and continued usage drives our revenue and we primarily generate revenue not through the upfront fee for our devices, but from the ongoing subscription revenue for our members to access to our integrated solution. Our agreements have fixed and variable pricing components based on the number of members. This results in a highly predictable revenue stream, which helps us plan for growth and scale. Furthermore, over time, many of our clients make our solutions available to a greater percentage of their employee population, allowing us to both increase enrollment within our existing clients, which we refer to as product intensity, and for the sale of additional solutions to existing clients, which we refer to as product density. Beginning in 2020, we introduced pricing options that provide members with access to multiple solutions in order to enable us to more fully address the health of the whole person. We typically enter into a higher percentage of agreements with new clients, as well as renewal agreements with existing clients, in our third and fourth quarters, which results in higher enrollment launch rates in the first quarter. We believe that this results in part from the timing of open enrollment periods of many of our clients. We sell to companies of all sizes, including employers, from small businesses to Fortune 500 enterprises, hospital payors government entities, and labor unions. We currently derive a high concentration of our revenue from sales to clients that are selfinsured employers, with hospital payors, government entities, and labor unions accounting for a smaller portion of our revenue. As of December 31, 2019 and December 31, 2018, we served 804 and 413 clients, respectively. As of December 31, 2019 and December 31, 2018, we had approximately 222,700 and 113,900 members, respectively, enrolled in our Livongo for Diabetes solution. In addition, we have a growing number of members enrolled in our hypertension, prediabetes and weight management, and behavioral health solutions. Our client and member base are located in the United States. See Note 2 under Part II, Item 8 of this report for information about significant customers and partners which represent 10% or more of our net accounts receivable balance or revenue during the period at each respective consolidated balance sheet date. We have experienced significant growth since our inception. Our revenue increased $101.8 million, or 149%, to $170.2 million for the year ended December 31, 2019, compared to $68.4 million for the year ended December 31, 2018. We have made significant investments to grow our business [/INST] Negative. </s>

Lovesac Co

2019-05-03

2019-02-03

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.1 The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes appearing elsewhere in this Annual Report on Form 10-K. As discussed in the section titled “Note About 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 identified below and those discussed in the section titled “Risk Factors” under Part I, Item 1A in this Annual Report on Form 10-K. 1 Pursuant to Reg S-K this can be limited to just Fiscal 2019 and 2018. Option to include Fiscal 2017 We operate on a 52- or 53-week fiscal year that ends on the Sunday closest to February 1. Each fiscal year generally is comprised of four 13-week fiscal quarters, although in the years with 53 weeks, the fourth quarter represents a 14-week period. Overview We are a technology driven, omni-channel company that designs, manufactures and sells unique, high quality furniture comprised of modular couches called Sactionals and premium foam beanbag chairs called Sacs. We market and sell our products through modern and efficient showrooms and, increasingly, through online sales. We believe that our ecommerce centric approach, coupled with our ability to deliver our large upholstered products through nationwide express couriers, are unique to the furniture industry. The name “Lovesac” was derived from our original innovative product, a premium foam beanbag chair, the Sac. The Sac was developed in 1995 and provided the foundation for the Company. We believe that the large size, comfortable foam filling and irreverent branding of our Sacs products have been instrumental in growing a loyal customer base and our positive, fun image. Our Sactionals product line currently represents a majority of our sales. Sactionals are a couch system that consists of two components, “seats” and “sides”, which can be arranged, rearranged and expanded into thousands of configurations easily and without tools. Our Sactional products include a number of patented features relating to their geometry and modularity, coupling mechanisms and other features. We believe that these high quality premium priced products enhance our brand image and customer loyalty and expect them to continue to garner a significant share of our sales. Sacs and Sactionals come in a wide variety of colors and fabrics that allow consumers to customize their purchases in numerous configurations and styles. We provide lifetime warranties on our Sactionals frames and the proprietary foam used in both product lines, and three-year warranties on our covers. Our Designed for Life trademark reflects our dynamic product line that is built to last and evolve throughout a customer’s life. Customers can continually update their Sacs and Sactionals with new covers, additions and configurations to accommodate the changes in their family and housing situations. We currently market and sell our products through 75 showrooms at top tier malls, lifestyle centers and street locations in 30 states in the U.S. Our modern, efficient showrooms are designed to appeal to millennials and other purchasers looking for comfortable, enduring, premium furniture. They showcase the different sizes of our Sacs, the myriad forms into which our Sactionals can be configured, and the large variety of fabrics that can be used to cover our products. As part of our direct to consumer sales approach, we also sell our products through our ecommerce platform. We believe our products are uniquely suited to this channel. Our foam-based Sacs can be reduced to one-eighth of their normal size and each of our Sactionals components weighs less than 50 pounds upon shipping. Our showrooms and other direct marketing efforts work in concert to drive customer conversion in ecommerce. Product Overview We challenge the notion that a piece of furniture is static by offering a dynamic product line built to last and evolve throughout a customer’s life. Our products serve as a set of building blocks that can be rearranged, restyled and re-upholstered with any new setting, mitigating constant changes in fashion and style. Sactionals. We believe our Sactionals platform is unlike competing products in its adaptability yet is comparable aesthetically to similarly priced premium couches and sectionals. Our Sactional products include a number of patented features relating to its geometry and modularity, coupling mechanisms and other features. Utilizing only two, standardized pieces, “seats” and “sides,” and over 250 high quality, tight-fitting covers that are removable, washable, and changeable, customers can create numerous permutations of a sectional couch with minimal effort. Customization is further enhanced with our specialty-shaped modular offerings, such as our wedge seat and roll arm side. Our custom features and accessories can be added easily and quickly to a Sactional to meet endless design, style and utility preferences, reflecting our Designed for Life philosophy. Sactionals are built to meet the highest durability and structural standards applicable to fixed couches. Sactionals are comprised of standardized units and we guarantee their compatibility over time, which we believe is a major pillar of their value proposition to the consumer. Sacs. We believe that our Sacs product line is a category leader in oversized beanbags. The Sac product line offers 6 different sizes ranging from 22 pounds to 95 pounds with capacity to seat 3+ people on the larger model Sacs. Filled with Durafoam, a proprietary blend of shredded foam, Sacs provide serene comfort and guaranteed durability. Their removable covers are machine washable and may be easily replaced with a wide selection of cover offerings. Accessories. Our accessories complement our Sacs and Sactionals by increasing their adaptability to meet evolving consumer demands and preferences. Our current product line offers Sactional-specific drink holders, footsac blankets, decorative pillows, fitted seat tables and ottomans in varying styles and finishes, providing our customers with the flexibility to customize their furnishings with decorative and practical add-ons to meet evolving style preferences. We are in the process of developing additional accessories for the tech-savvy consumer. Sales Channels Lovesac offers its products through an inventory lean omni-channel platform that provides a seamless and meaningful experience to our customers in showrooms and online. In recent periods, we have increased our focus on providing a platform for the transaction of business online through digital and mobile applications. As consumers increasingly transact via various ecommerce channels, we believe our robust and user-friendly technological platform is well positioned to benefit from this growth. Additionally, our products’ compact packaging facilitates production scheduling, lower shipping costs and the outsourcing of our shipping function to nationwide express couriers, allowing us to quickly and cost-effectively deliver online orders. We leverage our showroom as both a traditional retail channel to purchase our products and an educational center for prospective online customers to learn about and interact with our products in real time. Compared to traditional retailers, our showrooms require significantly less square footage because we need to maintain only a few sample seats, sides and Sacs to demonstrate numerous configurations. Warehouse space is minimized by our ability to stack our inventory for immediate sale. In addition to providing a compelling customer experience, we believe that our showroom model provides a more efficient use of capital and logistical advantages over our competitors. We have an ongoing working relationship with Costco to operate “roadshows” in Costco’s stores, which we refer to as shop in shops, throughout fiscal 2019. Our shop in shops display select Sacs and Sactionals and are staffed similarly to our more traditional showrooms with associates trained to demonstrate and sell the product. Factors Affecting Our Operating Results While our growth strategy has contributed to our improving operating results, it also presents significant risks and challenges. These strategic initiatives will require substantial expenditures. The timing and magnitude of new showroom openings, existing showroom renovations, and marketing activities may affect our results of operations in future periods. Other factors that could affect our results of operations in future periods include: Overall Economic Trends The industry in which we operate is cyclical. In addition, our revenues are affected by general economic conditions. Purchases of our products are sensitive to a number of factors that influence the levels of consumer spending, including economic conditions, consumer disposable income, housing market conditions, consumer debt, interest rates and consumer confidence. Seasonality Our business is seasonal. As a result, our revenues fluctuate from quarter to quarter, which often affects the comparability of our results between periods. Net sales are historically higher in the fourth fiscal quarter due primarily to the impact of the holiday selling season. Competition The retail industry is highly competitive and retailers compete based on a variety of factors, including design, quality, price and customer service. Levels of competition and the ability of our competitors to attract customers through competitive pricing or other factors may impact our results of operations. How We Assess the Performance of Our Business In assessing the performance of our business, we consider a variety of financial and operating measures, including the following: Net sales Net sales reflect our sale of merchandise plus shipping and handling revenue collected from our customers, less returns and discounts. Sales made at Company operated showrooms, including shop in shops, are recognized at the point of sale when payment is tendered and ownership is transferred to the customer, which may occur subsequent to the sale. Sales of merchandise via the internet are recognized upon receipt and verification of payment and shipment of the merchandise to the customer. We expect to continue to experience healthy growth in net sales and web-based sales to increase as a percentage of total sales. For fiscal 2020 we intend to drive total net sales growth for the full year between 40% and 45%. We intend to open between 15-20 new showrooms and remodel eight showrooms. We intend to operate approximately 690 pop-up shop-in-shops with more than 75% of the shop-in shops occurring in the first three quarters of the fiscal year. Comparable Showroom Sales Comparable showroom sales are calculated based on showrooms that were open at least fifty-two weeks as of the end of the reporting period. A showroom is not considered a part of the comparable showroom sales base if the square footage of the showroom changed or if the showroom was relocated. If a showroom was closed for any period of time during the measurement period, that showroom is excluded from comparable showroom sales. For fiscal years 2019 and 2018, 14 and 6 showrooms, respectively were excluded from comparable showroom sales. Comparable showroom sales allow us to evaluate how our showroom base is performing by measuring the change in period-over-period net sales in showrooms that have been open for twelve months or more. While we review comparable showroom sales as one measure of our performance, this measure is less relevant to us than it may be to other retailers due to our fully integrated, omni-channel, go-to-market strategy. As a result, measures that analyze a single channel are less indicative of the performance of our business than they might be for other companies that operate their distribution channels as separate businesses. Further, certain of our competitors and other retailers calculate comparable showroom sales (or similar measures) differently than we do. As a result, the reporting of our comparable showroom sales may not be comparable to sales data made available by other companies. Customer Lifetime Value and Customer Acquisition Cost We calculate CAC on an annual basis by dividing our expenses associated with acquiring new customers for a fiscal year by the number of new customers we acquire in that fiscal year. We include premium rent for locations above commercial rates, media costs to new customers, and a portion of showroom merchandising costs in our marketing expenses associated with acquiring new customers when calculating our CAC. We believe that fiscal 2018 is the first fiscal year that our CAC fully reflects the implementation of changes to our marketing. In fiscal 2018 we significantly increased our spending on marketing expenses and media costs. Our marketing expenses for fiscal 2019 were equal to 11.1% of revenue as compared to 9.0% of revenue for fiscal 2018. For fiscal 2019, our CAC was $309.46 per customer compared to a CAC of $283.22 for fiscal 2018. This increase was a result of our increased marketing spend that targeted Sactional customers. We expect our CAC to continue to increase over the next few years as a result of our continued focus on increasing marketing efforts. We expect this increase in CAC to correspond with a continued increase in CLV. We monitor repeat customer transactions in aggregate and in groups based upon the year in which customers first made a purchase from us, which we refer to as cohorts, as a way to measure our customer’s engagement with our products over their lifetime. Our fiscal 2019 cohorts CLV is $1,540. In addition, our fiscal 2015 cohort has increased its CLV from $1,071 in fiscal 2015 to $1,277 in fiscal 2019, a 19% increase in customer value since the fiscal 2015 cohorts’ first purchases with Lovesac. Retail Sales Per Selling Square Foot Retail sales per selling square foot is calculated by dividing total net sales for all showrooms, comparable and non-comparable, by the average selling square footage for the period. Selling square footage is retail space at our showrooms used to sell our products. Selling square footage excludes backrooms at showrooms used for storage, office space or similar matters. Cost of merchandise sold Cost of merchandise sold includes the direct cost of sold merchandise; inventory shrinkage; inventory adjustments due to obsolescence, including excess and slow-moving inventory and lower of cost or net realizable value reserves; inbound freight; all freight costs to ship merchandise to our showrooms; design, buying and allocation costs; and all logistics costs associated with shipping product to our customers. Certain of our competitors and other retailers may report gross profit differently than we do, by excluding from gross profit some or all of the costs related to their distribution network and instead including them in selling, general and administrative expenses. As a result, the reporting of our gross profit and profit margin may not be comparable to other companies. The primary drivers of our cost of merchandise sold are raw materials costs, labor costs in the countries where we source our merchandise, and logistics costs. We expect gross profit to increase to the extent that we successfully grow our net sales and continue to realize scale economics with our manufacturing partners. We review our inventory levels on an ongoing basis in order to identify slow-moving merchandise and use product markdowns to efficiently sell these products. The timing and level of markdowns are driven primarily by customer acceptance of our merchandise. In addition, we offer financing for our products through a leading third party consumer financing company. Although we do not assume credit risk on these purchases, we do pay fees to these third party lenders, resulting in lower operating margins on these sales than non-financed sales. Gross Profit Gross profit is equal to our net sales less cost of merchandise sold. Gross profit as a percentage of our net sales is referred to as gross margin. In September 2018, the Office of the U.S. Trade Representative began imposing a 10 percent ad valorem duty on a subset of products imported from China, inclusive of various furniture product categories. In September 2018, the Office of the U.S. Trade Representative began imposing a 10 percent ad valorem duty on a subset of products imported from China, inclusive of various furniture product categories. Looking ahead, we expect fiscal 2020 gross profit margin to be 3% lower than fiscal 2019 gross profit margin as a result of the continued expected impact of product and margin shift, tariffs and investments into warehousing and distribution infrastructure to support growth. We are seeking to mitigate the 10% tariff in total dollars but it is expected to have impact on margin percent. Given the ramp up of our tariff mitigation strategies we expect the first quarter of fiscal 2020 to face the most pressure with a gross margin decline of over 3.5%. Selling, General and Administrative Expenses Selling, general and administrative expenses include all operating costs, other than marketing expense, not included in cost of merchandise sold. These expenses include all payroll and payroll-related expenses; showroom expenses, including occupancy costs related to showroom operations, such as rent and common area maintenance; occupancy and expenses related to many of our operations at our headquarters, including utilities; Selling, general and administrative expenses as a percentage of net sales is usually higher in lower volume quarters and lower in higher volume quarters because a significant portion of the costs are relatively fixed. Our recent revenue growth has been accompanied by increased selling, general and administrative expenses. The most significant components of these increases are payroll and rent costs. We expect these expenses, as well as rent expense associated with the opening of new showrooms, to increase as we grow our business. We expect to leverage total selling, general and administrative expenses as a percentage of sales as sales volumes continue to grow. We expect to invest in infrastructure over the next 18 months to support the Company’s growth. These investments will lessen the impact of expense leveraging during the period of investment with the greater impact of expense leveraging happening after the period of investment. However, total selling, general and administrative expenses generally will leverage during the periods of investments with the most deleverage occurring in the first three quarters of the fiscal year, and the greatest leverage occurring in the fourth quarter. As a result of our IPO, we incurred additional legal, accounting and other expenses that we did not incur as a private company, including costs associated with public company reporting and corporate governance requirements. These requirements include compliance with the Sarbanes-Oxley Act of 2002, the Dodd-Frank Wall Street Reform and Consumer Protection Act, other rules implemented by the SEC and applicable Nasdaq stock exchange rules. These rules and regulations have substantially increased our legal and financial compliance costs, made certain financial reporting and other activities more time-consuming and costly, and have required our management and other personnel to devote substantial time to these requirements. In this regard, we have hired additional accounting and financial staff with appropriate public company experience and technical accounting knowledge. Advertising and Marketing Advertising and marketing expense includes digital, social, and traditional marketing initiatives, that cover all of our business channels. Advertising and marketing expense will continue to increase as a percentage to sales as we continue to invest in advertising and marketing which has accelerated sales growth. We expect to continue to maintain our advertising and marketing investments at 10%-12% of net sales on an annual basis with the most deleverage occurring in the first quarterand greatest leverage occurring in the fourth. The investment by quarter may vary greatly. Basis of Presentation and Results of Operations The following discussion contains references to fiscal years 2019 and 2018 which represent our fiscal years ended February 3, 2019, and February 4, 2018, respectively. Our fiscal year ends on the Sunday closest to February 1. Fiscal year 2019 was 52 week period and fiscal 2018 was a 53 week period. The following table sets forth, for the periods for fiscal 2019 and fiscal 2018, our consolidated statement of operations as a percentage of total revenues: Fiscal 2019 Compared to Fiscal 2018 Net sales Net sales increased $ 64.1 million, or 62.9%, to $ 165.9 million in fiscal 2019 compared to $101.8 million in fiscal 2018. The increase in net sales is primarily due to an increase in new customers, which grew by 24.7% in fiscal 2019 as compared to 24.1% in fiscal 2018 and was accompanied by an increase in the total number of units sold by approximately 26.3%. The fiscal 2019 average net sales per showroom is $1,568,581, which reflects a higher average order volume per customer. We had 75 and 66 showrooms open as of February 3, 2019, and February 4, 2018, respectively. We opened 13 additional showrooms and closed 4 showrooms in fiscal 2019. Showroom sales increased $35.3 million, or 45.3%, to $113.1 million in fiscal 2019 compared to $77.8 million in fiscal 2018. This increase was due in large part to our comparable showroom sales increase of $24.1 million, or 35.2%, to $92.6 million in fiscal 2019 compared to $68.5 million in fiscal 2018. Retail sales per selling square foot increased $351, or 27.8%, to $1,613 in fiscal 2019 compared to $1,262 in fiscal 2018. Internet sales (sales made directly to customers through our ecommerce channel) increased $14.2 million, or 75.2%, to $33.0 million in fiscal 2019 compared to $18.9 million in fiscal 2018. We believe that the increase in both showroom and Internet sales was due primarily to our customers’ favorable reaction to our Sactionals products, the redesign of our showrooms and our increased marketing initiatives. We believe that the increase in showroom sales in fiscal 2019 can also be attributed to the opening of additional showrooms. Other sales, which include shop in shop sales, increased $14.6 million, or 286.2%, to $19.8 million in fiscal 2019 compared to $5.1 million in fiscal 2018. This increase was due in large part to our increase in the use of shop in shops. Gross profit Gross profit increased $ 33.7 million, or 58.8%, to $ 90.9 million in fiscal 2019 from $57.2 million in fiscal 2018. Gross margin decreased to 54.8% of net sales in fiscal 2019 from 56.2% of net sales in fiscal 2018. The decrease in gross margin percentage of 1.4 % was driven primarily by product mix as well as channel mix and higher freight costs as a percentage of net sales. The decrease in gross margin was partially offset by reduced costs of our Sactionals and Sacs products. The decrease in costs of our Sactionals and Sacs products was primarily related to cost savings from a change in the sourcing of our Lovesoft and down blend fills and volume rebates we received from certain vendors. Selling, general and administrative expenses Selling, general and administrative expenses increased $25.6 million, or 50.3%, to $76.4 million for the fiscal year ended February 3, 2019 compared to $50.8 million for the fiscal year ended February 4, 2018. The increase in selling, general and administrative expenses was primarily related to an increase in employment costs of $3.9 million, $4.5 million of increased rent associated with our net addition of 9 showrooms, $10.6 million of expenses related to the increase in sales such as $2.2 million of credit card fees, $0.8 million of showroom and web related selling expenses, $1.1 million of web affiliate program and web platform hosting commissions and $6.5 million of shop in shop sales agent fees. Overhead expenses increased $2.2 million to support Company initiatives and public company expenses, stock-based compensation increased $2.4 million and $1.9 million of expenses were related to capital raises. Selling, general and administrative expenses were 46.1% of net sales for fiscal year ended February 3, 2019 compared to 49.9% of net sales for fiscal year ended February 4, 2018. The decrease in selling, general and administrative expenses of 3.8% of net sales and was driven largely by leverage in employment costs and rent expense. The leverage in these expenses was partially offset by increases in stock compensation, public company costs, infrastructure investments and IPO and other financing initiative costs. We expect to leverage total selling, general and administrative expenses as a percentage of sales as sales volumes continue to grow. We expect to invest in infrastructure over the next 18 months to support the Company’s growth. We believe these investments will lessen the impact of expense leveraging during the period of investment with the greater impact of expense leveraging happening after the period of investment. Advertising and marketing Advertising and marketing expenses increased $9.2 million, or 99.8%, to $18.4 million for the fiscal year ended February 3, 2019 compared to $9.2 million for the fiscal year ended February 4, 2018. The increase in advertising and marketing costs relates to increased media and direct to consumer programs which are expected to drive revenue beyond the period of the expense. We expect to continue to maintain our advertising and marketing investments at 10%-12% of net sales on an annual basis. The investment by quarter may vary. Advertising and marketing expenses were 11.1% of net sales in fiscal 2019 compared to 9.0% of net sales in fiscal 2018. The increase in advertising and marketing expenses of 2.1% of net sales was driven largely by the investment in advertising and marketing initiatives this fiscal including Labor Day and holiday national advertising. Depreciation and amortization expenses Depreciation and amortization expenses increased $0.9 million or 41.5% in fiscal 2019 to $3.1 million compared to $2.2 million in fiscal 2018. The increase in depreciation and amortization expense is principally related to capital investments for new and remodeled showrooms. Interest income (expense), net Interest income (expense), net of $0.4 million reflects earnings related to the net proceeds from the IPO of $0.6 million net of interest expense of $0.2 million relating to unused line fees, interest on borrowings and amortization of deferred financing fees on the asset based loan for the fiscal year ended February 3, 2019. The decrease in interest expense from prior year was the result of no borrowings under the line of credit and interest income earned on the net proceeds from the initial public offering. Income tax expense Income tax expense was less than 0.1% of sales for both fiscal 2019 and fiscal 2018. Repeat customers Repeat customers accounted for approximately 38% of all transactions in fiscal 2019 compared to 39% in fiscal 2018. We expect this shift into new customer transactions to continue as we focus on driving acquisition due to our favorable CAC/CLV ratio. Quarterly Results and Seasonality The following table sets forth our historical quarterly consolidated statements of income for each of the last eight fiscal quarters for the period ended February 3, 2019. This unaudited quarterly information has been prepared on the same basis as our annual audited financial statements appearing elsewhere in this Annual Report on Form 10-K and includes all adjustments, consisting of only normal recurring adjustments that we consider necessary to present fairly the financial information for the fiscal quarters presented. The unaudited quarterly data should be read in conjunction with our audited consolidated financial statements and the related notes appearing elsewhere in this Annual Report on Form 10-K. Non-GAAP Quarterly Results Our business is seasonal and we have historically realized a higher portion of our net sales and net income in the fourth fiscal quarter due primarily to the holiday selling season. Working capital requirements are typically higher in the third fiscal quarter due to inventory built-up in advance of the holiday selling season. During these peak periods we have historically increased our borrowings under our line of credit. As such, results of a period shorter than a full year may not be indicative of results expected for the entire year, and the seasonal nature of our business may affect comparisons between periods. Liquidity and Capital Resources General Our business relies on cash flows from operations, our revolving line of credit (see “Revolving Line of Credit” below) and securities issuances as our primary sources of liquidity. Our primary cash needs are for marketing and advertising, inventory, payroll, showroom rent, capital expenditures associated with opening new showrooms and updating existing showrooms, as well as infrastructure and information technology. The most significant components of our working capital are cash and cash equivalents, inventory, accounts receivable, accounts payable and other current liabilities and customer deposits. When borrowing, our borrowings generally increase in our third fiscal quarter as we prepare for the holiday selling season, which is in our fourth fiscal quarter. We believe that cash expected to be generated from operations and cash generated from our IPO are sufficient to meet working capital requirements and anticipated capital expenditures for at least the next 12 months. We expect to incur approximately $13.0 million of capital expenditures in fiscal 2020 with the vast majority of this being spent on the opening of 15-20 new showrooms, remodeling approximately eight showrooms and $3.0 million investment in our vertically operated Sac manufacturing facility. The remaining expenditures are expected to be allocated to technology in our showrooms, inventory management and logistic systems, ecommerce platform enhancements and headquarters data and support systems. Cash Flow Analysis A summary of operating, investing, and financing activities during the periods indicated are shown in the following table: Net Cash Used in Operating Activities Cash from operating activities consists primarily of net loss adjusted for certain non-cash items, including depreciation, loss on disposal of property and equipment, stock-based compensation, non-cash interest expense and the effect of changes in working capital and other activities. In fiscal 2019, net cash used by operating activities was $7.0 million and consisted of changes in operating assets and liabilities of $7.7 million, a net loss of $6.7 million, and non-cash items of $7.4 million. Working capital and other activities consisted primarily of increases in inventory of $14.5 million and accounts receivable of $1.1 million, partially offset by a decrease in prepaid expenses of $0.1 million and increases in accrued liabilities and accounts payable of $7.7 million, and other current liabilities of $0.2 million. In fiscal 2018, net cash used by operating activities was $2.7 million and consisted of changes in operating assets and liabilities of $1.1 million, a net loss of $5.5 million, and non-cash items of $3.9 million. Working capital and other activities consisted primarily of increases in inventory of $2.2 million, prepaid expenses of $4.2 million and accounts receivable of $1.8 million, partially offset by increases in accrued liabilities and accounts payable of $6.9 million, and other current liabilities of $0.2 million. Net Cash Used In Investing Activities Investing activities consist primarily of investment in supply chain and systems infrastructure and capital expenditures related to new showroom openings and the remodeling of existing showrooms. For fiscal 2019, capital expenditures were $11.4 million as a result of investments in new and remolded showrooms and intangibles. For fiscal 2018, capital expenditures were $6.8 million as a result of investments in new and remolded showrooms and intangibles. Net Cash Provided By Financing Activities Financing activities consist primarily of the net proceeds from public offerings, borrowings and repayments related to the existing revolving line of credit and capital contributions from securities issuances. For fiscal 2019, net cash provided by financing activities was $58.3 million, primarily due to $58.9 million net proceeds from our IPO net of $0.3 million for the payment of financing costs on the new revolving credit facility with Wells Fargo Bank, National Association (“Wells”). For fiscal 2018, net cash provided by financing activities was $17.8 million, primarily due to an investment in our Series A, Series A-1 and Series A-2 preferred stock, which converted into approximately 3,287,441 shares of our common stock upon the closing of our IPO. The above change is inclusive of net debt pay downs of $3.3 million. Revolving Line of Credit On February 6, 2018, we entered a four-year, secured revolving credit facility with Wells. The credit facility with Wells permits borrowings of up to $25.0 million, subject to borrowing base and availability restrictions. For additional information regarding our line of credit with Wells, see Note 7 to our condensed consolidated financial statements. As of February 3,2019, the Company’s borrowing availability under the line of credit with Wells was $11.1 million. As of February 3, 2019, there was $31,373 in borrowings outstanding on this line of credit related to unused line charge fees. Contractual Obligations We generally enter into long-term contractual obligations and commitments in the normal course of business, primarily debt obligations and non-cancelable operating leases. As of February 3, 2019, our contractual cash obligations over the next several periods were as follows: Off Balance Sheet Arrangements We have no material off balance sheet arrangements as of February 3, 2019, except for operating leases and employment agreements entered into in the ordinary course of business. Critical Accounting Policies and Estimates The discussion and analysis of financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in conformity with GAAP. Certain accounting policies and estimates are particularly important to the understanding of our financial position and results of operations and require the application of significant judgment by our management or can be materially affected by changes from period to period in economic factors or conditions that are outside of our control. As a result, they are subject to an inherent degree of uncertainty. In applying these policies, management uses their judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on our historical operations, our future business plans and projected financial results, the terms of existing contracts, observance of trends in the industry, information provided by our customers and information available from other outside sources, as appropriate. Please see Note 1 to our audited consolidated financial statements included in this Annual Report on Form 10-K for a complete description of our significant accounting policies. There have been no material changes to the significant accounting policies during fiscal 2019. Revenue Recognition Company revenues consist of sales made to consumers at Company operated showrooms, and via the internet and also sales made business to business. Sales made at Company operated showrooms are recognized at the point of sale when payment is tendered and ownership is transferred to the customer. Sales of merchandise via the internet are recognized upon receipt and verification of payment and shipment of the merchandise to the customer. Ownership and risk of loss transfer to the customer upon shipment. Sales made to businesses are recognized at the point of shipment when ownership and the risk of loss transfer to the customer. Customer deposits are recorded for sales made for which ownership has not transferred as a result of payment received for goods upon order but not yet shipped at the end of any fiscal accounting period. These deposits are carried on our balance sheet until delivery is fulfilled which is typically within 3 - 4 days of order being processed. Recorded net sales provide for estimated returns and allowances. We permit our customers to return products between 30 to 60 days, along with defective products and incorrect shipments. The terms offered are standard for the industry. Revenue is recognized net of sales tax collected. Impairment of Long-Lived Assets The Company’s long-lived assets consist of property and equipment, which includes leasehold improvements. Long-lived assets are reviewed for potential impairment at such time that events or changes in circumstances indicate that the carrying amount of an asset might not be recovered. The Company evaluates long-lived assets for impairment at the individual showroom level, which is the lowest level at which individual cash flows can be identified. When evaluating long-lived assets for potential impairment, the Company will first compare the carrying amount of the assets to the individual showroom’s estimated future undiscounted cash flows. If the estimated future cash flows are less than the carrying amounts of the assets, an impairment loss calculation is prepared. An impairment loss is measured based upon the excess of the carrying value of the asset over its estimated fair value which is generally based on an estimated future discounted cash flow. If required, an impairment loss is recorded for that portion of the asset’s carrying value in excess of fair value. There were no impairments of long-lived assets during fiscal 2019 or fiscal 2018. Advertising and Catalog Costs The Company capitalizes direct-response advertising costs, which consist primarily of television advertising, postcards, catalogues and their mailing costs, and recognizes expense over the related revenue stream if the following conditions are met (1) the primary purpose of the advertising is to elicit sales to customers who could be shown to have responded specifically to the advertising, and (2) the direct-response advertising results in probable and estimable future benefits. For the years ended February 3, 2019 and February 4, 2018 the Company capitalized deferred direct-response television, postcard and catalogue costs of approximately $0 and $3,060,029, respectively. The net balance remaining at February 3, 2019 and February 4, 2018, after amortization, was $0 and $1,348,908, respectively. Direct-response advertising costs, which are included in prepaid expenses and other current assets, are amortized commencing the date the catalogs and post cards are mailed and the television commercial airs through the estimated period of time for the Company has determined the related advertising impacts sales. The entire outstanding balance as of February 4, 2018 was fully amortized in Fiscal 2019. There was no balance as of February 3, 2019. Advertising and marketing costs not associated with direct-response advertising are expensed as incurred. Advertising and marketing expenses (including amortization of direct-response advertising) were $18,363,491 in fiscal 2019 and $9,192,358 in fiscal 2018. Merchandise Inventories Merchandise inventories are comprised of finished goods and are carried at the lower of cost or net realizable value. Cost is determined on a weighted-average method basis (first-in, first out). Merchandise inventories consist primarily of foam filled furniture, sectional couches and related accessories. The Company adjusts its inventory for obsolescence based on historical trends, aging reports, specific identification and its estimates of future retail sales prices. New Accounting Pronouncements Except as described below, the Company has considered all other recently issued accounting pronouncements and does not believe the adoption of such pronouncements will have a material impact on its financial statements. The Company, as an emerging growth company, has elected to use the extended transition period for complying with new or revised financial accounting standards. In August 2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (“ASU”) No. 2015-14, which defers the effective date of ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) by one year. ASU 2014-09 is a comprehensive new revenue recognition model requiring a company to recognize revenue to depict the transfer of goods or services to a customer at an amount reflecting the consideration it expects to receive in exchange for those goods or services. As a result, ASU 2015-14 is now effective for fiscal years, and interim periods within those years, beginning after December 15, 2018, which for us is fiscal 2020. Earlier application is permitted. The Company will adopt the guidance for the annual reporting period beginning in the first quarter of fiscal year 2020 using the modified retrospective method. The Company has evaluated and continues to evaluate the impact of the adoption of the new revenue recognition standard. The adoption of this standard will not have a material impact on the Company’s financial position and results of operations other than the need for increased disclosure. In February 2016, FASB issued ASU No. 2016-02, Leases (Topic 842) amending lease guidance to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. ASU No. 2016-02 is effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020, with early adoption permitted. Management is currently evaluating the impact ASU No. 2016-02 will have on these consolidated financial statements. In August 2016, FASB issued ASU 2016-15, Statement of Cash Flows: Clarification of Certain Cash Receipts and Cash Payments, which eliminates the diversity in practice related to classification of certain cash receipts and payments in the statement of cash flows, by adding or clarifying guidance on eight specific cash flow issues. ASU 2016-15 is effective for fiscal years beginning after December 15, 2018, and interim periods within fiscal years beginning after December 15, 2019, which for the Company is, fiscal 2020. Early adoption is permitted, including adoption in an interim period. The Company has not yet determined the effect of the adoption of ASU 2016-15 on the Company’s consolidated financial position and results of operations.

<s>[INST] 1 Pursuant to Reg SK this can be limited to just Fiscal 2019 and 2018. Option to include Fiscal 2017 We operate on a 52 or 53week fiscal year that ends on the Sunday closest to February 1. Each fiscal year generally is comprised of four 13week fiscal quarters, although in the years with 53 weeks, the fourth quarter represents a 14week period. Overview We are a technology driven, omnichannel company that designs, manufactures and sells unique, high quality furniture comprised of modular couches called Sactionals and premium foam beanbag chairs called Sacs. We market and sell our products through modern and efficient showrooms and, increasingly, through online sales. We believe that our ecommerce centric approach, coupled with our ability to deliver our large upholstered products through nationwide express couriers, are unique to the furniture industry. The name “Lovesac” was derived from our original innovative product, a premium foam beanbag chair, the Sac. The Sac was developed in 1995 and provided the foundation for the Company. We believe that the large size, comfortable foam filling and irreverent branding of our Sacs products have been instrumental in growing a loyal customer base and our positive, fun image. Our Sactionals product line currently represents a majority of our sales. Sactionals are a couch system that consists of two components, “seats” and “sides”, which can be arranged, rearranged and expanded into thousands of configurations easily and without tools. Our Sactional products include a number of patented features relating to their geometry and modularity, coupling mechanisms and other features. We believe that these high quality premium priced products enhance our brand image and customer loyalty and expect them to continue to garner a significant share of our sales. Sacs and Sactionals come in a wide variety of colors and fabrics that allow consumers to customize their purchases in numerous configurations and styles. We provide lifetime warranties on our Sactionals frames and the proprietary foam used in both product lines, and threeyear warranties on our covers. Our Designed for Life trademark reflects our dynamic product line that is built to last and evolve throughout a customer’s life. Customers can continually update their Sacs and Sactionals with new covers, additions and configurations to accommodate the changes in their family and housing situations. We currently market and sell our products through 75 showrooms at top tier malls, lifestyle centers and street locations in 30 states in the U.S. Our modern, efficient showrooms are designed to appeal to millennials and other purchasers looking for comfortable, enduring, premium furniture. They showcase the different sizes of our Sacs, the myriad forms into which our Sactionals can be configured, and the large variety of fabrics that can be used to cover our products. As part of our direct to consumer sales approach, we also sell our products through our ecommerce platform. We believe our products are uniquely suited to this channel. Our foambased Sacs can be reduced to oneeighth of their normal size and each of our Sactionals components weighs less than 50 pounds upon shipping. Our showrooms and other direct marketing efforts work in concert to drive customer conversion in ecommerce. Product Overview We challenge the notion that a piece of furniture is static by offering a dynamic product line built to last and evolve throughout a customer’s life. Our products serve as a set of building blocks that can be rearranged, restyled and reupholstered with any new setting, mitigating constant changes in fashion and style. Sactionals. We believe our Sactionals platform is unlike competing products in its adaptability yet is comparable aesthetically to similarly priced premium couches and sectionals. Our Sactional products include a number of patented features relating to its geometry and modularity, coupling mechanisms and other features. Utilizing only two, standardized pieces, “seats” and “sides,” and over 250 high quality, tightfitting covers that are removable, washable, and changeable, customers can create numerous permutations of a sectional couch with minimal effort. Customization is further enhanced with our specialtyshaped modular offerings, such as our wedge seat and roll arm side. Our custom features and accessories [/INST] Positive. </s>

Conyers Park II Acquisition 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 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 All statements other than statements of historical fact included in this Report, 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 Report, 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 Commission. Overview We are a blank check company incorporated as a Delaware corporation on May 2, 2019 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 initial business combination using cash from the proceeds of our initial public offering and the private placement of warrants that occurred simultaneously with the consummation of the 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 in our initial public offering, which dilution would increase if the anti-dilution provisions in the Class B Common Stock resulted in the issuance of shares 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, 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. As indicated in the accompanying financial statements, at December 31, 2019, we had $951,060 in cash and cash equivalents. We expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete our initial business combination will be successful. Results of Operations For the period from May 2, 2019 (inception) to December 31, 2019, we had a net income of approximately $2.5 million. Our entire activity from May 2, 2019 through December 31, 2019, consisted of formation and preparation for our initial public offering and since our initial public offering, the search for a target business with which to consummate an initial business combination, and as such, we had no operations and no significant operating expenses. Subsequent to the closing of our initial public offering on July 22, 2019, our normal operating costs included costs associated with our search for the business combination, costs associated with our governance and public reporting, state franchise taxes and charges of $10,000 per month from our sponsor for administrative services. Our interest income earned on cash equivalents and marketable securities held in the trust account were approximately $3.6 million. Liquidity and Capital Resources Until the consummation of our initial public offering, our only sources of liquidity were an initial purchase of founder shares for $25,000 by the sponsor and loans to us of up to $300,000 by our sponsor under an unsecured promissory note. This promissory note was non-interest bearing and was paid in full on July 22, 2019 in connection with closing of our initial public offering. On July 22, 2019, we consummated our initial public offering in which we sold 45,000,000 Units, including 5,000,000 overallotment Units, at a price of $10.00 per Unit, generating gross proceeds of $450 million before underwriting discounts and expenses. The sponsor purchased an aggregate of 7,333,333 warrants at a price of $1.50 per warrant in a private placement that occurred simultaneously with our initial public offering. In connection with our initial public offering, we incurred offering costs of approximately $25.36 million (including an underwriting discount of $9 million and a Deferred Discount of $15.75 million). Other incurred offering costs consisted principally of formation and preparation fees related to our initial public offering. $450 million of the net proceeds from our initial public offering and certain of the proceeds from the private placement of the private placement warrants were deposited in a trust account established for the benefit of our public stockholders. As of December 31, 2019, we have available to us the $951,060 of cash and cash equivalents on our balance sheet. We will use these funds 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. We are also entitled to up to $1,000,000 in interest from the trust account to be used for working capital purposes. The amount of interest available to us from the trust account may be less than $1,000,000 as a result of the current interest rate environment. As of December 31, 2019, our interest income in the trust account is approximately $3.6 million. 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. Up to $1,500,000 of such loans may be convertible into warrants, at a price of $1.50 per warrant at the option of the lender. The warrants would be identical to the private placement warrants, including as to exercise price, exercisability and exercise period. The terms of such loans by our officers and directors, if any, have not been determined and no written agreements exist with respect to such loans. We do not expect to seek loans from parties other than our sponsor or an affiliate of our sponsor as we do not believe third parties will be willing to loan such funds and provide a waiver against any and all rights to seek access to funds in our trust account. We expect that we have sufficient resources subsequent to our initial public offering to fund our operations through July 22, 2021. We do not believe we will need to raise additional funds following our initial public offering and the sale of our private placement warrants 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, which may include a specified future issuance. 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 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 entered into any non-financial assets. Contractual Obligations 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 6,000,000 Units to cover over-allotments, if any, at the initial public offering price less the underwriting discounts and commissions. On July 22, 2019, the underwriters partially exercised their over-allotment option for 5,000,000 Units. The underwriters were entitled to underwriting discounts of $0.20 per unit, or $9.0 million in the aggregate, paid upon the closing of the initial public offering. In addition, $0.35 per unit, or approximately $15.75 million in the aggregate will be payable to the underwriters for deferred underwriting commissions. 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. Administrative Support Agreement Commencing on the date our securities were first listed on the NASDAQ, we agreed to pay our sponsor a total of $10,000 per month for office space, utilities and secretarial and administrative support. Upon completion of the initial business combination or our liquidation, we will cease paying these monthly fees. Critical Accounting Policies 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 sheet 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 Common Stock Subject to Possible Redemption Shares of Class A Common Stock subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable shares of Class A Common Stock (including shares of 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, shares of Class A Common Stock are classified as stockholders’ equity. Our shares of 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, 43,313,166 shares of Class A Common Stock subject to possible redemption at the redemption amount are presented as temporary equity, outside of the stockholders’ equity section of our balance sheet. Net Income (Loss) Per Share of Common Stock Net income (loss) per share is computed by dividing net income by the weighted-average number of shares of common stock outstanding during the period. We have not considered the effect of warrants sold in the initial public offering and private placement to purchase 18,583,333 shares of Class A Common Stock 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 shares of Class A Common Stock 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 common stock are calculated by dividing the interest income earned on investments and marketable securities held in the trust account of approximately $3.6 million, net of applicable taxes of $830,672 and $279,580 of working capital expenses (up to $1,000,000) available to be withdrawn from the trust account, resulting in a total of $2,469,141 for the year ended December 31, 2019 by the weighted average number of shares of Class A common stock outstanding for the period. Net loss per share, basic and diluted for Class B common stock is calculated by dividing the net income of $2,469,141, less income attributable to Class A common stock by the weighted average number of shares of Class B common stock of $2,469,141 outstanding for the period. 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, 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. Emerging Growth Company 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 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, 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 our 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.

<s>[INST] Cautionary Note Regarding ForwardLooking Statements All statements other than statements of historical fact included in this Report, 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 Report, 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 Commission. Overview We are a blank check company incorporated as a Delaware corporation on May 2, 2019 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 initial business combination using cash from the proceeds of our initial public offering and the private placement of warrants that occurred simultaneously with the consummation of the 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 in our initial public offering, which dilution would increase if the antidilution provisions in the Class B Common Stock resulted in the issuance of shares 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, 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. As indicated in the accompanying financial statements, at December 31, 2019, we had $951,060 in cash and cash equivalents. We expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete our initial business combination will be successful. Results of Operations For the period from May 2, 2019 ( [/INST] Negative. </s>

CHP Merger Corp.

2020-03-23

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 our audited financial statements and the notes related thereto which are included in “Item 8. Financial Statements and Supplementary Data” in this Form 10-K. Certain information contained in the discussion and analysis 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 “Special Note Regarding Forward-Looking Statements,” “Item 1A. Risk Factors” and elsewhere in this Form 10-K. Overview We are a blank check company formed under the laws of the State of Delaware on July 31, 2019 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 private placement warrants 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 founder shares resulted in the issuance of shares of Class A common stock on a greater than one-to-one basis upon conversion of the founder shares; • may subordinate the rights of holders of 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 units, 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 is payable on demand; • our inability to obtain necessary additional financing if the debt contains covenants restricting our ability to obtain such financing while the debt 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. 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 July 31, 2019 (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 our initial business combination. We do not expect to generate any operating revenues until after the completion of our initial 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 our initial business combination. For the period from July 31, 2019 (inception) through December 31, 2019, we had a net income of $184,511, which consists of interest income on marketable securities held in the trust account of $427,494, offset by operating costs of $170,940 and a provision for income taxes of $72,043. Liquidity and Capital Resources As of December 31, 2019, we had cash of $1,301,607 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 our sponsor and loans from our Sponsor. On November 26, 2019, we consummated the initial public offering of 30,000,000 Units, which included the partial exercise by the underwriters of the over-allotment option to purchase an additional 2,500,000 Units, at $10.00 per Unit, generating gross proceeds of $300,000,000. Simultaneously with the closing of the initial public offering, we consummated the sale of 8,000,000 Private placement warrants to our sponsor at a price of $1.00 per warrant, generating gross proceeds of $8,000,000. Following the initial public offering, the exercise of the over-allotment option and the sale of the Private placement warrants, a total of $300,000,000 was placed in the trust account. We incurred $17,070,862 in transaction costs, including $6,000,000 of underwriting fees, $10,500,000 of deferred underwriting fees and $570,862 of other offering costs. For the period from July 31, 2019 (inception) through December 31, 2019, cash used in operating activities was $152,531. Net income of $184,511 was offset by interest earned on marketable securities held in the trust account of $427,494 and changes in operating assets and liabilities, which provided $90,452 of cash from operating activities. As of December 31, 2019, we had cash and marketable securities held in the trust account of $300,427,494. 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. We may withdraw interest to pay taxes. 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. As of December 31, 2019, we had $1,301,607 of cash held outside of 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 our 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 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 warrants identical to the Private placement warrants, at a price of $1.00 per warrant 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 initial business combination or because we become obligated to redeem a significant number of our public shares upon consummation of our initial 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 initial 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 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 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 our sponsor a monthly fee of $10,000 for office space, utilities and secretarial and administrative support to the Company. We began incurring these fees on November 21, 2019 and will continue to incur these fees monthly until the earlier of the completion of our initial business combination and the Company’s liquidation. The underwriters are entitled to a deferred fee of $0.35 per Unit, or $10,500,000 in the aggregate. The deferred fee will be forfeited by the underwriters solely in the event that we fail to complete our initial 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 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. Net income per common share, basic and diluted for Class A redeemable common stock is calculated by dividing the interest income earned on the trust account, net of applicable franchise and income taxes, by the weighted average number of Class A redeemable common stock outstanding for the period. Net income per common share, basic and diluted for Class B non-redeemable common stock is calculated by dividing the net income, less income attributable to Class A redeemable common stock, by the weighted average number of Class B non-redeemable common stock outstanding for the period presented. Recent Accounting Pronouncements In July 2017, the FASB issued Accounting Standards Update (“ASU”) 2017-11, Earnings Per Share (Topic 260), Distinguishing Liabilities from Equity (Topic 480) and Derivatives and Hedging (Topic 815): Part I. Accounting for Certain Financial Instruments with Down Round Features; Part II. Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception. Part I of this update addresses the complexity of accounting for certain financial instruments with down round features. Down round features are features of certain equity-linked instruments (or embedded features) that result in the strike price being reduced on the basis of the pricing of future equity offerings. Also, entities must adjust their basic Earnings Per Share (“EPS”) calculation for the effect of the down round provision when triggered (that is, when the exercise price of the related equity-linked financial instrument is adjusted downward because of the down round feature). That effect is treated as a dividend and as a reduction of income available to common stockholders in basic EPS. An entity will also recognize the effect of the trigger within equity. The guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company adopted this guidance at inception. As a result, the warrants issued in connection with the initial public offering and the sale of the Private placement warrants have been equity classified. 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] 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” in this Form 10K. Certain information contained in the discussion and analysis set forth below includes forwardlooking statements. Our actual results may differ materially from those anticipated in these forwardlooking statements as a result of many factors, including those set forth under “Special Note Regarding ForwardLooking Statements,” “Item 1A. Risk Factors” and elsewhere in this Form 10K. Overview We are a blank check company formed under the laws of the State of Delaware on July 31, 2019 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 private placement warrants 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 founder shares resulted in the issuance of shares of Class A common stock on a greater than onetoone basis upon conversion of the founder shares; may subordinate the rights of holders of 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 units, 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 is payable on demand; our inability to obtain necessary additional financing if the debt contains covenants restricting our ability to obtain such financing while the debt 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. 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 July 31, 2019 (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 our initial business combination. We do not expect to generate any operating revenues until after the completion of our [/INST] Negative. </s>

Revolve Group, Inc.

2020-02-26

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 Item 6 - Selected Financial Data and our consolidated financial statements and related notes, each included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements based upon current plans, expectations and beliefs that 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 “Forward-Looking Statements” in this Annual Report. A discussion regarding our financial condition and results of operations for fiscal year ended December 31, 2018, compared to the fiscal year ended December 31, 2017, can be found in our prospectus filed pursuant to Rule 424(b) under the Securities Act of 1933, as amended, with the SEC on June 7, 2019. Overview REVOLVE is the next-generation fashion retailer for Millennial and Generation Z consumers. As a trusted, premium lifestyle brand, and a go-to online source for discovery and inspiration, we deliver an engaging customer experience from a vast yet curated offering of apparel, footwear, accessories and beauty styles. Our dynamic platform connects a deeply engaged community of millions of consumers, thousands of global fashion influencers, and hundreds of emerging, established and owned brands. Through 17 years of continued investment in technology, data analytics, and innovative marketing and merchandising strategies, we have built a powerful platform and brand that we believe is connecting with the next generation of consumers and is redefining fashion retail for the 21st century. We were founded in 2003 by our co-CEOs, Michael Mente and Mike Karanikolas. We sell merchandise through two differentiated segments, REVOLVE and FORWARD, that leverage one platform. Through REVOLVE we offer a highly-curated assortment of full-price premium apparel and footwear, accessories and beauty products from emerging, established and owned brands. Through FORWARD we offer an assortment of iconic and emerging luxury brands. We believe that FORWARD provides our customer with a destination for luxury products as her spending power increases and her desire for fashion and inspiration remains central to her self-expression. We believe our product mix reflects the desires of the next-generation consumer and we optimize this mix through the identification and incubation of emerging brands and continued development of our owned brand portfolio. In 2019, emerging third-party brands, established third-party brands, owned brands and other net sales contributed approximately 40%, 23%, 36% and 1% of net sales through the REVOLVE segment, respectively. The focus on emerging and owned brands minimizes our assortment overlap with other retailers, supporting marketing efficiency, conversion and sales at full price. We have invested in our robust and scalable internally-developed technology platform to meet the specific needs of our business and to support our customers’ experience. We use proprietary algorithms and 17 years of data to efficiently manage our merchandising, marketing, product development, sourcing and pricing decisions. Our platform works seamlessly across devices and analyzes browsing and purchasing patterns and preferences to help us make purchasing decisions, which when combined with the small initial orders for new products, allows us to manage inventory and fashion risk. We have also invested in our creative capabilities to produce high-quality visual merchandising that caters to our customers by focusing on style with a distinct point of view rather than on individual products. The combination of our online sales platform and our in-house creative photography allows us to showcase brands in a distinctive and compelling manner. We are pioneers of social media and influencer marketing, using social channels and cultural events designed to deliver authentic and aspirational, yet attainable, experiences to attract and retain Millennial consumers, and these efforts have led to higher earned media value than competitors. We complement our social media efforts through a variety of brand marketing campaigns and events, which generate a constant flow of authentic content. While social media and influencer marketing are key components of our strategy, approximately 75% of our marketing expenses is devoted to performance marketing efforts. Once we have attracted potential new customers to our sites, our goal is to convert them into active customers and then encourage repeat purchases. We acquire and retain customers through retargeting, paid search/product listing ads, affiliate marketing, paid social, personalized email marketing and mobile “push” communications through our app. We have developed an efficient logistics infrastructure, which allows us to provide free shipping and returns to our customers in the United States. We support our logistics network with proprietary algorithms to optimize inventory allocation, reduce shipping and fulfillment expenses and deliver merchandise quickly and efficiently to our customers, which allows us to ship approximately 98% of orders on the same day if placed before noon Pacific Time or the next business day if placed after. In 2019, we expanded our capacity by occupying a new centralized warehouse facility, which we believe will support growth beyond 2023. To date, we have primarily focused on expanding our U.S. business and have grown internationally with limited investment and no physical presence. We began offering a more localized shopping experience, including free returns and all-inclusive pricing, for customers in the United Kingdom and the European Union in May 2018, in Australia in late 2018, and in New Zealand and Singapore in January 2020. For 2019 and 2018, we generated $98.1 million and $89.4 million, respectively, in net sales shipped to customers internationally, or 16.3% and 17.9% of total net sales, respectively. In addition to expanding our global footprint of influencers, we are gradually increasing our level of investment in international expansion, by focusing on Europe, Australia and Canada as well as Asia Pacific over the long term. We will continue to invest in and develop international markets while maintaining our focus on the core U.S. market. Key Operating and Financial Metrics We use the following metrics to assess the progress of our business, make decisions on where to allocate capital, time and technology investments and assess the near-term and longer-term performance of our business. Adjusted EBITDA and free cash flow are non-GAAP measures. See the section captioned “Item 6 - Selected Financial Data” for information regarding our use of Adjusted EBITDA and free cash flow and their reconciliation to net income and net cash provided by operating activities, respectively. Gross Margin Gross profit is equal to our net sales less cost of sales. Gross profit as a percentage of our net sales is referred to as gross margin. Cost of sales consists of our purchase price of merchandise sold to customers and includes import duties and other taxes, freight in, defective merchandise returned from customers, receiving costs, inventory write-offs, and other miscellaneous shrinkage. Gross margin is impacted by the mix of brands that we sell on our sites. Gross margin on sales of owned brands is higher than that for third-party brands. Gross margin is also affected by the percentage of sales through the REVOLVE segment, which consists primarily of emerging third-party, established third-party and owned brands, compared to our FORWARD segment, which consists primarily of established third-party brands. One of our long-term strategies has been to increase the percentage of net sales from owned brands given the attractive margin profile associated with them. However, in the near term, we expect that the contribution of owned brands will moderate or potentially decrease, which would adversely impact our overall gross margin. Merchandise mix will vary from period to period and if we do not effectively manage our owned brands and accurately forecast demand, our growth, margins and inventory levels may be adversely affected. We review our inventory levels on an ongoing basis to identify slow-moving merchandise and use product markdowns to efficiently sell these products. We monitor the percentage of sales that occur at full price, which we believe reflects customer acceptance of our merchandise and the sense of urgency we create through frequent product introductions in limited quantities. Gross margin is impacted by the mix of sales at full price and markdowns, as well as the level of markdowns. Certain of our competitors and other retailers report cost of sales differently than we do. As a result, the reporting of our gross profit and gross margin may not be comparable to other companies. Adjusted EBITDA Adjusted EBITDA is a non-GAAP financial measure that we calculate as net income before other expense, net, taxes, depreciation and amortization, adjusted to exclude the effects of equity-based compensation expense and certain non-routine items. Adjusted EBITDA is a key measure used by management to evaluate our operating performance, generate future operating plans and make strategic decisions regarding the allocation of capital. In particular, the exclusion of certain expenses in calculating Adjusted EBITDA facilitates operating performance comparisons on a period-to-period basis and, in the case of exclusion of the impact of equity-based compensation, excludes an item that we do not consider to be indicative of our core operating performance. See the section captioned “Item 6 - Selected Financial Data” for information regarding our use of Adjusted EBITDA and a reconciliation of Adjusted EBITDA to net income, the most directly comparable GAAP measurement, for the periods presented. Free Cash Flow Free cash flow is a non-GAAP financial measure that we calculate as net cash provided by (used in) operating activities less net cash used in capital expenditures. We view free cash flow as an important indicator of our liquidity because it measures the amount of cash we generate. Free cash flow also reflects changes in working capital. See the section captioned “Item 6 - Selected Financial Data” for information regarding our use of free cash flow and a reconciliation of free cash flow to net cash provided by (used in) operating activities, the most directly comparable GAAP measurement, for the periods presented. Adjusted Diluted Earnings per Share Adjusted diluted earnings per share is a non-GAAP financial measure that we calculate as diluted earnings (net loss) per share adjusted to exclude the per share impact of the issuance and repurchase of Class B common stock as part of our initial public offering, or IPO. We believe adjusted earnings per share, excluding the impact of the repurchase of our Class B common stock, is a measure that is useful to investors and management in understanding our ongoing operations and in analysis of ongoing operating trends. See Note 9, (Net loss) Earnings per Share, of our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for more information regarding our calculation of (net loss) earnings per share. A reconciliation of non-GAAP adjusted diluted earnings per share to diluted (net loss) earnings per share for the years ended December 31, 2019, 2018 and 2017 is as follows (in dollars): Active Customers We define an active customer as a unique customer account from which a purchase was made across our platform at least once in the preceding 12-month period. We calculate the number of active customers on a trailing 12-month basis given the volatility that can be observed when calculating it on the basis of shorter periods that may not be reflective of longer-term trends; however, such a methodology may not be indicative of other short-term trends, such as changes in new customers. In any particular period, we determine our number of active customers by counting the total number of customers who have made at least one purchase in the preceding 12-month period, measured from the last date of such period. We view the number of active customers as a key indicator of our growth, the reach of our sites, the value proposition and consumer awareness of our brand, the continued use of our sites by our customers and their desire to purchase our products. We believe the number of active customers is a measure that is useful to investors and management in understanding our growth, brand awareness and market opportunity. Our number of active customers drives both net sales and our appeal to vendors. Total Orders Placed We define total orders placed as the total number of customer orders placed by our customers across our platform in any period. We view total orders placed as a key indicator of the velocity of our business and an indication of the desirability of our products and sites to our customers. Total orders placed, together with average order value, is an indicator of the net sales we expect to recognize in a given period. We believe that total orders placed is a measure that is useful to investors and management in understanding our ongoing operations and in analysis of ongoing operating trends. In 2019, average order value for merchandise sold through the REVOLVE and FORWARD segments was approximately $256 and $636, respectively, reflecting the brands sold and typical profile of the shoppers on such sites. Total orders placed and total orders shipped in any given period may differ slightly due to orders that are in process at the end of any particular period. Average Order Value We define average order value as the sum of the total gross sales from our sites in a given period divided by the total orders placed in that period. We believe our high average order value demonstrates the premium nature of our product. We believe that average order value is a measure that is useful to investors and management in understanding our ongoing operations and in analysis of ongoing operating trends. Average order value varies depending on the site through which we sell merchandise, the percentage of sales at full price and for sales at less than full price, the level of markdowns. Average order value may also fluctuate as we expand into and increase our presence in additional product categories and price points, including the expansion of lower price points including the launch of the superdown.com site in 2019. Factors Affecting Our Performance Overall Economic Trends The overall economic environment and related changes in consumer behavior have a significant impact on our business. In general, positive conditions in the broader economy promote customer spending on our sites, while economic weakness, which generally results in a reduction of customer spending, may have a more pronounced negative effect on spending on our sites. Macroeconomic factors that can affect customer spending patterns, and thereby our results of operations, include employment rates, business conditions, changes in the housing market, the availability of credit, interest rates, fuel and energy costs, geo-political activity and region-specific or worldwide health crises. In addition, during periods of low unemployment, we generally experience higher labor costs. Customer Acquisition and Growth in Brand Awareness Our focus since inception has been on profitable growth, which has created our disciplined approach to acquiring new customers and retaining existing customers at a reasonable cost, relative to the contributions we expect from such customers. Growth in the number of new customers has in the past, and is expected in the future, to vary from period to period and the percentage of new customer growth rate may slow as our customer base grows. Failure to attract new visitors to our sites and convert them to customers impacts future net sales growth. As social media and influencer based marketing gains popularity, the market for these channels has become increasingly competitive. We believe we have maintained the effectiveness and efficiency of these channels in recent periods; however, if competition continues to increase, it may impact our operating results. We intend to continue investing in our brand marketing efforts, with a specific focus on increasing REVOLVE brand awareness. Since 2013 we have made significant investments to strengthen the REVOLVE brand through a series of high-profile events and expansion of our social media presence. If we fail to cost-effectively promote our brand or convert impressions into new customers, our net sales growth and profitability would be adversely affected. Customer Retention Our success is impacted not only by efficient and profitable customer acquisition and growth in brand awareness, but also by our ability to retain customers and encourage repeat purchases. Existing customers, whom we define as customers in a year who have purchased from us in any prior year, account for a greater and greater share of active customers over time. Existing customers as a percentage of total active customers were 33%, 33%, 38%, 41%, 41% and 45% for 2014, 2015, 2016, 2017, 2018 and 2019, respectively. Existing customers place more orders annually than new customers, resulting in existing customers representing approximately 71% of orders and approximately 74% of net sales in 2019, up from 57% of orders and 58% of net sales in 2014, again having increased in each year. We believe these increasing metrics are reflective of our ability to engage and retain our customers through our differentiated marketing and compelling merchandise offering and shopping experience. The increasing share of our net sales from existing customers reflects our customer loyalty and the net sales retention behavior we see in our cohorts. This cohort behavior demonstrates our ability to not only retain customers, but also increase the customers’ spend on our platform as our loyal customers place orders more frequently and at increasing average order values. We have substantially increased the net sales contribution and retention from existing customer cohorts as our active customer base has grown. Cohort net sales retention is calculated as net sales attributable to a given customer cohort divided by the total net sales attributable to the same customer cohort from one year prior. In 2019, we retained 89% of the prior cohorts’ net sales in 2018, which represents an improvement from 84% net sales retention in 2014. We believe that the trends reflected by these cohorts are illustrative of the value of our customer base; however, changes in customer retention and purchasing patterns could adversely impact our operating results. Merchandise Mix We offer merchandise across a variety of product types, brands and price points. The brands we sell on our platform consist of a mix of emerging third-party, established third-party and owned brands. Our product mix consists primarily of apparel, footwear and accessories. In 2016, we launched beauty products on REVOLVE and expect to offer additional product types in the future. We sell merchandise across a broad range of price points and we launched superdown, our lower price point site in early 2019 that further broadens our price point offerings. Our merchandise mix across our two reporting segments and across our owned brand and third-party products within the REVOLVE segment carry a range of margin profiles and may cause fluctuations in our gross margin. For example, our owned brands have generally contributed higher gross margin as compared to third-party brands. Historically, we have sought to increase the percentage of net sales from owned brands, which has led to an increase in gross margin over time. The mix between owned and third-party net sales and the pace of growth for owned-brand net sales will vary. In the near term, we expect that the contribution of owned brands will moderate or potentially decrease, which would adversely impact our overall gross margin. In addition, shifts in merchandise mix driven by customer demand may result in fluctuations in our gross margin from period to period. Inventory Management We leverage our platform to buy and manage our inventory, including merchandise assortment and fulfillment center optimization. We utilize a data-driven “read and react” buying process to merchandise and curate the latest on-trend fashion. We make shallow initial inventory buys, and then use our proprietary technology tools to identify and re-order best sellers, taking into account customer feedback across a variety of key metrics, which allows us to manage inventory and fashion risk. To ensure sufficient availability of merchandise, we generally purchase inventory in advance and frequently before apparel trends are confirmed. As a result, we are vulnerable to demand and pricing shifts and to suboptimal selection and timing of merchandise purchases. We incur inventory write-offs, which impact our gross margins. Moreover, our inventory investments will fluctuate with the needs of our business. For example, entering new categories will require additional investments in inventory. Shifts in inventory levels may result in fluctuations in the percentage of full price sales, levels of markdowns, merchandise mix, as well as gross margin. In recent periods, our inventory position has increased at a greater rate than that of net sales, particularly in our REVOLVE segment where we have made significant investments in our owned brand platform and the launch of the superdown.com site, our lower price point offering. We believe our efforts to manage inventory levels have impacted the percentage of sales at full price, gross margins on marked-down merchandise, and gross margin in the current period and will likely continue to impact the percentage of sales at full price, gross margin on marked-down merchandise, and gross margin in the near term. These efforts have and may continue to impact the pace of growth in net sales in the near term. 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 platform and understanding of fashion trends to inform investments in operations and infrastructure. We anticipate that our expenses will increase as we continue to hire additional personnel and further improve our platform. Moreover, we have made and will continue to make capital investments in our inventory, fulfillment center, and logistics infrastructure as we launch new brands, expand internationally and drive operating efficiencies. We expect to continue to invest in these areas in the future and cannot be certain that these efforts will grow our customer base or be cost-effective. However, we believe these strategies will yield positive returns in the long term. Segment and Geographic Performance Our financial results are affected by the performance across our two reporting segments, REVOLVE and FORWARD, as well as across the various geographies in which we serve our customers. The REVOLVE segment contributes to a majority of our net sales, representing 87.7% and 86.9% of our net sales for the years ended December 31, 2019 and 2018, respectively. During the years ended December 31, 2019 and 2018, REVOLVE generated $527.3 million and $433.5 million in net sales, respectively, representing an increase of 21.6%. The net sales increase in the year ended December 31, 2019, as compared to 2018, was primarily due to an increase in the number of orders placed by customers, partially offset by a decrease in average order value. Contributing to the increase in orders and net sales was the investment in inventory to support the expansion of our owned brand platform and the launch of the superdown.com site, our lower price point offering. We believe our efforts to manage inventory levels have impacted, and may continue to impact, the pace of growth in net sales and our gross margin in the near term. If we are unable to re-accelerate net sales growth and improve gross margins as a result of the inventory correction, our financial results would be adversely impacted. The FORWARD segment contributes to a smaller portion of our overall net sales, representing 12.3% and 13.1% or our net sales for the years ended December 31, 2019 and 2018, respectively. During the years ended December 31, 2019 and 2018, FORWARD generated $73.7 million and $65.2 million in net sales, respectively, representing an increase of 13.1%. The net sales increase in the year ended December 31, 2019, as compared to 2018, was primarily due to an increase in the number of orders placed by customers, partially offset by a decrease in average order value. After completing the normalization of our FORWARD segment inventory levels in the second quarter of 2019 and as we continued to enhance our product offering, we experienced year-over-year growth in 2019. However, if we are unable to continue to generate revenue and gross profit growth in the FORWARD segment, our financial results would be adversely impacted. Net sales to customers outside of the United States contributed to 16.3% and 17.9% of our net sales for the years ended December 31, 2019 and 2018, respectively. During the years ended December 31, 2019 and 2018, net sales to customers outside of the United States were $98.1 million and $89.4 million, respectively, representing an increase of 9.7%. Net sales to customers outside of the United States is impacted by various factors including import and export taxes, currency fluctuations and other macroeconomic conditions described in “-Overall Economic Trends” above. Increases in taxes and negative movements in currencies have had, and may continue to have, an adverse impact on our financial results. Seasonality Seasonality in our business does not follow that of traditional retailers, such as typical concentration of net sales in the holiday quarter. We believe our results are impacted by a pattern of increased sales leading up to #REVOLVEfestival in April and during May and June, which results in peak sales during the second quarter of each fiscal year. We also have experienced seasonally lower activity during the first quarter of each fiscal year. In 2020, we expect the outbreak of COVID-19 coronavirus will have an impact to our supply chain and may delay the receipt of product that is sourced from China in the first and second quarters, which may change the seasonality trends that we have experienced historically. With the exception of this specific event or events like it, we expect this seasonality to continue in future years. Our operating income has also been affected by these historical trends because many of our expenses are relatively fixed in the short term. If our growth rates begin to moderate, the impact of these seasonality trends on our results of operations may become more pronounced. Components of Our Results of Operations Net Sales Net sales consist primarily of sales of women’s apparel, footwear and accessories. We recognize product sales at the time control is transferred to the customer, which is when the product is shipped. Net sales represent the sales of these items and shipping revenue when applicable, net of estimated returns and promotional discounts. Net sales are primarily driven by growth in the number of our customers, the frequency with which customers purchase and average order value. Cost of Sales Cost of sales consists of our purchase price for merchandise sold to customers and includes import duties and other taxes, freight-in, defective merchandise returned from customers, receiving costs, inventory write-offs, and other miscellaneous shrinkage. Cost of sales is primarily driven by growth in orders placed by customers, the mix of the product available for sale on our sites and transportation costs related to inventory receipts from our vendors. We expect our cost of sales to fluctuate as a percentage of net sales primarily due to how we manage our inventory and merchandise mix. Fulfillment Expenses Fulfillment expenses represent those costs incurred in operating and staffing the fulfillment center, including costs attributed to inspecting and warehousing inventories and picking, packaging and preparing customer orders for shipment. Fulfillment expenses also include the cost of warehousing facilities. We expect fulfillment expenses to increase in absolute dollars as we continue to scale our business. As a percentage of net sales, we experienced a short-term increase as a result of the expansion of our warehouse facilities, which led to short-term inefficiencies. Over the long term, we expect fulfillment expenses to decrease as a percentage of net sales. Selling and Distribution Expenses Selling and distribution expenses consist primarily of shipping and other transportation costs incurred delivering merchandise to customers and from customers returning merchandise, merchant processing fees, and customer service. We expect selling and distribution expenses to increase in absolute dollars as we continue to scale our business. Over the long term, we expect selling and distribution costs to decrease as a percentage of net sales. Marketing Expenses Marketing expenses consist primarily of targeted online performance marketing costs, such as retargeting, paid search/product listing ads, affiliate marketing, paid social, search engine optimization, personalized email marketing and mobile “push” communications through our app. Marketing expenses also include our spend on brand marketing channels, including cash compensation to influencers, events and other forms of online and offline marketing. Marketing expenses are primarily related to growing and retaining our customer base, building the REVOLVE and FORWARD brands and expanding our owned brand presence. We make opportunistic investments in marketing and expect marketing expenses to increase in absolute dollars as we continue to scale our business, but remain relatively consistent as a percentage of net sales. General and Administrative Expenses General and administrative expenses consist primarily of payroll and related benefit costs and equity-based compensation expense for our employees involved in general corporate functions including merchandising, marketing, studio and technology, as well as costs associated with the use by these functions of facilities and equipment, such as depreciation, rent and other occupancy expenses. General and administrative expenses are primarily driven by increases in headcount required to support business growth and meet our obligations as a public company. We expect general and administrative expenses to decline as a percentage of net sales as we scale our business and leverage investments in these areas. Other Expense, Net Other expense, net consists primarily of interest expense and other fees associated with our line of credit and interest income on our money market funds. Results of Operations The following tables set forth our results of operations for the periods presented and express the relationship of certain line items as a percentage of net sales for those periods. The period-to-period comparison of financial results is not necessarily indicative of future results. Comparison of Years Ended 2019 and 2018 Net Sales The overall increase in net sales was primarily due to sales to a larger number of customers, as the number of active customers increased 26.6% in 2019 compared to the number of active customers in 2018. Additionally, the number of orders placed by customers increased 27.1% in 2019 as compared to 2018. These increases were partially offset by a decrease in average order value to $275 in the 2019 from $279 in 2018, primarily due to lower average order values within each segment as well as the REVOLVE segment comprising a larger percentage of consolidated net sales. Net sales in the REVOLVE segment increased 21.6% to $527.3 million in 2019 compared to net sales of $433.5 million in 2018. Net sales generated from our FORWARD segment increased 13.1% to $73.7 million in 2019 compared to net sales of $65.2 million in 2018. Cost of Sales The increase in cost of sales was primarily due to an increase in the volume of merchandise sold. The decrease in cost of sales as a percentage of net sales was due to a favorable mix of merchandise sales combined with a higher mix of sales generated from the REVOLVE segment which generally carry a higher margin than that of the FORWARD segment. Further, within the FORWARD segment, we experienced higher gross margin year over year. Fulfillment Expenses The increase in fulfillment expenses was the result of an increase in the number of units processed as well as the expansion of our fulfillment center infrastructure which led to overcapacity and duplicative capacity that we believe will be reduced over time. We also incurred incremental costs related to the implementation of additional automation during the third quarter. Selling and Distribution Expenses The increase in selling and distribution expenses was the result of an increase in the number of orders shipped and increases in merchant processing fees and customer service costs. Shipping and handling costs increased $9.9 million, merchant processing fees increased $4.3 million, and customer service costs increased $1.8 million in 2019 as compared to 2018. The increase in selling and distribution expenses as a percentage of net sales was due to higher merchant processing fees and employee-related customer service costs. Marketing Expenses The increase in marketing expenses primarily due to increased marketing investment to acquire customers and retain existing customers to drive higher net sales. Performance marketing expenses increased $10.5 million in 2019 as compared to 2018. We also experienced an increase of $4.2 million in 2019 as compared to 2018, in marketing expenses related to REVOLVE branded marketing events. General and Administrative Expenses The increase in general and administrative expenses was due to a $4.9 million increase in salaries and related benefits and equity-based compensation expenses related to increases in our headcount across functions, a $3.8 million increase in professional services and occupancy costs to support business growth and operate as a public company, and a $2.5 million increase in other operating expenses, studio, and design costs, as a result of our business growth. The decrease in general and administrative expenses as a percentage of net sales resulted primarily from efficiencies gained from scale, partially offset by an increase in costs to operate as a public company. Income Taxes The decrease in the effective tax rate was primarily due to the exercise of non-qualified stock options and the use of federal net operating losses during 2019. Quarterly Results of Operations and Other Financial and Operations Data The following tables set forth selected unaudited quarterly results of operations and other financial and operations data for each of the quarters indicated. 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 include only normal recurring adjustments, necessary for the fair statement of our consolidated results of operations for these periods. This data should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. Our quarterly results of operations will vary in the future. These quarterly operating results are not necessarily indicative of our operating results for any future period. (1) Adjusted EBITDA is a non-GAAP financial measure that we calculate as net income before other expense (income), net, taxes, depreciation and amortization, adjusted to exclude the effects of equity-based compensation expense, and certain non-routine items. Please see Item 6 of this report captioned “Selected Financial Data” for more information. Non-routine items include certain items that we consider non-routine and not reflective of the underlying trends in our core business operations. Non-routine items in the first quarter of 2018 included expenses related to our entity restructuring. Non-routine items in the second and third quarters of 2018 related to our initial public offering. Non-routine items in the first and fourth quarters of 2019 related primarily to legal settlements. The following table reflects the reconciliation of net income to Adjusted EBITDA: The following table presents a reconciliation of free cash flow, a non-GAAP financial measure, to net cash provided by operating activities, as well as information regarding net cash used in investing activities and net cash provided by (used in) financing activities: (1) Free cash flow is a non-GAAP financial measure that we calculate as net cash provided by (used in) operating activities less net cash used for purchases of property and equipment. Please see Item 6 of this report captioned “Selected Financial Data” for more information. (2) Net cash used in investing activities includes payments for purchases of property and equipment, which is also included in our calculation of free cash flow. Seasonality and Quarterly Trends Seasonality in our business does not follow that of traditional retailers, such as typical concentration of net sales in the holiday quarter. We believe our results are impacted by a pattern of increased sales leading up to #REVOLVEfestival in April and during May and June, which results in peak sales during the second quarter of each fiscal year. We have also experienced seasonally lower activity during the first quarter of each fiscal year. In 2020, we expect the outbreak of COVID-19 coronavirus will have an impact to our supply chain and may delay the receipt of product that is sourced from China in the first and second quarters, which may change the seasonality trends that we have experienced historically. With the exception of this specific event or events like it, we expect this seasonality to continue in future years. Our operating income has also been affected by these historical trends because many of our expenses are relatively fixed in the short term. As our growth rates begin to moderate, the impact of these seasonality trends on our results of operations will become more pronounced. We focus our internal measurements of performance on quarterly year-over-year comparisons but discuss quarterly sequential information below to help investors understand fluctuations in our business. Our quarterly net sales are reflective of the seasonality as discussed above with the second quarter of 2018 reflecting the impact of #REVOLVEfestival and seasonal increases leading up to the early summer months. Net sales decreased in the third quarter of 2018 and increased in the fourth quarter of 2018 due to seasonality. Net sales increased in the first quarter of 2019 due to continued growth in the business and further increased in the second quarter of 2019 due to growth in the business and seasonality. Net sales decreased in the third quarter of 2019 due to seasonality. We believe net sales in the fourth quarter of 2019 were impacted by a reduction in new inventory receipts within the REVOLVE segment. As noted above, the seasonality of our business has resulted in variability in our total net sales quarter-to-quarter. As a result, we believe that comparisons of net sales and results of operations for a given quarter to net sales and results of operations for the corresponding quarter in the prior fiscal year are generally more meaningful than comparisons of net sales and results of operations for sequential quarters. Our quarterly gross profit has fluctuated quarter to quarter primarily due to the quarterly fluctuations in net sales. In addition, gross margin has been lower in the first quarter of each year and higher in the second quarter of each year, reflecting the seasonal demand of our merchandise as discussed above. We believe the fourth quarter of 2019 was sequentially lower due to increased levels of discounting that we believe was due to a reduction in the new inventory receipts in the REVOLVE segment as discussed above. Fulfillment expenses and selling and distribution expenses have also fluctuated quarter-to-quarter, primarily due to the quarterly fluctuation in net sales. The fluctuation in fulfillment costs is driven by the costs incurred to fulfill orders placed by our customers, while the fluctuation in selling and distribution costs is primarily due to the costs incurred to package and ship products ordered by our customers, ship returns from our customers, provide customer service and costs incurred related to merchant processing. Fulfilment expenses increased in the first, second and third quarters of 2019, partially as the result of investments in our fulfillment capabilities through the expansion of our fulfillment center infrastructure and the implementation of further automation within our facility. Marketing expenses vary quarter-to-quarter, primarily due to the timing of our brand marketing events. The second quarters of 2018 and 2019 include marketing expense related to #REVOLVEfestival. The third quarters of 2018 and 2019 included marketing expense related to #REVOLVEsummer. The fourth quarters of 2018 and 2019 included marketing expense related to the #REVOLVEawards. Marketing expense will continue to fluctuate quarter-to-quarter, depending on the timing of events. General and administrative expenses have generally increased sequentially quarter-to-quarter as we have continued to increase our headcount to support business growth. The first and fourth quarters of 2019 included incremental professional services costs associated with operating as a public company and certain non-routine items primarily related to legal settlements. We had net income for all periods presented. Our business is directly affected by the behavior of consumers. Economic conditions and competitive pressures can significantly impact, both positively and negatively, the level of demand by customers for our products. Consequently, the results of any prior quarterly or annual periods should not be relied upon as indications of our future operating performance. Liquidity and Capital Resources The following tables show our cash and cash equivalents, accounts receivable and working capital as of the dates indicated: As of December 31, 2019, the majority of our cash and cash equivalents was held for working capital purposes. We increased our capital expenditures in the fourth quarter of 2018 as well as in the first and second quarters of 2019, and to a lesser extent in the third quarter of 2019, to support the growth in our business and operations, specifically the consolidation of and increased automation within our fulfillment facility. We believe that our existing cash and cash equivalents as well as the available borrowing capacity under our line of credit 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 borrow funds under our line of credit or raise additional funds at any time through equity, equity-linked or debt financing arrangements. Our future capital requirements and the adequacy of available funds will depend on many factors, including those described in Item 1A - Risk Factors of this report. We may not be able to secure additional financing to meet our operating requirements on acceptable terms, or at all. Sources of Liquidity Since our inception, we have financed our operations and capital expenditures primarily through cash flows generated by operations, private sales of equity securities, the incurrence of debt, as well as the net proceeds we received through our IPO. As of December 31, 2019, we have raised a total of $68.3 million from the sale of equity units, net of costs and expenses associated with such financings, including net proceeds from our IPO. 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 used a substantial portion of the proceeds from the IPO to repurchase shares of our Class B common stock. We believe our existing cash and cash equivalent 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. Line of Credit In March 2016, we entered into a line of credit with Bank of America, N.A. with an expiration date of March 23, 2021, that provides us with up to $75.0 million aggregate principal in revolver borrowings. Borrowings under the credit agreement accrue interest, at our option, at (1) a base rate equal to the highest of (a) the federal funds rate plus 0.50%, (b) the prime rate and (c) the LIBOR rate plus 1.00%, in each case plus a margin ranging from 0.25% to 0.75%, or (2) an adjusted LIBOR rate plus a margin ranging from 1.25% to 1.75%. We are also obligated to pay other customary fees for a credit facility of this size and type, including an unused commitment fee and fees associated with letters of credit. The credit agreement also permits us, in certain circumstances, to request an increase in the facility by an additional amount of up to $25.0 million (in an initial minimum amount of $10 million and in increments of $5 million thereafter) at the same maturity, pricing and other terms. As of December 31, 2019 and 2018, there were no amounts outstanding under the line of credit. Historically, our debt has resulted from the need to help fund our normal operations and working capital needs. Our obligations under the credit agreement are secured by substantially all of our assets. The credit agreement also contains customary covenants restricting our activities, including limitations on our ability to sell assets, engage in mergers and acquisitions, enter into transactions involving related parties, obtain letters of credit, incur indebtedness or grant liens or negative pledges on our assets, make loans or make other investments. Under these covenants, we are prohibited from paying cash dividends with respect to our capital stock. We were in compliance with all covenants as of December 31, 2019. Historical Cash Flows Net Cash Provided by Operating Activities Cash from operating activities consists primarily of net income adjusted for certain non-cash items, including depreciation, equity-based compensation, and the effect of changes in working capital and other activities. For the year ended December 31, 2019, we generated $46.1 million of operating cash flow as compared to $26.7 million in 2018. The increase in our operating cash flow was primarily due to higher net income generated and favorable changes in working capital. Net Cash Used in Investing Activities Our primary investing activities have consisted of purchases of property and equipment to support our fulfillment center and our overall business growth and internally developed software for the continued development of our proprietary technology infrastructure. Purchases of property and equipment may vary from period-to-period due to timing of the expansion of our operations. Net cash used in investing activities was $12.5 million and $3.0 million for the year ended December 31, 2019 and 2018, respectively. The increase in 2019 was primarily due to capital expenditures relating to the consolidation of and investment in our fulfillment center infrastructure. Net Cash Provided by (Used in) Financing Activities Until our IPO, our financing activities historically have consisted of borrowings and repayments related to the existing line of credit. Net cash provided by financing activities was $15.2 million for the year ended December 31, 2019, which was attributable to the proceeds from our IPO, net of the repurchase of the preference amount and underwriting discounts, and proceeds from the exercise of stock options, partially offset by the payment of deferred offering costs. Net cash used in financing activities was $17.6 million in 2018, which was attributable to repayments made on our line of credit and payments of deferred offering costs in connection with our IPO. Off Balance Sheet Arrangements We did not have any off balance sheet arrangements in 2019 or 2018, except for operating leases as discussed below. Contractual Obligations As of December 31, 2019, we leased various offices and our fulfilment center, including our corporate headquarters in Los Angeles County, California, under operating lease agreements that expire from 2020 to 2023. The terms of the lease agreements provide for rental payments on a graduated basis. We recognize rent expense on a straight-line basis over the lease periods. We do not have any debt or material capital lease obligations and most of our property, equipment and software have been purchased with cash. We have no material long-term purchase obligations outstanding with any vendors or third parties. Our future minimum payments under non-cancelable operating leases for equipment and office facilities are as follows as of December 31, 2019: The contractual commitment amounts in the table above are associated with agreements that are enforceable and legally binding. Critical Accounting Policies Our management’s discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, net sales, 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. Our actual results could differ from these estimates. We believe that the assumptions and estimates associated with revenue recognition, inventory, 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. For further information on all of our significant accounting policies, please see Note 2, Significant Accounting Policies, of the accompanying notes to our consolidated financial statements included elsewhere in this report. Net Sales Revenue is primarily derived from the sale of apparel merchandise through our sites and, when applicable, shipping revenue. Prior to the adoption of Accounting Standards Codification, or ASC, 606, Revenues from Contracts with Customers, on January 1, 2019, revenue was recognized when all of the following criteria were satisfied in accordance with the then applicable accounting literature: (1) persuasive evidence of an arrangement existed; (2) the sales price was fixed or determinable; (3) collectability was reasonably assured; and (4) the product had been shipped and title passed to the customer. These criteria were met when the customer ordered an item, the customer’s credit card had been charged, and the item was fulfilled and shipped to the customer. In accordance with ASC 606, we now recognize revenue through the following steps: (1) identification of the contract, or contracts, with the customer; (2) identification of the performance obligations in the contract; (3) determination of the transaction price; (4) allocation of the transaction price to the performance obligations in the contract; and (5) recognition of revenue when, or as, we satisfy a performance obligation. A contract is created with our customer at the time the order is placed by the customer, which creates a single performance obligation to deliver the product to the customer. We recognize revenue for our single performance obligation at the time control of the merchandise passes to the customer, which is at the time of shipment. In addition, we have elected to treat shipping and handling as fulfillment activities and not a separate performance obligation. In accordance with our return policy, merchandise returns are accepted for full refund if returned within 30 days of the original purchase date and may be exchanged up to 60 days from the original purchase date. At the time of sale, we establish a reserve for merchandise returns, based on historical experience and expected future returns, which is recorded as a reduction of sales and cost of sales. We may also issue store credit in lieu of cash refunds or exchanges and sell gift cards without expiration dates to our customers. Store credits issued and proceeds from the issuance of gift cards are recorded as deferred revenue and recognized as revenue when the store credit or gift cards are redeemed or, as a result of the adoption of ASC 606, upon inclusion in our store credit and gift card breakage estimates. Revenue recognized in net sales on breakage on store credit and gift cards for the year ended December 31, 2019 was $2.4 million. In the third quarter of 2019, our breakage revenue increased as the result of a change in our breakage rate estimate which is periodically updated based on historical redemption patterns. We did not recognize any revenue related to unredeemed gift cards or store credits in 2018 or 2017. Results for reporting periods beginning January 1, 2019 and thereafter are presented under ASC 606, while prior period amounts have not been adjusted and continue to be reported in accordance with ASC 605. For more information on the transitional impact of adopting ASC 606, please see the section entitled, “Recent Accounting Pronouncements” in Note 2 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. Sales taxes and duties collected from customers and remitted to governmental authorities are accounted for on a net basis and therefore are excluded from net sales. We have exposure to losses from fraudulent credit card charges. We record losses when incurred related to fraudulent charges as such amounts have historically been insignificant. Inventory Inventories are stated at the lower of cost and net realizable value. Cost is determined using the specific identification method. Cost of inventory includes import duties and other taxes and transport and handling costs. We write down inventory where it appears that the carrying cost of the inventory may not be recovered through subsequent sale of the inventory. We analyze the quantity of inventory on hand, the quantity sold in the past year, the anticipated sales volume, the expected sales price and the cost of making the sale when evaluating the value of our inventory. If the sales volume or sales price of specific products declines, additional write-downs may be required. Income Taxes Income taxes are accounted for under the asset and liability method. 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 and are recorded net on the face of the balance sheet. 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 includes the enactment date. We recognize the effect of income tax positions only if those positions are more-likely than-not of being sustained. Recognized income tax positions are measured at the largest amount that is greater than 50% likely of being realized. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs. Deferred tax assets are recognized to the extent it is believed that these assets are more-likely than-not to be realized. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of 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. Management considers the scheduled reversal of deferred tax liabilities (including the impact of available carryback and carryforward periods), projected future taxable income, and tax-planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more-likely than-not that we will realize the benefits of these deductible differences, net of the valuation allowance. The amount of the deferred tax asset considered realizable, however, could be reduced in the near term if estimates of future taxable income during the carryforward period are reduced. Recent Accounting Pronouncements See Note 2, Significant Accounting Policies, to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for additional information regarding recent accounting pronouncements.

<s>[INST] The following discussion and analysis of our financial condition and results of operations should be read in conjunction with Item 6 Selected Financial Data and our consolidated financial statements and related notes, each included elsewhere in this Annual Report on Form 10K. This discussion contains forwardlooking statements based upon current plans, expectations and beliefs that 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 “ForwardLooking Statements” in this Annual Report. A discussion regarding our financial condition and results of operations for fiscal year ended December 31, 2018, compared to the fiscal year ended December 31, 2017, can be found in our prospectus filed pursuant to Rule 424(b) under the Securities Act of 1933, as amended, with the SEC on June 7, 2019. Overview REVOLVE is the nextgeneration fashion retailer for Millennial and Generation Z consumers. As a trusted, premium lifestyle brand, and a goto online source for discovery and inspiration, we deliver an engaging customer experience from a vast yet curated offering of apparel, footwear, accessories and beauty styles. Our dynamic platform connects a deeply engaged community of millions of consumers, thousands of global fashion influencers, and hundreds of emerging, established and owned brands. Through 17 years of continued investment in technology, data analytics, and innovative marketing and merchandising strategies, we have built a powerful platform and brand that we believe is connecting with the next generation of consumers and is redefining fashion retail for the 21st century. We were founded in 2003 by our coCEOs, Michael Mente and Mike Karanikolas. We sell merchandise through two differentiated segments, REVOLVE and FORWARD, that leverage one platform. Through REVOLVE we offer a highlycurated assortment of fullprice premium apparel and footwear, accessories and beauty products from emerging, established and owned brands. Through FORWARD we offer an assortment of iconic and emerging luxury brands. We believe that FORWARD provides our customer with a destination for luxury products as her spending power increases and her desire for fashion and inspiration remains central to her selfexpression. We believe our product mix reflects the desires of the nextgeneration consumer and we optimize this mix through the identification and incubation of emerging brands and continued development of our owned brand portfolio. In 2019, emerging thirdparty brands, established thirdparty brands, owned brands and other net sales contributed approximately 40%, 23%, 36% and 1% of net sales through the REVOLVE segment, respectively. The focus on emerging and owned brands minimizes our assortment overlap with other retailers, supporting marketing efficiency, conversion and sales at full price. We have invested in our robust and scalable internallydeveloped technology platform to meet the specific needs of our business and to support our customers’ experience. We use proprietary algorithms and 17 years of data to efficiently manage our merchandising, marketing, product development, sourcing and pricing decisions. Our platform works seamlessly across devices and analyzes browsing and purchasing patterns and preferences to help us make purchasing decisions, which when combined with the small initial orders for new products, allows us to manage inventory and fashion risk. We have also invested in our creative capabilities to produce highquality visual merchandising that caters to our customers by focusing on style with a distinct point of view rather than on individual products. The combination of our online sales platform and our inhouse creative photography allows us to showcase brands in a distinctive and compelling manner. We are pioneers of social media and influencer marketing, using social channels and cultural events designed to deliver authentic and aspirational, yet attainable, experiences to attract and retain Millennial consumers, and these efforts have led to higher earned media value than competitors. We complement our social media efforts through a variety of brand marketing campaigns and events, which generate a constant flow of authentic content. While social media and influencer marketing [/INST] Negative. </s>

Satsuma Pharmaceuticals, 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 the section titled “Selected Financial Data” and our 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 developing a novel therapeutic product for the acute treatment of migraine. Our product candidate, STS101, is a drug-device combination of a proprietary dry-powder formulation of dihydroergotamine mesylate, or DHE, which can be quickly and easily self-administered with a proprietary pre-filled, single-use, nasal delivery device. DHE products have long been recommended as a first-line therapeutic option for the acute treatment of migraine and have significant advantages over other therapeutics for many patients. However, broad use has been limited by invasive and burdensome administration and/or sub-optimal clinical performance of available injectable and liquid nasal spray products. STS101 is specifically designed to deliver the clinical advantages of DHE while overcoming these shortcomings. We have completed a Phase 1 clinical trial in 42 healthy volunteers, in which STS101 demonstrated rapid and sustained DHE plasma concentrations within ranges previously associated with efficacy and safety in controlled studies of other DHE products, low pharmacokinetic variability, and a favorable safety and tolerability profile. In July 2019, we initiated our Phase 3 EMERGE efficacy trial of STS101 and expect to report topline data in the second half of 2020. Since our inception in June 2016, we have invested substantially all of our efforts and financial resources in the development of STS101 for the acute treatment of migraine. We have incurred significant operating losses to date and expect that our operating expenses will increase significantly as we advance STS101 through clinical development, manufacturing and regulatory approval, and as we prepare for commercialization of STS101, if approved; 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 $28.2 million, $7.3 million and $5.2 million for the years ended December 31, 2019, 2018 and 2017, respectively. As of December 31, 2019, we had an accumulated deficit of $43.0 million. We do not have any products approved for sale and have not generated any product revenue since our inception. Prior to the completion of our IPO in September 2019, we have funded our operations primarily with an aggregate of $78.8 million in gross cash proceeds from the sale and issuance of convertible preferred stock, a convertible promissory note, and long-term debt. In April 2019, we received gross cash proceeds of $61.7 million from the sale and issuance of Series B convertible preferred stock. In September 2019, we sold and issued 5,500,000 shares of common stock at $15.00 per share for gross proceeds of $82.5 million. In October 2019, we sold and issued an additional 552,116 shares of common stock at $15.00 per share for gross proceeds of $8.3 million as a result of the partial exercise by the underwriters of their option to purchase additional shares. These gross proceeds are before underwriting discounts, commissions and offering costs. Upon the closing of our IPO, all redeemable convertible preferred shares then outstanding automatically converted into 9,936,341 shares of common stock, 5,116 warrants were net exercised immediately after the IPO resulting issuance of 4,801 shares of common stock. Our ability to generate product revenue will depend on the successful development and eventual commercialization of STS101. Until such time as we can generate significant revenue from sales of STS101, 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 STS101. As of December 31, 2019, we had cash, cash equivalents and marketable securities of $117.9 million. We believe that those cash, cash equivalents and marketable securities will be sufficient to fund our projected operations for at least 12 months from the issuance of our financial statements as of and for the year ended December 31, 2019. Components of Operating Results Operating Expenses Research and Development Expenses All of our research and development expenses consist of expenses incurred in connection with the development of STS101 for the acute treatment of migraine. These expenses include: • payroll and personnel-related expenses, including salaries, annual cash bonuses, employee benefit costs and stock-based compensation expenses for our research and product development employees; • fees paid to third parties to conduct preclinical and clinical studies and other research and development activities, including contract research organizations, or CROs, contract manufacturing organizations, or CMOs, and other service providers; and • costs for licenses and allocated overhead, including rent, equipment, depreciation, information technology costs and utilities. We expense both internal and external research and development expenses as they are incurred. We have entered into various agreements with CROs and CMOs. Our research and development accruals are estimated based on the level of services performed, progress of the studies, including the phase or completion of events or tasks, and contracted costs. The estimated costs of research and development provided, but not yet invoiced, are included in accrued and other current liabilities on the balance sheet. If the actual timing of the performance of services or the level of effort varies from the original estimates, we adjust the accrual accordingly. Payments made to CROs and 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. 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 as prepaid expenses and other current assets on our balance sheet. The capitalized amounts are recognized as expense as the goods are delivered or the related services are performed. We expect our research and development expenses to increase substantially, as we advance STS101 through clinical development, manufacturing and regulatory approval, and as we prepare for commercialization of STS101, if approved. Predicting the timing or the 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, if we experience significant delays in enrollment in any of our clinical trials or if we experience delays in manufacturing with any of our CMOs, 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 STS101 will receive regulatory approval with any certainty. General and Administrative Expenses General and administrative expenses consist principally of payroll and personnel expenses, including salaries, benefits and stock-based compensation expenses, professional fees for legal, consulting, accounting and tax services, directors and officers insurance, allocated overhead, including rent, debt service, equipment, depreciation, information technology costs, 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 salaries, benefits and stock-based compensation expenses, expanded infrastructure and higher consulting, legal and accounting services associated with maintaining compliance with stock exchange listing and Securities and Exchange Commission, or SEC, requirements, investor relations costs and director and officer insurance premiums associated with being a public company. Interest Income Interest income consists primarily of interest earned on our cash, cash equivalents and marketable securities. Interest Expense Interest expense consists primarily of interest related to our long-term debt, convertible note, and accretion of debt discount and debt issuance costs. Other Income (Expense), Net Other income (expense), net primarily consists of changes in the fair value of convertible preferred stock tranche liability and the obligation to issue additional shares of common stock. Results of Operations Comparison of the Years Ended December 31, 2019 and 2018 Research and Development Expenses Research and development expenses increased by $17.8 million, or 276%, from the year ended December 31, 2018 to the year ended December 31, 2019. The increase in research and development expenses was primarily due to an increase of $15.9 million in fees paid to CROs and CMOs as a result of increased clinical and non-clinical trial activities, an increase of $1.0 million in payroll and personnel expenses, including salaries, benefits and stock-based compensation expenses, due to increases in headcount partially offset with payroll tax credit, an increase of $0.8 million in allocated overhead, including depreciation and travel expenses and an increase of $0.1 million of other research and development related expenses. General and Administrative Expenses General and administrative expenses increased by $3.6 million, or 333%, from the year ended December 31, 2018 to the year ended December 31, 2019. The increase in general and administrative expenses was primarily due to an increase of $1.1 million of payroll and personnel expenses, including salaries, benefits and stock-based compensation expenses, due to increases in headcount, and an increase of $2.5 million of professional fees for legal, consulting, accounting, tax and other services. Interest Income Interest income increased by $1.1 million from the year ended December 31, 2018 to the year ended December 31, 2019, which was primarily due to an increase in interest income on our cash, cash equivalents and marketable securities balances, which increased as a result of the net proceeds from our Series B convertible preferred stock in April 2019 and IPO in September 2019. Interest Expense Interest expense increased by $0.4 million from the year ended December 31, 2018 to the year ended December 31, 2019, which was primarily attributable to interest expense related to our long-term debt, including accretion of debt discount and debt issuance costs. Other Income (Expense), Net Other income (expense), net decreased by $0.2 million from the year ended December 31, 2018 to the year ended December 31, 2019, which was primarily due to a decrease in the fair value of the convertible preferred stock tranche liability of $0.3 million during the year ended December 31, 2018 partially offset with change in fair value of SNBL grant liability of $0.1 million. Comparison of the Years Ended December 31, 2018 and 2017 Research and Development Expenses Research and development expenses increased by $2.2 million, or 53%, from the year ended December 31, 2017 to the year ended December 31, 2018. The increase in research and development expenses was primarily due to an increase of $1.3 million in fees paid to CROs and CMOs, and an increase of $0.9 million in payroll and personnel expenses, including salaries, benefits and stock-based compensation expenses, due to increases in headcount. General and Administrative Expenses General and administrative expenses increased by $0.3 million, or 44%, from the year ended December 31, 2017 to the year ended December 31, 2018. The increase in general and administrative expenses was primarily due to an increase of $0.1 million of payroll and personnel expenses, including salaries, benefits and stock-based compensation expenses, and an increase of $0.1 million of professional fees for legal, consulting, accounting, tax and other services. Interest Income Interest income increased by less than $0.1 million from the year ended December 31, 2017 to the year ended December 31, 2018, which was primarily attributable to interest income from cash and cash equivalents. Interest Expense Interest expense increased by $0.1 million from the year ended December 31, 2017 to the year ended December 31, 2018, which was primarily attributable to interest expense related to our long-term debt, including accretion of debt discount and debt issuance costs. Other Income (Expense), Net Other income (expense), net increased by $0.4 million from the year ended December 31, 2017 to the year ended December 31, 2018, which was primarily due to a decrease in the fair value of the convertible preferred stock tranche liability of $0.3 million during the year ended December 31, 2018. Liquidity and Capital Resources; Plan of Operations Sources of Liquidity Prior to the completion of our IPO in September 2019, we had funded our operations since our inception primarily through private placements of convertible preferred stock, a convertible promissory note, and long-term debt. We do not have any products approved for sale and have never generated any revenue. In August 2016, we received $0.1 million under a convertible promissory note. We received gross cash proceeds of $6.0 million from the sale and issuance of Series A convertible preferred stock during the year ended December 31, 2016, and gross cash proceeds of $6.0 million from the sale and issuance of Series A convertible preferred stock during the year ended December 31, 2018. In April 2019, we received gross cash proceeds of $61.7 million from the sale and issuance of Series B convertible preferred stock. We also entered into the credit facility described below with Silicon Valley Bank. In September 2019, we sold and issued 5,500,000 shares of common stock at $15.00 per share for gross proceeds of $82.5 million. In October 2019, we sold and issued an additional 552,116 shares at $15.00 per share for gross proceeds of $8.3 million as a result of the partial exercise by the underwriters of their option to purchase additional shares. These gross proceeds are before underwriting discounts, commissions and offering costs. Credit Facility In October 2018, we entered into the Loan Agreement with Silicon Valley Bank. The Loan Agreement provides for loan advances of up to $10.0 million. We drew down the first advance of $5.0 million as of the effective date of the Loan Agreement. The remaining $5.0 million is available for draw down in $1.0 million increments. The Loan Agreement contains customary affirmative and negative covenants and events of default, including covenants and restrictions that among other things, restrict our ability to incur liens, incur additional indebtedness, make loans and investments, engage in mergers and acquisitions, engage in asset sales or sale and leaseback transactions, and declare dividends or redeem or repurchase capital stock. Interest on the loan advances is payable monthly at a floating per annum rate equal to the greater of 1.5% above the prime rate and 6.5%. Upon the occurrence of an event of default, interest will increase to 5.0% above the rate that is otherwise applicable. Principal on the outstanding loan advance is repayable commencing on December 1, 2019 in 30 monthly payments through maturity. The maturity date of the loan advances is May 1, 2022. Future Funding Requirements We have incurred net losses since our inception. Our net losses were $28.2 million, $7.3 million and $5.2 million for the years ended December 31, 2019, 2018 and 2017, respectively. Based on our current business plan, we believe that our existing cash, cash equivalents and marketable securities, will be sufficient to fund our planned operations for at least 12 months from the issuance of our financial statements as of and for the year ended December 31, 2019. We do not expect to generate any meaningful revenue unless and until we obtain regulatory approval of and commercialize STS101 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 the losses to increase as we continue the development of, and seek regulatory approvals for, STS101 and begin to commercialize STS101, if approved. We are subject to 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. We will continue to require additional capital to develop STS101 and fund operations for the foreseeable future. We may seek to raise capital through private or public 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. Our failure to raise capital as and when needed would have a negative impact on our financial condition and our ability to pursue the development and commercialization of STS101. We anticipate that we will need to raise substantial additional capital, the requirements for which will depend on many factors, including: • the scope, timing, rate of progress, results and costs of our clinical trials for STS101; • the number and scope of clinical programs we decide to pursue; • the scope and costs of manufacturing development and commercial manufacturing activities; • the cost, timing and outcome of regulatory review of STS101; • the cost of building a sales force in anticipation of commercialization of STS101; • the cost and timing associated with commercializing STS101, if approved; • the costs of preparing, filing and prosecuting patent applications, maintaining and enforcing our intellectual property rights and defending • intellectual property-related claims; • any product liability or other lawsuits related to STS101; • our efforts to enhance operational systems and our ability to attract, hire and retain qualified personnel, including personnel to support the • development and commercialization of STS101; • the extent to which we acquire or in-license other product candidates or technologies; • the payment of royalty payments owed under our existing license agreement; • our ability to establish and maintain collaborations on favorable terms, if at all; • the costs associated with being a public company; and • the timing, receipt and amount of sales of STS101, if approved. A change in the outcome of any of these or other variables with respect to the development of STS101 could significantly change the costs and timing associated with its development. 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 debt financing into which we enter may impose upon us 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 or engage in certain merger, consolidation or asset sale transactions. For example, the Loan Agreement contains many of these restrictions. 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 our development program and clinical trials. We may also be required to sell or license to others rights to STS101 in certain territories or indications that we would prefer to develop and commercialize ourselves. Adequate additional funding may not be available to us on acceptable terms or at all. See “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 and cash equivalents for each of the periods presented below: Cash Flows used in Operating Activities Net cash used in operating activities was $29.6 million for the year ended December 31, 2019. Cash used in operating activities was primarily due to the use of funds in our operations to develop STS101, which resulted in a net loss of $28.2 million, adjusted for an increase in prepaid expenses and other assets of $6.5 million and a decrease of other non-current liabilities by $0.1 million, net amortization of premiums and discounts on marketable securities of $0.1 million, which amounts were partially offset by an increase in accounts payable of $4.0 million, an increase in accrued and other liabilities of $0.2 million, depreciation expense of $0.1 million, stock-based compensation expense of $0.7 million, non-cash interest expense and amortization of debt discount and issuance costs of $0.1 million. The increase in accounts payable resulted from the timing of payments to our service providers. The increase in accrued and other liabilities was primarily due to an increase in accrued research and development and accrued compensation. Net cash used in operating activities was $7.0 million for the year ended December 31, 2018. Cash used in operating activities was primarily due to the use of funds in our operations to develop STS101, which resulted in a net loss of $7.3 million, adjusted for changes in fair value of convertible preferred stock tranche liability of $0.3 million, an increase in prepaid expenses and other assets of $0.5 million, a decrease in accounts payable of $0.2 million, which amounts were partially offset by depreciation expense of $0.1 million, change in the fair value of the obligation to issue additional common stock by $0.1 million, stock-based compensation expense of $0.2 million, and an increase in accrued and other liabilities of $0.9 million. The decrease in accounts payable resulted from the timing of payments to our service providers. The increase in accrued and other liabilities was primarily due to an increase in accrued research and development and accrued compensation. Net cash used in operating activities was $4.3 million for the year ended December 31, 2017. Cash used in operating activities was primarily due to the use of funds to develop STS101, which resulted in a net loss of $5.2 million, adjusted for an increase in prepaid expenses and other assets of $0.3 million, which amounts were partially offset by a change in the fair value of the obligation to issue additional shares of common stock of $0.2 million, stock-based compensation expense of $0.1 million, an increase in accrued and other liabilities of $0.4 million, and an increase in accounts payable of $0.4 million. The increase in accrued and other liabilities was primarily due to an increase in accrued research and development and accrued compensation. The increase in accounts payable resulted from the timing of payments to our service providers. Cash Flows used in Investing Activities Net cash used in investing activities was $95.9 million for the year ended December 31, 2019, which consisted of purchases of marketable securities of $99.9 million, which amounts were partially offset by proceeds from maturities of marketable securities of $4.5 million and purchases of property and equipment of $0.5 million. Net cash used in investing activities was $0.4 million for the year ended December 31, 2018, which consisted of $0.4 million used to purchase property and equipment. Net cash used in investing activities was $0.1 million for the year ended December 31, 2017, which consisted of $0.1 million used to purchase property and equipment. Cash Flows provided by Financing Activities Net cash provided by financing activities was $143.1 million for the year ended December 31, 2019, which consisted of $61.5 million of net cash proceeds from our issuance of Series B convertible preferred stock, $81.4 million of net cash proceeds from our IPO and $0.3 million from exercise of stock options, partially offset by repayment of debt of 0.2 million. Net cash provided by financing activities was $10.9 million for the year ended December 31, 2018, which consisted of $6.0 million of net cash proceeds from the issuance of Series A convertible preferred stock and borrowings of $4.9 million under our long-term debt facility with Silicon Valley Bank, net of issuance costs. We did not undertake any financing activities in the year ended December 31, 2017. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2019: (1) We lease our office facilities in South San Francisco, California under non-cancelable operating leases through April 2021. There is an option to renew for an additional three years. The minimum lease payments above do not include any related common area maintenance charges or real estate taxes. In July 2019, we entered into a lease agreement to lease another office space in North Carolina. Тhe lease term is three years and the lease expires in July 2022. (2) In October 2018, we entered into the Loan Agreement with Silicon Valley Bank. The Loan Agreement provides for loan advances of up to $10.0 million. The first advance of $5.0 million was drawn down during the year ended December 31, 2018. The loan is repayable commencing on December 1, 2019 in 30 monthly payments through maturity. In addition to regular monthly payments, a final payment equal to the original amount of the loan multiplied by 5.0% is due on the earliest to occur of (a) May 1, 2020 or (b) the prepayment in full of the loan. We repaid $0.2 million of the loan in December 2019. We enter into contracts in the normal course of business with third-party contract organizations for clinical trials, manufacturing and testing 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. Under the terms of our license agreement with Shin Nippon Biomedical Laboratories, Ltd., or SNBL, we have agreed to make royalty payments based on a low single-digit percentage of worldwide net sales of certain products covered thereby, payable on a product-by-product and country-by-country basis until the latest of the expiration of the last-to-expire patent covering such product and the ten-year anniversary of the first commercial sale of such product in such country. No upfront or milestone payments are otherwise owed pursuant to the license agreement. 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. Critical Accounting Policies, Significant Judgments and Use of Estimates Our financial statements have been prepared in accordance with U.S. generally accepted accounting principles, or GAAP. The preparation of these 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 financial statements and 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. For more detail on our critical accounting policies, refer to Note 1 to the financial statements included elsewhere in this Annual Report on Form 10-K. Accrued Research and Development We monitor the activity under its various agreements with CROs, CMOs and other service providers to the extent possible through communication with each service provider, detailed invoice and task completion review, analysis of actual expenses against budget, pre-approval of any changes in scope, and review of contractual terms. Our research and development accruals are estimated based on the level of services performed, progress of the studies, including the phase or completion of events, and contracted costs. These estimates may or may not match the actual services performed by the service providers. The estimated costs of research and development provided, but not yet invoiced, are included in accrued liabilities on the balance sheet. 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 service providers 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 We use a fair value-based method to account for all stock-based compensation arrangements with employees and non-employees, including stock options and stock awards. Our determination of the fair value of stock options on the date of grant utilizes the Black-Scholes option pricing model. The fair value of the option granted is recognized on a straight-line basis over the period during which an optionee is required to provide services in exchange for the option award, known as the requisite service period, which usually is the vesting period. We account for forfeitures as they occur. Estimates of the fair value of equity awards as of the grant date using valuation models such as the Black-Scholes option pricing model are affected by assumptions with a number of complex variables. Changes in the assumptions can materially affect the fair value and ultimately the amount of stock-based compensation expense recognized. These inputs are subjective and generally require significant analysis and judgment to develop. Changes in the following assumptions can materially affect the estimate of the fair value of stock-based compensation: • Expected Term - The expected term is calculated using the simplified method, which is available where there is insufficient historical data about exercise patterns and post-vesting employment termination behavior. The simplified method is based on the vesting period and the contractual term for each grant, or for each vesting-tranche for awards with graded vesting. The mid-point between the vesting date and the maximum contractual expiration date is used as the expected term under this method. For awards with multiple vesting-tranches, the times from grant until the mid-points for each of the tranches may be averaged to provide an overall expected term. • Expected Volatility - For all stock options granted to date, the volatility data was estimated based on a study of publicly traded industry peer companies as we did not have any trading history for our common stock. For purposes of identifying these peer companies, we considered the industry, stage of development, size and financial leverage of potential comparable companies. For each grant, we measured historical volatility over a period equivalent to the expected term. We will continue to apply this process until a sufficient amount of historical information regarding the volatility of our own stock price becomes available. • Expected Dividend - The Black-Scholes valuation model calls for a single expected dividend yield as an input. We currently have no history or expectation of paying cash dividends on our common stock. Accordingly, we have estimated the dividend yield to be zero. • Risk-Free Interest Rate - The risk-free interest rate is based on the yield available on U.S. Treasury instruments whose term is similar in duration to the expected term of the respective stock option. 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. JOBS Act Accounting Election 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. We have elected to use this extended transition period under the JOBS Act. 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, which may make comparison of our financials to those of other public companies more difficult. Recent Accounting Pronouncements See “Organization and Summary of Significant Accounting Policies-Recent Accounting Pronouncements” in Note 1 to our financial statements included elsewhere in this Annual Report on Form 10-K for additional information.

<s>[INST] Overview We are a clinicalstage biopharmaceutical company developing a novel therapeutic product for the acute treatment of migraine. Our product candidate, STS101, is a drugdevice combination of a proprietary drypowder formulation of dihydroergotamine mesylate, or DHE, which can be quickly and easily selfadministered with a proprietary prefilled, singleuse, nasal delivery device. DHE products have long been recommended as a firstline therapeutic option for the acute treatment of migraine and have significant advantages over other therapeutics for many patients. However, broad use has been limited by invasive and burdensome administration and/or suboptimal clinical performance of available injectable and liquid nasal spray products. STS101 is specifically designed to deliver the clinical advantages of DHE while overcoming these shortcomings. We have completed a Phase 1 clinical trial in 42 healthy volunteers, in which STS101 demonstrated rapid and sustained DHE plasma concentrations within ranges previously associated with efficacy and safety in controlled studies of other DHE products, low pharmacokinetic variability, and a favorable safety and tolerability profile. In July 2019, we initiated our Phase 3 EMERGE efficacy trial of STS101 and expect to report topline data in the second half of 2020. Since our inception in June 2016, we have invested substantially all of our efforts and financial resources in the development of STS101 for the acute treatment of migraine. We have incurred significant operating losses to date and expect that our operating expenses will increase significantly as we advance STS101 through clinical development, manufacturing and regulatory approval, and as we prepare for commercialization of STS101, if approved; 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 $28.2 million, $7.3 million and $5.2 million for the years ended December 31, 2019, 2018 and 2017, respectively. As of December 31, 2019, we had an accumulated deficit of $43.0 million. We do not have any products approved for sale and have not generated any product revenue since our inception. Prior to the completion of our IPO in September 2019, we have funded our operations primarily with an aggregate of $78.8 million in gross cash proceeds from the sale and issuance of convertible preferred stock, a convertible promissory note, and longterm debt. In April 2019, we received gross cash proceeds of $61.7 million from the sale and issuance of Series B convertible preferred stock. In September 2019, we sold and issued 5,500,000 shares of common stock at $15.00 per share for gross proceeds of $82.5 million. In October 2019, we sold and issued an additional 552,116 shares of common stock at $15.00 per share for gross proceeds of $8.3 million as a result of the partial exercise by the underwriters of their option to purchase additional shares. These gross proceeds are before underwriting discounts, commissions and offering costs. Upon the closing of our IPO, all redeemable convertible preferred shares then outstanding automatically converted into 9,936,341 shares of common stock, 5,116 warrants were net exercised immediately after the IPO resulting issuance of 4,801 shares of common stock. Our ability to generate product revenue will depend on the successful development and eventual commercialization of STS101. Until such time as we can generate significant revenue from sales of STS101, 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 [/INST] Negative. </s>

Fastly, Inc.

2020-03-04

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 consolidated financial statements and related notes that are included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements 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” and in other parts of this Annual Report on Form 10-K. Our fiscal year ends on December 31. As used herein, "Fastly," "we," "our," "the Company" and similar terms include Fastly, Inc. and its subsidiaries, unless the context indicates otherwise. Overview Developers are reinventing the way we live, work, and play online. Yet they repeatedly encounter innovation barriers when delivering modern digital experiences. Expectations for digital experiences are at an all-time high; they must be fast, secure, and highly personalized. If they aren’t reliable, end-users simply take their business elsewhere. The challenge today is enabling developers to deliver a modern digital experience while simultaneously providing scale, security, and performance. We built our edge cloud platform to solve this problem. The edge cloud is a new category of Infrastructure as a Service ("IaaS") that enables developers to build, secure, and deliver digital experiences, at the edge of the internet. This service represents the convergence of the Content Delivery Network ("CDN") with functionality that has been traditionally delivered by hardware-centric appliances such as Application Delivery Controllers ("ADC"), Web Application Firewalls ("WAF"), Bot Detection, and Distributed Denial of Service ("DDoS") solutions. It also includes the emergence of a new, but growing, edge computing market which aims to move compute power and logic as close to the end-user as possible. The edge cloud uses the emerging cloud computing, serverless paradigm in which the cloud provider runs the server and dynamically manages the allocation of machine resources. When milliseconds matter, processing at the edge is an ideal way to handle highly dynamic and time-sensitive data. The edge cloud complements data center, central cloud, and hybrid solutions. Our mission is to fuel the next modern digital experience by providing developers with a programmable and reliable edge cloud platform that they adopt as their own. Organizations must keep up with complex and ever-evolving end-user requirements. We help them surpass their end-users’ expectations by powering fast, secure, and scalable digital experiences. We built a powerful edge cloud platform, designed from the ground up to be programmable and support agile software development. We believe our platform gives our customers a significant competitive advantage, whether they were born into the digital age or are just embarking on their digital transformation journey. Our platform consists of four key components: a programmable edge, a software-defined modern network, safety in depth, and a philosophy of customer empowerment. Our programmable edge provides developers with real-time visibility and control, where they can write and deploy code to push application logic to the edge. It supports modern application delivery processes, freeing developers to innovate without constraints. Our software-defined modern network is built for the software-defined future. It is powerful, efficient, and flexible, designed to enable us to rapidly scale to meet the needs of the most demanding customers and never be a barrier to their growth. Our 74 terabit software-centric network is located in 68 uniquely designed Points-of-Presence ("POPs") across 53 markets, as of December 31, 2019. Our safety in depth approach integrates security into multiple layers of development: architecture, engineering, and operations. That's why we invest in building security into the fabric of our platform, alongside performance. We believe our platform provides developers and security operations teams with a fast, safe environment to create, build, and run modern applications. Finally, being developers ourselves, we empower customers to build great things while supporting their efforts through frictionless tools and a deeply technical support team that facilitates ongoing collaboration. We serve both established enterprises and technology-savvy organizations. Our customers represent a diverse set of organizations across many industries with one thing in common: they are competing by using the power of software to build differentiation at the edge. With our edge cloud platform, our customers are disrupting existing industries and creating new ones. For example, several of our customers have reinvented digital publishing by connecting readers through subscription models to indispensable content, helping people understand the world through deeply reported independent journalism. Our customers’ software applications use our edge cloud platform to ensure concert goers can buy tickets to the live events they love, travelers can book flights seamlessly and embark on their next great adventure, and sports fans can stream events in real time, across all devices. The range of applications that developers build with our edge cloud platform continues to surpass our expectations. We generate substantially all of our revenue from charging our customers based on their usage of our platform. Initially, customers typically choose to become platform customers, for which we charge fees based on their committed or actual use of our platform, as measured in gigabytes and requests. Many of our customers generate billings in excess of their minimum commitment. We also generate revenue from additional products as well as professional and other services, such as implementation. We charge a flat one-time or recurring fee for these additional products and services. Potential customers have the opportunity to test our platform for free. If they choose to make use of our platform for live production delivery, they have the ability to sign up online by providing their credit card information and agreeing to a minimum monthly fee of $50. We focus our direct selling efforts on medium to large organizations as well as smaller companies that are exhibiting significant growth. We engage with and support these customers with our field sales representatives, account managers, and technical account managers who focus on customer satisfaction and drive expansion of their usage of our platform and products. These teams work with technical and business leaders to help our customers’ end-users receive the best possible digital experience, while also lowering our customers’ total cost of ownership. We have established and continue to maintain our position by improving upon our programmable edge platform and software-defined modern network architecture. We continue to focus on empowering our developer community through events and conferences, including our Altitude conferences. The success of these direct selling efforts is reflected by our 288 enterprise customers as of December 31, 2019 that generated 87% of our total revenue for the trailing 12 months ended December 31, 2019. As our customers become more successful and grow, they typically increase their usage of our platform and adopt additional Fastly products. A meaningful indicator of the increased activity from our existing customer accounts and overall customer satisfaction is our Dollar-Based Net Expansion Rate ("DBNER"), which was 135.5%, 132.0%, and 147.3% for the trailing 12 months ended December 31, 2019, 2018, and 2017 respectively. We believe that an annual cohort analysis of our customers, as depicted in the chart below, demonstrates our success in customer expansion. Once a customer begins to generate revenue for us, they tend to increase their usage of our platform, in particular in their second year. Customer accounts acquired in 2015, 2016, 2017, 2018, and 2019 are referred to as the Cohort, 2015 Cohort, 2016 Cohort, 2017 Cohort, 2018 Cohort, and 2019 Cohort, respectively. Our 2015 Cohort increased its revenue 2.5 times after its first year and has grown at approximately a 44% CAGR over the last four years. In 2015, we generated $7.8 million of revenue from the 2015 Cohort. Revenue from the 2015 Cohort grew to $20.1 million in 2016, representing a year-over-year growth rate of 157%. In 2016, we generated $6.6 million of revenue from the 2016 Cohort. Revenue from the 2016 Cohort grew to $22.0 million in 2017, representing 233% year-over-year growth. In 2017, we generated $5.6 million of revenue from the 2017 Cohort. Revenue from the 2017 Cohort grew to $16.8 million in 2018, representing 200% year-over-year growth. In 2018, we generated $11.2 million of revenue from the 2018 Cohort. Revenue from the 2018 Cohort grew to $34.4 million in 2019, representing 207% year-over-year growth. Summary of Revenue Generated by Customer Cohorts Over Time (in millions): Customers that have negotiated contracts with us generate a substantial majority of our revenue. These customers typically purchase one or more products, for which we charge a monthly recurring or one-time fee depending on the products selected. Some of these customers also choose to purchase various levels of account management and enhanced customer support for a monthly fee. Typically, the term of these contracts is 12 months and includes a minimum monthly billing commitment in exchange for more favorable pricing terms. Many of these customers generate billings in excess of their minimum commitment. In addition, customers can sign up online by providing their credit card information and agreeing to a minimum monthly fee. The timing of our sales is difficult to predict. The length of our sales cycle, from initial evaluation to payment, can range from several months to well over a year and can vary substantially from customer to customer. Similarly, the onboarding and ramping process with new enterprise customers can take several months. We have achieved significant growth in recent periods. For the years ended December 31, 2019 and 2018, our revenue was $200.5 million and $144.6 million, respectively. Our 10 largest customers generated an aggregate of 29% and 32% of our revenue in the trailing 12 months ended December 31, 2019 and 2018, respectively. We incurred a net loss of $51.6 million and $30.9 million in the years ended December 31, 2019 and 2018, respectively. Factors Affecting Our Performance Winning New Customers We are focused on continuing to attract new customers. Our customer base includes both large, established enterprises that are undergoing digital transformation and emerging companies spanning a wide array of industries and verticals. In both instances, developers within these companies often use and advocate the adoption of our platform by their companies. We also benefit from word-of-mouth promotion across the broader developer community. We will continue to invest in our developer outreach, leveraging it as a cost-efficient approach to attracting new customers. We also plan to dedicate significant resources to sales and marketing programs, including various online marketing activities as well as targeted account-based advertising. This will require us to dedicate significant resources to further develop the market for our platform and differentiate our platform from competitive products and services. We will also need to expand, retain, and motivate our sales and marketing personnel in order to target our sales efforts at larger enterprises and senior management of these potential customers. Expanding within our Existing Customer Base We emphasize retaining our customers and expanding their usage of our platform and adoption of our other products. Customers often begin with smaller deployments of our programmable edge platform and then expand their usage over time. In addition, our programmable edge platform includes a variety of other offerings, such as load balancing, shielding, web security, and WAF. As our customers mature, we assist them in expanding their use of our platform, including the use of additional offerings beyond edge cloud delivery. As enterprises grow and experience increased traffic, their needs evolve, leading them to find additional use cases for our platform and expand their usage accordingly. In addition, given that customer acquisition costs are incurred largely for acquiring and initial onboarding, we gain operating leverage to the extent that existing customers expand their use of our platform and products. Our ability to retain our customers and expand their usage could be impaired for a variety of reasons, including a customer moving to another provider or reducing usage within the term of their contract to their minimum usage commitment. Even if our customers expand their usage of our platform, we cannot guarantee that they will maintain those usage levels for any meaningful period of time or that they will renew their commitments. International Customer Growth We intend to continue expanding our efforts to attract customers outside of the United States by augmenting our sales teams and strategically increasing the number of POPs in select international markets. As of December 31, 2019 and 2018, 49% and 46% of our customers were headquartered outside of the United States, respectively. Our international expansion, including our global sales efforts, will add increased complexity and cost to our business. This will require us to significantly expand our sales and marketing capabilities outside of the United States, as well as increase the number of POPs in select international markets to support our customers. We have limited experience managing the administrative aspects of a global organization, and we have only recently begun to establish and operate offices in foreign countries, which could place a strain on our business and culture. Investing in Sales and Marketing Our customers have been pivotal in driving brand awareness and broadening our reach. While we continue to leverage our self-service approach to drive adoption by developers, we intend to continue to expand our sales and marketing efforts, with an increased focus on sales to enterprises globally. Utilizing our direct sales force, we have multiple selling points within organizations to acquire new customers and increase usage from our existing customers. We intend to increase our discretionary marketing spend, including account based and brand spend, to drive the effectiveness of our sales teams. As a result, we expect our total operating expenses to increase as we continue to expand. Our investments in our sales and marketing teams are intended to help accelerate our sales, onboarding, and ramp cycles. As of December 31, 2019, we had 69 sales representatives and sales managers across our company. These efforts will require us to invest significantly in financial and other resources. Furthermore, we believe that there is significant competition for sales personnel with the skills and technical knowledge that we require. Our ability to achieve significant revenue growth will depend, in large part, on our success in recruiting, training, and retaining sufficient numbers of sales personnel to support our growth. Continued Investment in Our Platform and Network Infrastructure We must continue to invest in our platform and network infrastructure to maintain our position in the market. We expect our revenue growth to be dependent on an expanding customer base and continued adoption of our edge cloud platform. In anticipation of winning new customers and staying ahead of our customers’ needs, we plan to continue to invest in order to expand the scale and capacity of our software-defined modern network, resulting in increased network service provider fees, which could adversely affect our gross margins if we are unable to offset these costs with revenue from new customers and increased revenue from existing customers. Our customers require constant innovation within their own organizations and expect the same from us. Therefore, we will continue to invest in resources to enhance our development capabilities and introduce new products and features on our platform. We believe that investment in research and development will contribute to our long-term growth but may also negatively impact our short-term profitability. For the years ended December 31, 2019 and 2018, our research and development expenses as a percentage of revenue was 23% and 24%, respectively. Developers use our platform to build custom applications and require a state-of-the-art infrastructure to test and run these applications. We will continue to invest in our network infrastructure by strategically increasing our POPs. We also anticipate making investments in upgrading our technology and hardware to continue providing our customers a fast and secure platform. Our total investment in property and equipment for the years ended December 31, 2019 and 2018 were $30.3 million and $18.7 million, respectively, representing 15% and 13% of our revenue in such periods. We expect our investment in property and equipment to increase on an absolute basis and may increase as a percentage of revenue in future periods. Our gross margins and operating results are impacted by these investments. As of December 31, 2019, we had 68 POPs in 53 markets across 26 countries. In the event that there are errors in software, failures of hardware, damages to a facility or misconfigurations of any of our services-whether caused by our products, third-party error, our own error, natural disasters, or security breaches-we could experience lengthy interruptions in our platform as well as delays and additional expenses in arranging new facilities and services. In addition, there can be no assurance that we are adequately prepared for unexpected increases in bandwidth demands by our customers, particularly when customers experience cyber-attacks. The bandwidth we have contracted to purchase may become unavailable for a variety of reasons, including service outages, payment disputes, network providers going out of business, natural disasters, networks imposing traffic limits, or governments adopting regulations that impact network operations. Uncertainty of the Coronavirus (COVID-19) Outbreak The extent that the coronavirus (COVID-19) outbreak will spread widely and its impact on our results will depend on future developments, which are highly uncertain and unpredictable. Although uncertain at this time, the outbreak could impede our ability to sell, grow and attract new domestic and international customers. Our employees travel frequently to establish and maintain relationships with our customers. Although we continue to monitor the situation and may adjust our current policies as more information and guidance become available, suspending travel and doing business in-person could negatively impact our marketing efforts and also challenge our ability to enter into customer contracts in a timely manner, which in turn could harm our business performance. Our business is dependent upon the timely supply of certain parts and components manufactured in China to construct our servers. To the extent that our suppliers are impacted by the coronavirus (COVID-19) outbreak, it likely will reduce the availability, or result in delays, of parts and components to us, which in turn could interrupt our ability to timely complete the construction of our servers to meet the intended usage and needs of our customers. For additional details, refer to our risk factors included in Part I. Item 1A. of this Annual Report on Form 10-K. Key Business Metrics We regularly review a number of metrics, including the key metrics presented in the table below, to evaluate our business, measure our performance, identify trends affecting our business, prepare financial projections, and make strategic decisions. The calculation of the key metrics and other measures discussed below may differ from other similarly titled metrics used by other companies, securities analysts, or investors. Number of Customers We believe that the number of customers is an important indicator of the adoption of our platform. Our definition of a customer consists of identifiable operating entities with which we have a billing relationship in good standing, from which we recognized revenue during the period, and are active as of the end of the period. In addition to our paying customers, we also have trial, developer, nonprofit and open source program, and other non-paying accounts that are excluded from our customer count metric. As of December 31, 2019 and 2018, we had 1,743 and 1,582 customers, respectively. Number of Enterprise Customers Historically our revenue has been driven primarily by a subset of customers who have leveraged our platform substantially from a usage standpoint. These enterprise customers are defined as customers with revenue in excess of $100,000 over the previous 12-month period. As of December 31, 2019, we had 288 enterprise customers which generated 87% of our revenue for the trailing 12 months ended December 31, 2019. As of December 31, 2018, we had 227 enterprise customers which generated 84% of our revenue for the trailing 12 months ended December 31, 2018. We believe the recruitment and cultivation of enterprise customers is critical to our long-term success. Dollar-Based Net Expansion Rate ("DBNER") Our ability to generate and increase our revenue is dependent upon our ability to increase the number of new customers and usage of our platform and increase the purchase of additional products by our existing customers. We track our performance in this area by measuring our DBNER. Our DBNER increases when customers increase their usage of our platform or purchase additional products, and declines when they reduce their usage, benefit from lower pricing on their existing usage, or curtail their purchases of additional products. We believe DBNER is a key metric in measuring the long-term value of our customer relationships and our ability to grow our revenue through increased usage of our platform and purchase of additional products by our existing customers. However, our calculation of DBNER indicates only expansion among continuing customers and does not indicate any decrease in revenue attributable to former customers, which may differ from similar metrics of other companies. We calculate DBNER by dividing the revenue for a given period from customers who remained customers as of the last day of the given period ("current period") by the revenue from the same customers for the same period measured one year prior ("base period"). The revenue included in the current period excludes revenue from (i) customers that churned after the end of the base period and (ii) new customers that entered into a customer agreement after the end of the base period. For example, to calculate our DBNER for the trailing 12 months ended December 31, 2019, we divide (i) revenue for the trailing 12 months ended December 31, 2019, from customers that entered into a customer agreement prior to January 1, 2019, and that remained customers as of December 31, 2019, by (ii) revenue for the trailing 12 months ended December 31, 2018 from the same set of customers. For the trailing 12 months ended December 31, 2019 and 2018 our DBNER was 135.5% and 132.0%, respectively. We believe that an annual cohort analysis of our customers demonstrates our success in customer expansion. Once a customer begins to generate revenue for us, they tend to increase their usage of our platform, in particular in their second year. Customer accounts acquired in 2017, 2018, and 2019 are referred to as the 2017 Cohort, 2018 Cohort, and 2019 Cohort, respectively. As described above, our customers tend to increase their usage of our platform in their second year, which is typically followed by more modest increases in usage, if any, in ensuing years. For example, the DBNER for the 2017 Cohort was 305.5% for the year ended December 31, 2018. However, the DBNER for the 2017 Cohort was 144.3% for the year ended December 31, 2019, which generally represents their third year as a customer, depending on when they entered into a customer agreement. While DBNER may fluctuate from quarter to quarter based on, among other things, the timing associated with new customer accounts, we expect our DBNER to decrease as customers that have used our platform for more than two years become a larger portion of both our overall customer base and the revenue that we use to calculate DBNER. We separately monitor customer retention and churn on an annual basis by measuring our annual revenue retention rate, which we calculate by multiplying the final full month of revenue from a customer that terminated its contract with us (a "Churned Customer") by the number of months remaining in the same calendar year ("Annual Revenue Churn"). The quotient of the Annual Revenue Churn from all of our Churned Customers divided by our annual revenue of the same calendar year is then subtracted from 100% to determine our annual revenue retention rate. We believe this calculation is helpful in that it is based on the amount of revenue that we would expect to have received in the remaining portion of a particular period had a customer not terminated its contract with us. It is not indicative of the actual revenue contribution from churned customers in past periods. By comparing this amount to actual revenue for the period, we are able to assess our ability to replace terminated revenue by generating revenue from new and continuing customers. Our annual revenue retention rate for the years ended December 31, 2019 and 2018 was 99.3% and 98.9%, respectively. Key Components of Statement of Operations Revenue We derive our revenue primarily from usage-based fees earned from customers using our platform. We also earn flat fees from certain products and services. Customers are generally invoiced in arrears on a monthly basis. Many customers have tiered usage pricing which reflects discounted rates as usage increases. For most contracts, usage charges are determined on a monthly basis based on actual usage within the month and do not impact usage charges within any other month. Our larger customers often enter into contracts that contain minimum billing commitments and reflect discounted pricing associated with such usage levels. We define U.S. revenue as revenue from customers that have a billing address in the United States, and we define international revenue as revenue from customers that have a billing address outside of the United States. Our revenue has been and will continue to be impacted by new and existing customers’ usage of our products, international expansion, and the success of our sales efforts. Cost of Revenue and Gross Margin Cost of revenue consists primarily of fees paid for bandwidth, peering, and colocation. Cost of revenue also includes personnel costs, such as salaries, benefits, bonuses, and stock-based compensation for our customer support and infrastructure employees, and non-personnel costs, such as amortization of capitalized internal-use software development costs and depreciation of our network equipment. Our arrangements with network service providers require us to pay fees based on bandwidth use, in some cases subject to minimum commitments, which may be underutilized. We expect our cost of revenue to continue to increase on an absolute basis and may increase as a percentage of revenue, including as a result of depreciation and amortization associated with capital expenditures in future periods. Our gross margin has been and will continue to be affected by a number of factors, including the timing and extent of our investments in our operations, our ability to manage our network service providers and cloud infrastructure-related fees, the timing of amortization of capitalized software development costs, depreciation of our network equipment, and the extent to which we periodically choose to pass on our cost savings from network optimization efforts to our customers in the form of lower usage rates. Research and Development Research and development expenses consist primarily of personnel costs, including salaries, benefits, bonuses, and stock-based compensation. Research and development expenses also include cloud infrastructure fees for development and testing, amortization of capitalized internal-use software development costs, and an allocation of our general overhead expenses. We capitalize the portion of our software development costs that meet the criteria for capitalization. We continue to focus our research and development efforts on adding new features and products including new use cases, improving the efficiency and performance of our network, and increasing the functionality of our existing products. We expect our research and development expenses to continue to increase on an absolute basis and may increase as a percentage of revenue in future periods. Sales and Marketing Sales and marketing expenses consist primarily of personnel costs, including commissions for our sales employees, salaries, benefits, bonuses, and stock-based compensation. Sales and marketing expenses also include expenditures related to advertising, marketing, our brand awareness activities, costs related to our Altitude conferences, professional services fees, and an allocation of our general overhead expenses. We focus our sales and marketing efforts on generating awareness of our company, platform and products, creating sales leads, and establishing and promoting our brand, both domestically and internationally. We plan to increase our investment in sales and marketing by hiring additional sales and marketing personnel, expanding our sales channels, driving our go-to-market strategies, building our brand awareness, and sponsoring additional marketing events. We expect our sales and marketing expenses to continue to increase on an absolute basis and may increase as a percentage of revenue in future periods. General and Administrative General and administrative expenses consist primarily of personnel costs, including salaries, benefits, bonuses, and stock-based compensation for our accounting, finance, legal, human resources and administrative support personnel, and executives. General and administrative expenses also include costs related to legal and other professional services fees, sales and other taxes, depreciation and amortization, an allocation of our general overhead expenses, and bad debt expense. We expect that we will incur costs associated with supporting the growth of our business, our operation as a public company, and to meet the increased compliance requirements associated with our international expansion. Our general and administrative expenses include a significant amount of sales and other taxes to which we are subject based on the manner we sell and deliver our products. Historically, we have not collected such taxes from our customers and have therefore recorded such taxes as general and administrative expenses. We expect that these expenses will decline in future years as we continue to implement our sales tax collection mechanisms and start collecting these taxes from our customers. We expect our general and administrative expenses to continue to increase on an absolute basis and may increase as a percentage of revenue in future periods. Income Taxes Our income tax expense consists primarily of income taxes in certain foreign jurisdictions where we conduct business and state minimum income taxes in the United States. We have a valuation allowance for deferred tax assets, including net operating loss carryforwards. We expect to maintain this valuation allowance for the foreseeable future. Results of Operations The following tables set forth our results of operations for the period presented and as a percentage of our revenue for that period. __________ (1) Includes stock-based compensation expense as follows: __________ * Columns may not add up to 100% due to rounding. Revenue 2019 compared to 2018 Revenue was $200.5 million for the year ended December 31, 2019 compared to $144.6 million for the year ended December 31, 2018, an increase of $55.9 million, or 39%. We had 1,743 customers and 288 enterprise customers as of December 31, 2019. We had 1,582 customers and 227 enterprise customers as of December 31, 2018. This represents an increase of 161, or 10%, in customers and 61, or 27%, in enterprise customers from December 31, 2018. Approximately 93% of our revenue in the year ended December 31, 2019 was driven by usage on our platform. The remainder of our revenue was generated by our other products and services, including support and professional services. U.S. revenue was $142.8 million and 71% of revenue for the year ended December 31, 2019, and $110.8 million and 77% of revenue for the year ended December 31, 2018. This represents an increase of $32.0 million, or 29%. International revenue was $57.6 million and 29% of revenue for the year ended December 31, 2019, and $33.7 million and 23% of revenue for the year ended December 31, 2018. This represents an increase of $23.9 million, or 71%. We had 891 domestic customers and 852 international customers as of December 31, 2019. We had 861 domestic customers and 721 international customers as of December 31, 2018. This is an increase in domestic customers of 30, or 3%, and an increase in international customers of 131, or 18%, compared to December 31, 2018. 2018 compared to 2017 Revenue was $144.6 million for the year ended December 31, 2018 compared to $104.9 million for the year ended December 31, 2017, an increase of $39.7 million, or 38%. We had 1,582 customers and 227 enterprise customers as of December 31, 2018. We had 1,439 customers and 170 enterprise customers as of December 31, 2017. This was an increase of 143, or 10%, in customers and 57, or 34%, in enterprise customers from December 31, 2017. Approximately 95% of our revenue in 2018 was driven by usage on our platform. The remainder of our revenue was generated by our other products and services, including support and professional services. U.S. revenue was $110.9 million and 77% of revenue for the year ended December 31, 2018. U.S. revenue was $82.7 million and 79% of revenue for the year ended December 31, 2017. This was an increase of $28.2 million, or 34%, from U.S. revenue for the year ended December 31, 2017. International revenue was $33.7 million and 23% of revenue for the year ended December 31, 2018. International revenue was $22.2 million and 21% of revenue for the year ended December 31, 2017. This was an increase of $11.5 million, or 52%, from international revenue for the year ended December 31, 2017. We had 830 domestic customers and 609 international customers in 2017. We had 861 domestic customers and 721 international customers in 2018. This was an increase in domestic customers of 31, or 4%, from 2017 and an increase in international customers of 112, or 18%, from 2017. Cost of Revenue For the years ended December 31, 2019, 2018, and 2017, our cost of revenue consisted of bandwidth, peering, and colocation fees, as well as personnel costs including salaries, benefits, bonuses, and stock-based compensation for employees who support the build out and operation of the network. Our cost of revenue also includes depreciation expense for network equipment, amortization of capitalized internal-use software, and other network costs. 2019 compared to 2018 Cost of revenue was $88.3 million for the year ended December 31, 2019 compared to $65.5 million for the year ended December 31, 2018, an increase of $22.8 million, or 35%. The increase in cost of revenue was primarily due to an increase in bandwidth costs of $6.2 million, an increase in colocation costs of $3.9 million, and an increase in other network costs of $2.5 million due to increased traffic on our platform. Personnel costs increased by $5.5 million due to an increase in headcount. Depreciation and amortization expense increased by $2.9 million due to increased investments in our platform. Travel costs increased by $0.7 million due to travel associated with the deployment of new POPs. Software licenses increased by $0.5 million. 2018 compared to 2017 Cost of revenue was $65.5 million for the year ended December 31, 2018 compared to $48.7 million for the year ended December 31, 2017, an increase of $16.8 million, or 35%. The increase in cost of revenue was due to an increase in bandwidth costs of $3.5 million, an increase of colocation costs of $2.3 million, and an increase in other network costs of $2.3 million due to increased traffic on our platform. Depreciation and amortization expense increased by $3.2 million due to increased investments in our platform. Personnel costs increased by $2.7 million due to an increase in headcount. Gross Profit and Gross Margin 2019 compared to 2018 Gross profit was $112.1 million for the year ended December 31, 2019 compared to $79.1 million for the year ended December 31, 2018, an increase of $33.1 million, or 42%. The increase in gross profit in the year ended December 31, 2019 compared to 2018 is due to the increase in revenue from usage of our platform. Gross margin was 56% for the year ended December 31, 2019 compared to 55% for the year ended December 31, 2018, an increase of 1%. The increase is due to better utilization of our platform. 2018 compared to 2017 Gross profit was $79.1 million for the year ended December 31, 2018 compared to $56.2 million for the year ended December 31, 2017, an increase of $22.8 million, or 41%. The increase in gross profit is due to an increase in revenue from usage of our platform. Gross margin was 55% for the year ended December 31, 2018 compared to 54% for the year ended December 31, 2017, an increase of 1%. The increase is due to better utilization of our platform. Operating Expenses Research and development-2019 compared to 2018 Research and development expenses were $46.5 million for the year ended December 31, 2019 compared to $34.6 million for the year ended December 31, 2018, an increase of $11.9 million, or 34%. This is primarily due to an increase of $8.1 million of personnel related costs, such as salaries, benefits, bonuses, and stock-based compensation due to an increase in headcount and an increase in stock-based compensation expense related to the increase in the fair value of our stock options, the issuance of restricted stock units ("RSUs"), and expense associated with the Employee Stock Purchase Plan ("ESPP"). Software licenses increased by $1.6 million. Travel costs increased by $1.2 million. Facilities and information system costs increased by $0.9 million. These increases were offset by an increase in the capitalization for internal-use software of $1.2 million. Research and development-2018 compared to 2017 Research and development expenses were $34.6 million for the year ended December 31, 2018 compared to $29.0 million for the year ended December 31, 2017, an increase of $5.6 million, or 19%. This growth in expenses is due to an increase of $6.2 million of personnel related costs, such as salaries, benefits, bonuses, and stock-based compensation. This was offset by an increase in capitalized internal-use software of $1.9 million. Sales and marketing-2019 compared to 2018 Sales and marketing expenses were $71.1 million for the year ended December 31, 2019 compared to $50.1 million for the year ended December 31, 2018, an increase of $21.0 million, or 42%. This is primarily due to a $13.2 million increase in personnel related costs, such as salaries, sales commissions, benefits, and stock-based compensation, due to an increase in headcount, and an increase in stock-based compensation expense related to the increase in the fair value of our stock options, the issuance of RSUs, and expense associated with the ESPP. Facilities and information costs increased by $2.4 million. Marketing costs increased by $1.6 million. Professional services increased by $1.5 million. Travel costs increased by $1.3 million. Software licenses increased by $0.8 million. Sales and marketing-2018 compared to 2017 Sales and marketing expenses were $50.1 million for the year ended December 31, 2018 compared to $40.8 million for the year ended December 31, 2017, an increase of $9.3 million, or 23%. This is primarily due to an increase of $5.1 million in personnel related costs, such as salaries, sales commissions, benefits and stock-based compensation, due to an increase in headcount. Facilities and information system costs increased by $1.5 million. Travel costs increased by $1.1 million. External marketing costs for marketing events, including our Altitude conferences, sponsorships, and advertising increased by $0.8 million. General and administrative-2019 compared to 2018 General and administrative costs were $41.1 million for the year ended December 31, 2019 compared to $23.5 million for the year ended December 31, 2018, an increase of $17.6 million, or 75%. This is primarily due to an increase of $8.5 million of personnel related costs, such as salaries, benefits, and stock-based compensation, due to an increase in headcount, and an increase in stock-based compensation expense related to the increase in the fair value of our stock options, the issuance of RSUs, and expense associated with the ESPP. The increase is also due to an increase of $2.6 million in external professional services such as legal, accounting, and enterprise systems, an increase of $2.1 million business insurance costs associated with becoming a public company, an increase of $1.9 million in transaction taxes primarily due to the release of a reserve in the prior period, and an increase of $1.2 million costs for software licenses, and an increase of $1.1 million in travel costs. General and administrative-2018 compared to 2017 General and administrative costs were $23.5 million for the year ended December 31, 2018 compared to $17.5 million for the year ended December 31, 2017, an increase of $6.0 million, or 34%. This increase is due to an increase of $6.2 million of personnel related costs, such as salaries, benefits, and stock-based compensation due to an increase in headcount, and an increase of $1.0 million in external professional services such as legal, accounting, and enterprise systems. Transaction taxes decreased by $1.3 million primarily due to the release of a reserve of $1.9 million that was no longer required. Other Income and Expense Interest Income 2019 compared to 2018 Interest income was $3.3 million for the year ended December 31, 2019 compared to $0.9 million for the year ended December 31, 2018, an increase of $2.3 million, or 250%. This increase is due to interest on proceeds raised from our IPO. 2018 compared to 2017 Interest income was $0.9 million for the year ended December 31, 2018 compared to $0.4 million for the year ended December 31, 2017, an increase of $0.5 million, or 112%. This increase is due to interest on cash raised from our Series F convertible Preferred Stock financing in 2018. Interest Expense 2019 compared to 2018 Interest expense was $5.2 million for the year ended December 31, 2019 compared to $1.8 million for the year ended December 31, 2018, an increase of $3.4 million, or 189%. This increase is primarily due to the acceleration of the amortization of debt issuance costs due to the early payment of the $20.0 million outstanding loan on our Credit Facility as well as an increase in average outstanding debt. 2018 compared to 2017 Interest expense was $1.8 million for the year ended December 31, 2018 compared to $1.1 million for the year ended December 31, 2017, an increase of $0.7 million, or 62%. This increase is due to additional borrowings during 2018. Other income (expense), net 2019 compared to 2018 Other expense, net was $2.6 million for the year ended December 31, 2019 compared to $0.7 million for the year ended December 31, 2018, an increase in other expense, net of $1.8 million, or 246%. This increase is primarily due to mark-to-market adjustments for warrant liabilities prior to the conversion to additional paid in capital upon the IPO. 2018 compared to 2017 Other expense, net was $0.7 million for the year ended December 31, 2018 compared to $0.5 million for the year ended December 31, 2017, an increase of $0.2 million, or 37%. This increase is primarily due to mark-to-market adjustments for warrant liabilities. Quarterly Results of Operations The following table sets forth our unaudited quarterly statements of operations data for each of the quarters indicated. The unaudited quarterly statements of operations data set forth below have been prepared on the same basis as our audited consolidated financial statements and, in the opinion of management, reflect all adjustments, consisting only of normal recurring adjustments, that are necessary for the fair statement of such data. Our historical results are not necessarily indicative of the results that may be expected in the future, and the results for any quarter are not necessarily indicative of results to be expected for a full year or any other period. The following quarterly financial data should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K. __________ (1) Includes stock-based compensation expense as follows: __________ (1) See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Key Business Metrics” for our definitions of these metrics. Quarterly Revenue Trends Our quarterly revenue increased in each period presented, primarily due to an increase in the usage of our platform by our existing customers and the addition of new customers. Quarterly Cost of Revenue Trends Our cost of revenue increased sequentially in each of the quarters presented, primarily driven by expanded use of our platform by existing and new customers, which resulted in increased network costs. We expect our cost of revenue to continue to increase on an absolute basis in future quarters and may periodically increase as a percentage of revenue based on the timing of investments made in our network. Quarterly Gross Margin Trends Our gross margin can fluctuate quarter to quarter due to the timing of investments made in our network. Quarterly Operating Expense Trends Our operating expenses generally have increased in almost every fiscal quarter primarily due to increases in headcount and other related expenses to support our growth. Our research and development costs increased sequentially in each of the quarters presented, primarily driven by increased hiring and investment in our growth as a company. Our sales and marketing costs can fluctuate based on the timing of our external conferences, such as Altitude. Our general and administrative expenses for the quarter ended June 30, 2018 reflect the release of $1.9 million of reserves related to a transaction tax matter that was favorably resolved. We expect our operating expenses to continue to increase on an absolute basis in future quarters. Liquidity and Capital Resources As of December 31, 2019, we had cash, cash equivalents, and marketable securities totaling $131.1 million, and restricted cash totaling $70.1 million. Our cash, cash equivalents, and marketable securities primarily consisted of bank deposits and money market funds held at major financial institutions and investment-grade commercial paper and corporate debt securities. On May 21, 2019, upon the completion of our IPO, we received net proceeds of $192.5 million, after deducting underwriting discounts and commissions, from sales of 12,937,500 shares of our Class A common stock in the IPO. The net proceeds include additional proceeds of $25.1 million, net of underwriters' discounts and commissions, from the exercise of the underwriters' option to purchase an additional 1,687,500 shares of our Class A common stock. To date, we have financed our operations primarily through equity issuances, payments received from customers, the net proceeds we received through sales of equity securities, and borrowings under our credit facilities. Our principal uses of cash in recent periods have been funding our operations and capital expenditures. We believe that our cash and cash equivalents balances, our credit facilities, and the cash flows generated by our operations will be sufficient to satisfy our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. Credit Facility On November 4, 2019, we entered into a Revolving Credit Agreement for an aggregate commitment amount of $70.0 million with a maturity date of November 3, 2022. The amount of borrowings available under the Revolving Credit Agreement at any time are collateralized by our cash. As of December 31, 2019, $20.3 million had been drawn on the Revolving Credit Agreement. The interest rate associated with each advance under the Revolving Credit Agreement is equal to the sum of LIBOR for the applicable interest period plus 1.50%, which is a per annum rate based on outstanding borrowings. The commitment fee is 0.20% per annum based on the average daily unused amount of the commitment amount. Interest payments on outstanding borrowings are due on the last day of each interest period and payments for the commitment fee are due at the end of each calendar quarter. Cash Flows The following table summarizes our cash flows for the period indicated: Cash Flows from Operating Activities For the year ended December 31, 2019, cash used in operating activities consisted primarily of our net loss of $51.6 million adjusted for non-cash items, including $16.6 million of depreciation and amortization, $12.1 million of stock-based compensation expense, $0.7 million of amortization of deferred rent, an increase in the fair value of our common stock warrants of $2.4 million, and amortization of debt issuance costs of $1.9 million. With respect to changes in operating assets and liabilities, there was an increase in accounts receivable of $12.8 million, primarily due to the growth of our business and the timing of cash receipts from certain of our larger customers, an increase in other long-term assets of $2.2 million due to the adoption of Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers, and an increase of $2.1 million in prepaid expenses and other assets due to pre-payments for SaaS licenses. This was partially offset by an increase of $5.5 million in accounts payable, accrued expenses, and other liabilities due to timing of payments. For the year ended December 31, 2018, cash used in operating activities consisted primarily of our net loss of $30.9 million adjusted for non-cash items, including $13.4 million of depreciation and amortization, $4.1 million of stock-based compensation expense, and an increase in our bad debt expense of $0.6 million. With respect to changes in operating assets and liabilities, accounts payable, accrued expenses, and other liabilities increased by $4.7 million. This was partially offset by an increase in accounts receivable of $6.2 million and prepaid expenses and other assets of $2.3 million, primarily due to the growth of our business and the timing of cash receipts from certain of our larger customers, pre-payments for insurance, rent, and software licenses, as well as an increase in VAT receivable. For the year ended December 31, 2017, cash used in operating activities consisted primarily of our net loss of $32.5 million adjusted for non-cash items, including $2.8 million of stock-based compensation expense, $9.6 million of depreciation and amortization, and an increase in our bad debt expense of $1.0 million. With respect to changes in operating assets and liabilities, accounts payable, accrued expenses, and other liabilities increased $2.2 million. This was partially offset by an increase in accounts receivable and prepaid expenses of $9.6 million, which primarily resulted from the growth of our business and the timing of cash receipts from certain of our larger customers, pre-payments for travel, benefits, and commissions as well as an increase in short-term deposits and VAT receivables. Cash Flows from Investing Activities For the year ended December 31, 2019, cash used in investing activities was $87.7 million, primarily consisting of $191.0 million in purchases of marketable securities, $14.6 million of payments related to purchases of property and equipment to expand our network, and $4.9 million of additions to capitalized internal-use software. This was offset by $123.4 million of maturities and sales of marketable securities. For the year ended December 31, 2018, cash used in investing activities was $47.1 million, primarily consisting of $62.7 million in purchases of marketable securities and $16.7 million of payments related to purchases of property and equipment to expand our network, offset by $35.2 million of maturities of marketable securities. For the year ended December 31, 2017, cash used in investing activities was $15.8 million, primarily consisting of $46.1 million in purchases of marketable securities and $13.2 million of payments related to purchases of property and equipment to expand our network, offset by $43.5 million of maturities of marketable securities. Cash Flows from Financing Activities For the year ended December 31, 2019, cash provided by financing activities was $168.1 million, primarily consisting of $192.5 million in proceeds from our IPO, net of underwriting fees, $5.4 million in proceeds from the ESPP, $6.1 million in proceeds from stock option exercises by our employees and directors. This was partially offset by $30.5 million of net debt repayments and $5.5 million of payments of costs related to our IPO. For the year ended December 31, 2018, cash provided by financing activities was $69.6 million, primarily consisting of $39.9 million of proceeds from our sales of Series F convertible preferred stock, net of issuance expenses, $27.1 million of net borrowings, and $2.6 million in proceeds from stock option exercises by our employees and directors. For the year ended December 31, 2017, cash provided by financing activities was $55.4 million, primarily consisting of $49.8 million in proceeds from our sale of Series E convertible preferred stock, net of issuance expenses, $4.9 million of net borrowings, and $0.6 million in proceeds from stock option exercises by our employees. Contractual Obligations and Other Commitments The following table summarizes our non-cancelable contractual obligations as of December 31, 2019: __________ (1) Operating lease represent total future minimum rent payments under non-cancelable operating lease agreements, net of sublease income of $1.2 million. (2) Purchase obligations represent total future minimum payments under contracts with our cloud infrastructure provider, network service providers, and other vendors. Purchase obligations exclude agreements that are cancelable without penalty. (3) Debt represents principal and interest payments under our loan and security agreements. 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 We prepare our consolidated financial statements in accordance with U.S. GAAP. The preparation of our consolidated financial statements requires us to make estimates, judgments, and assumptions that affect the reported amounts of assets, liabilities, revenue, costs, expenses, and related disclosures. Actual results and outcomes could differ significantly from our estimates, judgments, and assumptions. To the extent that there are material differences between these estimates and actual results, our future financial statement presentation, financial condition, results of operations, and cash flows will be affected. 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 enter into contracts that can include various combinations of products and services, each of which are distinct and accounted for as separate performance obligations. Revenue is recognized net of any taxes collected from customers, which are subsequently remitted to governmental authorities. We primarily derive revenue from the sale of services to customers executing contracts in which the standard contract term is one year, although terms may vary by contract. Most of our contracts are non-cancelable over the contractual term. These contracts can commit the customer to a minimum monthly level of usage and specify the rate at which the customer must pay for actual usage above the monthly minimum. A performance obligation is a promise in a contract to transfer a distinct good or service to the customer and is the unit of account in Topic 606. Our contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment. For contracts with multiple performance obligations, we allocate the contract transaction price to each performance obligation using our estimate of the standalone selling price ("SSP") of each distinct good or service in the contract. Judgment is required to determine the SSP for each distinct performance obligation. We analyze separate sales of our products and services as a basis for estimating the SSP of our products and services. We then use that SSP as the basis for allocating the transaction price when our product and services are sold together in a contract with multiple performance obligations. In instances where SSP is not directly observable, such as when we do not sell the product or service separately, we determine the SSP using information that may include market conditions and other observable inputs. We typically have more than one SSP for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, we may use information, such geographic region and distribution channel, in determining the SSP. The transaction price in a contract is typically equal to the minimum commit price in the contract less any discounts provided. Because our typical contracts represent distinct services delivered over time with the same pattern of transfer to the customer, usage-based consideration primarily related to actual consumption over the minimum commit levels is allocated to the period to which it relates. The amount of consideration recognized for usage above the minimum commit price is limited to the amount we expect to be entitled to receive in exchange for providing services. We have elected to apply the practical expedient for estimating and disclosing the variable consideration when variable consideration is allocated entirely to a wholly unsatisfied performance obligation or to a wholly unsatisfied promise to transfer a distinct good or service that forms part of a single performance obligation from our remaining performance obligations under these contracts. Performance obligations represent stand-ready obligations that are satisfied over time as the customer simultaneously receives and consumes the benefits provided by us. These obligations can be content delivery, security, professional services, support, edge cloud platform services, and others. Accordingly, our revenue is recognized over time, consistent with the pattern of benefit provided to the customer over the term of the agreement. At times, customers may request changes that either amend, replace, or cancel existing contracts. Judgment is required to determine whether the specific facts and circumstances within the contracts should be accounted for as a separate contract or as a modification. In contracts where there are timing differences between when we transfer a promised good or service to the customer and when the customer pays for that good or service, we have determined our contracts do not include a significant financing component. We have also elected the practical expedient to not measure financing components for any contract where the timing difference is less than one year. From time to time we enter into arrangements to establish and run private POPs for customers. These arrangements include content delivery services as well as professional services and the provision of hardware. For accounting purposes, we have determined that the provisioning of hardware is an operating lease. We recognize the revenue from these leases monthly on a straight-line basis over the term of the relevant customer agreements. On January 1, 2019, we adopted Accounting Standards Update 2014-09, Revenue from Contracts with Customers (ASU 2014-09 or Topic 606) using the modified retrospective method applied to those contracts which were not completed as of January 1, 2019. Results for reporting periods beginning after January 1, 2019 are presented under Topic 606, while prior period amounts are not adjusted, and continue to be reported in accordance with our historical accounting under Topic 605. We recorded a net increase in stockholders’ equity (retained earnings) of $5.7 million as of January 1, 2019 due to the cumulative impact of adopting Topic 606 and Topic 340, Other Assets and Deferred Costs. The area most significantly impacted was related to the treatment of incremental costs of obtaining contracts with customers. Using Topic 606, we determine revenue recognition through the following steps: • Identification of the contract, or contracts, with a customer; • Identification of the performance obligations in the contract; • Determination of the transaction price; • Allocation of the transaction price to the performance obligations in the contract; and • Recognition of revenue when, or as, we satisfy a performance obligation. Stock-Based Compensation-Restricted Stock Units ("RSUs") and Stock Options We account for stock-based compensation in accordance with the authoritative guidance on stock compensation. Under the fair value recognition provisions of this guidance, stock-based compensation is measured at the grant date based on the fair value of the award and is recognized as expense in the statement of operations over the requisite service period, which is generally the vesting period of the respective award. We account for forfeitures as they occur. Determining the fair value of stock-based awards at the grant date requires judgment. We estimate the fair value of RSUs at our stock price on the grant date. We use the Black-Scholes option-pricing model to determine the fair value of stock options and purchase rights under our Employee Stock Purchase Plan ("ESPP") granted to our employees and directors. The determination of the grant date fair value of options using an option-pricing model is affected by our estimated common stock fair value as well as assumptions regarding a number of other complex and subjective variables. These variables include the fair value of our common stock, the expected term of the options, our expected stock price volatility over the expected term of the options, risk-free interest rates for the expected term of the award, and expected dividends. Internal-Use Software Development Costs We capitalize certain costs related to the development of our platform and other software applications for internal use. In accordance with authoritative guidance, we begin to capitalize our costs to develop software when preliminary development efforts are successfully completed, management has authorized and committed project funding, and it is probable that the project will be completed and the software will be used as intended. We stop capitalizing these costs when the software is substantially complete and ready for its intended use, including the completion of all significant testing. These costs are amortized on a straight-line basis over the estimated useful life of the related asset, generally estimated to be three years. We also capitalize costs related to specific enhancements when it is probable the expenditure will result in additional functionality and expense costs incurred for maintenance and minor enhancements. Costs incurred prior to meeting these criteria together with costs incurred for training and maintenance are expensed as incurred and recorded within research and development expenses in our consolidated statement of operations. We exercise judgment in determining the point at which various projects may be capitalized, in assessing the ongoing value of the capitalized costs and in determining the estimated useful lives over which the costs are amortized. To the extent that we change the manner in which we develop and test new features and functionalities related to our platform, assess the ongoing value of capitalized assets, or determine the estimated useful lives over which the costs are amortized, the amount of internal-use software development costs we capitalize and amortize could change in future periods. Legal and Other Contingencies From time to time, we have been and will continue to be subject to legal proceedings and claims. Periodically, we evaluate the status of each legal matter and assess our potential financial exposure. If the potential loss from any legal proceeding or litigation is considered probable and the amount can be reasonably estimated, we accrue a liability for the estimated loss. Significant judgment is required to determine the probability of a loss and whether the amount of the loss is reasonably estimable. The outcome of any proceeding is not determinable in advance. As a result, the assessment of a potential liability and the amount of accruals recorded are based only on the information available to us at the time. As additional information becomes available, we reassess the potential liability related to the legal proceeding or litigation, and may revise our estimates. Any revisions could have a material effect on our results of operations. We conduct operations in many tax jurisdictions throughout the United States. In many of these jurisdictions, non-income-based taxes, such as sales and use and telecommunications taxes are assessed on our operations. We are subject to indirect taxes, and may be subject to certain other taxes, in some of these jurisdictions. Historically, we have not billed or collected these taxes and, in accordance with U.S. GAAP, we have recorded a provision for our tax exposure in these jurisdictions when it is both probable that a liability has been incurred and the amount of the exposure can be reasonably estimated. As a result, we have recorded a liability of $3.9 million as of December 31, 2019. These estimates are based on several key assumptions, including the taxability of our products, the jurisdictions in which we believe we have nexus and the sourcing of revenues to those jurisdictions. In the event these jurisdictions challenge our assumptions and analysis, our actual exposure could differ materially from our current estimates. Recent Accounting Pronouncements Refer to "Note 2--Summary of Significant Accounting Policies" included in the Notes to the Consolidated Financial Statements. JOBS Act Accounting Election We are an emerging growth company, as defined in 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 (1) are no longer an emerging growth company or (2) 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.

<s>[INST] As used herein, "Fastly," "we," "our," "the Company" and similar terms include Fastly, Inc. and its subsidiaries, unless the context indicates otherwise. Overview Developers are reinventing the way we live, work, and play online. Yet they repeatedly encounter innovation barriers when delivering modern digital experiences. Expectations for digital experiences are at an alltime high; they must be fast, secure, and highly personalized. If they aren’t reliable, endusers simply take their business elsewhere. The challenge today is enabling developers to deliver a modern digital experience while simultaneously providing scale, security, and performance. We built our edge cloud platform to solve this problem. The edge cloud is a new category of Infrastructure as a Service ("IaaS") that enables developers to build, secure, and deliver digital experiences, at the edge of the internet. This service represents the convergence of the Content Delivery Network ("CDN") with functionality that has been traditionally delivered by hardwarecentric appliances such as Application Delivery Controllers ("ADC"), Web Application Firewalls ("WAF"), Bot Detection, and Distributed Denial of Service ("DDoS") solutions. It also includes the emergence of a new, but growing, edge computing market which aims to move compute power and logic as close to the enduser as possible. The edge cloud uses the emerging cloud computing, serverless paradigm in which the cloud provider runs the server and dynamically manages the allocation of machine resources. When milliseconds matter, processing at the edge is an ideal way to handle highly dynamic and timesensitive data. The edge cloud complements data center, central cloud, and hybrid solutions. Our mission is to fuel the next modern digital experience by providing developers with a programmable and reliable edge cloud platform that they adopt as their own. Organizations must keep up with complex and everevolving enduser requirements. We help them surpass their endusers’ expectations by powering fast, secure, and scalable digital experiences. We built a powerful edge cloud platform, designed from the ground up to be programmable and support agile software development. We believe our platform gives our customers a significant competitive advantage, whether they were born into the digital age or are just embarking on their digital transformation journey. Our platform consists of four key components: a programmable edge, a softwaredefined modern network, safety in depth, and a philosophy of customer empowerment. Our programmable edge provides developers with realtime visibility and control, where they can write and deploy code to push application logic to the edge. It supports modern application delivery processes, freeing developers to innovate without constraints. Our softwaredefined modern network is built for the softwaredefined future. It is powerful, efficient, and flexible, designed to enable us to rapidly scale to meet the needs of the most demanding customers and never be a barrier to their growth. Our 74 terabit softwarecentric network is located in 68 uniquely designed PointsofPresence ("POPs") across 53 markets, as of December 31, 2019. Our safety in depth approach integrates security into multiple layers of development: architecture, engineering, and operations. That's why we invest in building security into the fabric of our platform, alongside performance. We believe our platform provides developers and security operations teams with a fast, safe environment to create, build, and run modern applications. Finally, being developers ourselves, we empower customers to build great things while supporting their efforts through frictionless tools and a deeply technical support team that facilitates ongoing collaboration. We serve both established enterprises and technologysavvy organizations. Our customers represent a diverse set of organizations across many industries with one thing in common: they are competing by using the power of software to build differentiation at the edge. With our edge cloud platform, our customers are disrupting existing industries and creating new ones. For example, several of our customers have reinvented digital publishing by connecting readers through subscription models to indispensable content, helping people understand the world through deeply reported independent journalism. Our customers’ software applications use our edge cloud platform to ensure concert goers can buy tickets to the live events they love, travelers can book flights seamlessly and embark on their next great adventure, and sports fans can stream events in real time, across all devices. The range of applications that developers build with our edge cloud platform continues to surpass our expectations. We generate substantially all of our revenue from charging our customers based on their usage of our platform. Initially, customers typically choose to become platform customers, for which we charge fees based [/INST] Positive. </s>

Greenlane Holdings, Inc.

2020-04-24

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview We are one of the largest global sellers of premium cannabis accessories and liquid nicotine products in the world. We operate as a powerful house of brands, third party brand accelerator and distribution platform for consumption devices and lifestyle brands serving the global cannabis, hemp-derived CBD, and liquid nicotine markets with an expansive customer base of retail locations, including licensed cannabis dispensaries, and smoke and vape shops. We continue to be well-funded to execute upon our business transformation plans, with $47.8 million in cash as of December 31, 2019, compared to $7.3 million as of December 31, 2018. During the fourth quarter of 2019, we delivered on our strategy to move away from high-volume, low-margin products and sales, in favor of high-margin sales and the promotion of our house brands. Specifically, the JUUL sales percentage was reduced to 15.9% for the fourth quarter 2019, compared to 45.4% for the third quarter 2019, and we improved gross margin on fourth quarter JUUL sales by 4.7%, while sales of JUUL products decreased from $20.2 million for the third quarter 2019 to $5.9 million for the fourth quarter 2019. We also continued to grow and diversify our portfolio of house brands and direct-to-consumer retail operations, including the following highlights: •Increased house brands share of net sales to 11.8% in the fourth quarter of 2019, equaling approximately $4.4 million dollars in net sales; •Completed the construction work on Higher Standards’ third retail location in Malibu, CA during the fourth quarter and announced the opening of the store on January 23, 2020; •Launched a new house brand, the K.Haring Collection, a selection of functional glass art and lifestyle products with the iconic imagery of artist Keith Haring; and •Doubled sales of VIBES over every sequential quarter since launch, with the brand now present at over 1,500 B2B customers and growing. We closed on the acquisition of Pollen Gear in January 2019, a leading supplier of premium child-resistant packaging to the cannabis industry. In September 2019, we also closed on the acquisition of Conscious Wholesale, thereby establishing our European operating segment. Vapor.com, the Company’s e-commerce platform, experienced sustained growth over sequential quarters, both in terms of daily store transactions and average basket size, which were up approximately 30% and 7%, respectively, from the third quarter of 2019. Furthermore, we signed new distribution and exclusive partnership agreements with leading players in the industry, including Omura, Santa Cruz Shredder, Storz & Bickel and Cookies. In December 2019, a novel strain of coronavirus known as COVID-19 was reported in Wuhan, China. In March 2020, the World Health Organization declared the outbreak of COVID-19 a pandemic. In response to the COVID-19 pandemic, many state and local governments throughout the United States began issuing "stay at home" orders directing the closure of non-essential businesses and directing citizens to remain home unless they are conducting essential business or other prescribed activities. Similar orders have proliferated in Canada and Europe. Although we have been able to continue operations, the pandemic is impacting our sales in several ways. Since the implementation of "stay at home" orders, there has been a significant decline in sales to smoke shops, vape shops, and similar independent retailers that comprise a large portion of our customer base. Many of these customers are closed as a result of the "stay at home" orders and it is possible that some of these customers may close permanently as a result of business lost during the pandemic. Since these stay at home orders have gone into effect, average daily revenues attributable to these customers for the period of January 1, 2020 through March 14, 2020 as compared to average daily revenues attributable to these customers for the period of March 15, 2020 through April 22, 2020 declined by approximately 43%, which could be the result of these mandatory store closures. Conversely, we have seen significant growth in sales made through our e-commerce channels and online marketplaces. Since March 15, 2020, merchandise revenue generated from our Vapor.com website has increased more than 100%. While we do attribute a portion of this increase to promotional deals offered through all of our channels related to the April 20, 2020 holiday, our e-commerce site did experience a significant increase in the number of visitors since the stay at home orders went into effect, with the number of customers ordering from Vapor.com increasing, on average. by 24.7% for each subsequent week since March 15, 2020 through April 11, 2020. Although these online channels comprised a minority of our sales for the year ended December 31, 2019, sales made through these online channels typically carry significantly higher gross margins than sales made to brick-and-mortar retailers. Thus, while we expect the pandemic may cause a decline in revenue, we could potentially maintain comparable gross profits levels by continued focus on our gross margins. We have implemented or are in the process of implementing several measures in response to the COVID-19 pandemic, including but not limited to the following: •Encouraging remote work for employees in our U.S. and European offices •Temporarily closing of our Canada office •Temporarily closing of our brick-and-mortar retail stores •Reducing our expenses through a variety of measures, including targeted layoffs and furloughs •Enhancing our focus on sales through our higher margin e-commerce channels •Focusing sales efforts on customers whose retail stores are most likely to remain open during and following the pandemic, including medical cannabis dispensaries •Adjusting purchasing to meet anticipated changes in demand and product availability Although the foregoing steps are intended to minimize the impact to our business of the COVID-19, we cannot reasonably estimate the length or severity of this pandemic, or whether the measures we have taken or in the future may take in response to the COIVD-19 pandemic will be sufficient to mitigate the adverse impacts of the pandemic. While we expect that the COVID-19 pandemic will negatively impact our financial conditions and results of operations, the extent to which the COVID-19 pandemic may impact our financial condition or results of operations is uncertain. The extent of the impact of the pandemic on our operational and financial performance will depend on certain developments that remain uncertain and cannot be predicted as of the date of this Form 10-K, including but not limited to the following: •The duration, severity, and spread of the pandemic; •the impact on our customers, including their ability to remain in business and make payments to us in the ordinary course; •the impact on end-user demand for our products, including whether any scientific findings demonstrate smoking or vaping negatively impact health outcomes of individuals who contract COVID-19; •our ability to hold and attend employee and industry events; •our ability to operate our retail stores; •our employees' ability to work effectively in a remote work environment; •our ability to continue operating our distribution centers; •our ability to capitalize on any new consumer trends resulting from the pandemic; and •the pandemic's effect on our vendors. Critical Accounting Policies and Estimates We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (“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 disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. We evaluate our estimates and assumptions on an ongoing basis. We base our estimates on historical experience, outside advice from parties believed to be experts in such matters, and on 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 value of assets and liabilities that are not readily apparent from other sources. Judgments and uncertainties affecting the application of those policies may result in materially different amounts being reported under different conditions or using different assumptions. See "Note 2-Summary of Significant Accounting Policies" of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K for a description the significant accounting policies and methods used in the preparation of our consolidated financial statements. Inventories Inventories, consisting of finished products, are primarily accounted for using the weighted average method, and are valued at the lower of cost and net realizable value. This valuation requires us to make judgments, based on currently available information, about the likely method of disposition, such as through sales to customers or liquidations. Assumptions about the future disposition of inventory are inherently uncertain and changes in our estimates and assumptions may cause us to realize material write-downs in the future. Valuation of Goodwill Assets acquired and liabilities assumed in business combinations are generally recognized at the date of acquisition at their respective fair values. Any excess of the purchase price over the estimated fair values of the net assets acquired is recognized as goodwill. Subsequent to acquisition, goodwill is tested at least annually for impairment, or when events or changes in circumstances indicate it is more likely than not that the carrying amount of goodwill may not be recoverable. As of December 31, 2019, no impairment of goodwill has been identified. Our annual assessment may consist of a qualitative or quantitative analysis to determine whether it is more likely than not that fair value exceeds the carrying value. When performing a qualitative analysis, the factors we consider include our share price, our projected financial performance, long-term financial plans, macroeconomic, industry and market conditions as well as the results of our most recently completed annual impairment test. When performing a quantitative analysis, we use a combination of an income approach, using discounted cash flow techniques, and market valuation methods, using the guideline public company method, and may weigh the outcomes of valuation approaches when estimating the fair value of each reporting unit. We then compare the fair value to its carrying amount to determine the amount of impairment, if any. If a reporting unit’s fair value is less than its carrying amount, we record an impairment charge based on that difference, up to the amount of goodwill allocated to that reporting unit. Inputs and assumptions used to determine fair value are determined from a market participant view, which might be different than our specific views. The valuation process is complex and requires significant input and judgment. Market approaches depend on the availability of guideline companies and representative transactions. When using the income approach, complex and judgmental matters applicable to the valuation process include projections of future revenues, which are estimated after considering many factors such as historical results, market opportunity, pricing, and sales trajectories. The estimated fair value of a reporting unit is highly sensitive to changes in projections and assumptions; therefore, in some instances, changes in these assumptions could potentially lead to impairment. Ultimately, future potential changes in these assumptions may impact the estimated fair value of a reporting unit and cause the fair value of the reporting unit to be below its carrying value. We believe that our estimates are consistent with the assumptions that market participants would use in their fair value determination. Certain adverse developments in the first quarter of 2020, such as the significant decrease in share price of our Class A common stock since December 31, 2019 and outbreak of COVID-19, may have material impacts on the assumptions used in determining the fair value of our reporting units. Specifically, the risk of a pandemic, or public perception of the risk, could cause temporary or long-term disruptions in our supply chains and/or delays in the delivery of our inventory, adversely influence customer spending habits, and otherwise cause material disruptions in the operations of our business. Should these factors persist unabated, the fair value of our reporting units may decrease below their carrying values and result in a material impairment to goodwill in future periods. We will continue to monitor and evaluate the development of these factors in future evaluations of goodwill. Income Taxes and TRA Liability We are subject to U.S. federal, state and foreign income taxes with respect to our allocable share of any taxable income or loss of Greenlane Holdings, LLC and will be taxed at the prevailing corporate tax rates on such income. Significant judgment is required in determining our provision or benefit for income taxes and in evaluating uncertain tax positions. We account for income taxes under the asset and liability method, which requires the recognition of deferred tax assets or deferred tax liabilities for the expected future tax consequences of events included in our financial statements. Greenlane Holdings, LLC is a limited liability company and is treated as a partnership for U.S. federal and most applicable state and local income tax purposes. As a result, we are not liable for U.S. federal or state and local income taxes in most jurisdictions in which we operate, and the income, expenses, gains and losses are reported on the returns of our members. Greenlane Holdings, LLC is subject to Canadian, Dutch, and U.S. state and local income tax in certain jurisdictions in which it is not treated as a partnership for income tax purposes, and in which jurisdictions it pays an immaterial amount of taxes. In addition to tax expenses, we may incur expenses related to our operations and may be required to make payments under the Tax Receivable Agreement (the "TRA"), which could be significant. Pursuant to the Greenlane Operating Agreement, Greenlane Holdings, LLC will generally make pro rata tax distributions to its members in an amount sufficient to fund all or part of their tax obligations with respect to the taxable income of Greenlane Holdings, LLC that is allocated to them and possibly in excess of such amount. Legal Contingencies In the ordinary course of business, we are involved in legal proceedings involving a variety of matters. Certain of these matters include speculative claims for substantial or indeterminate amounts of damages. We evaluate the associated developments on a regular basis and accrue a liability when we believe that it is both probable that a loss has been incurred and the amount can be reasonably estimated. If we determine there is a reasonable possibility that we may incur a loss and the loss or range of loss can be estimated, we disclose the possible loss in the accompanying notes to the consolidated financial statements to the extent material. We review the developments in our contingencies that could affect the amount of the provisions that have been previously recorded, and the matters and related reasonably possible losses disclosed. We make adjustments to our provisions and changes to our disclosures accordingly to reflect the impact of negotiations, settlements, rulings, advice of legal counsel, and updated information. Significant judgment is required to determine both the probability of loss and the estimated amount of loss. The outcome of these matters is inherently uncertain. Therefore, if one or more of these matters were resolved against us for amounts in excess of management's expectations, our results of operations and financial condition, including in a particular reporting period in which any such outcome becomes probable and estimable, could be materially adversely affected. See "Note 7-Commitments and Contingencies" of the Notes to Consolidated Financial Statements included in Part II, Item 8 and Part I, Item 3, "Legal Proceedings" of this Form 10-K for additional information regarding these contingencies. Recent Accounting Pronouncements See "Note 2-Summary of Significant Accounting Policies" of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K. Results of Operations The following table presents operating results as a percentage of total net sales: Net Sales We sell a broad array of premium consumption accessories and vaporization products across a variety of categories, including premium vaporizers and parts, cleaning products, grinders and storage containers, pipes, rolling papers and customizable lines of premium specialty packaging, primarily to B2B customers, including retailers, distributors and licensed cannabis cultivators, processors and dispensaries. We also sell our products directly to B2C consumers through our e-commerce operations and, to a lesser extent, through our retail stores. Shipping costs billed to our customers are included in net sales, while shipping and handling costs, which include inbound freight costs and the cost to ship products to our customers, are typically included in cost of sales. Net sales increased approximately $6.1 million, or 3.4%, for the year ended December 31, 2019, which included incremental sales of $7.2 million or 48.3% growth in our Canadian segment due to the legalization of cannabis in the region, and an incremental $2.6 million in sales contributed by our acquisition of Conscious Wholesale and establishment of our European segment on September 30, 2019. The increases in net sales were partially offset by a decrease in net sales of our U.S. segment of $3.8 million, which was largely attributable to our business transformation and strategy to reduce JUUL concentration and focus on higher-margin sales and industry headwinds and consumer concerns around vaping-related health conditions. Net sales of products subject to the United States Food and Drug Administration's ("FDA") Enforcement Priorities for Electronic Nicotine Delivery Systems and Other Deemed Products on the Market Without Premarket Authorization guidance ("ENDS Enforcement Guidance") accounted for approximately 17.8% and 25.6% of our total net sales for the years ended December 31, 2019 and 2018, respectively. The net sales increase of $6.1 million (including sales in the United States, Canada and Europe) is also driven largely by increased popularity and availability of our top product lines. Specifically, the top seven selling product lines during the year ended December 31, 2019 collectively resulted in net sales of approximately $140.1 million, compared to approximately $138.1 million for the year ended December 31, 2018, representing an increase of approximately $2.0 million, or 1.4%. This $2.0 million increase comprised of several components: an increase of approximately $4.0 million in sales of child-resistant storage solution products conforming partially to ASTM standards; an increase of approximately $2.9 million in sales of e-cigarette products; and a decrease of approximately $4.9 million in sales of vaporizers and vaporizer accessory products. The remaining increase in net sales of approximately $4.2 million is attributable to increased sales in various product lines, including hemp-derived CBD products, which, in the aggregate, generated approximately $3.0 million for the year ended December 31, 2019. Our revenue from hemp-derived CBD products was not substantial for the year ended December 31, 2018, as sales activity for these products did not pick up until March 2019, when we fully launched the product line. Cost of Sales and Gross Margin Cost of sales consists primarily of product costs and the cost to ship our products, including both inbound freight and handling and outbound freight of products sold to customers. Our cost of sales excludes depreciation and amortization. Our shipping costs, both inbound and outbound, will fluctuate from period to period based on customer and product mix due to varying shipping terms and other factors. Our products are sourced from suppliers who may use their own third-party manufacturers. Our product costs and gross margins will be impacted from period to period based on the product mix we sell in any given period. For example, our vaporizer products tend to have a higher product cost and lower gross margins than our grinder products. Gross margin, or gross profit as a percentage of net sales, has been and will continue to be affected and fluctuate based upon a variety of factors, including the average mark-up over cost of our products, the mix of products sold and purchasing efficiencies. Cost of sales increased in 2019 compared to 2018 primarily due to an increase of approximately $14.9 million, or 11.2%, in cost of merchandise expense from approximately $132.6 million for the year ended December 31, 2018 to approximately $147.5 million in the year ended December 31, 2019. This $14.9 million increase was partially offset by an approximately decrease of $3.0 million in cost of sales due to volume purchase rebates that were not in place in 2018. The decrease in gross profit percentage is mainly attributable to the decrease in gross margin recognized on JUUL product sales in fiscal 2019. We also noted that gross profit recognized from sales of products affected by the FDA's ENDS Enforcement Guidance accounted for approximately 7.1% and 22.6% of our gross profit for the years ended December 31, 2019 and 2018, respectively. Operating Expenses Salaries, Benefits and Payroll Taxes Salaries, benefits and payroll taxes consist of wages for all department personnel, including salaries, bonuses, equity-based compensation expense, and other employment-related costs, as well as workers' compensation insurance, medical insurance and 401(k) matching contributions. Salaries, benefits and payroll taxes expenses increased in 2019 compared 2018 primarily due to an increase in personnel expenses of approximately $6.2 million resulting from the addition of 95 employees since December 31, 2018 as we continued to expand our domestic sales and marketing efforts. We had 256 employees as of December 31, 2018 and 351 employees as of December 31, 2019. Further, we recorded approximately $8.0 million of equity-based compensation expense for the year ended December 31, 2019 related to Common Units of the Operating Company which were awarded as equity-based compensation, stock options awarded in April 2019 in connection with the IPO, and stock options awarded to certain employees in August 2019, as compared to approximately $4.1 million at December 31, 2018, an increase of approximately $3.9 million. General and Administrative Expenses General and administrative expenses consist of legal, subcontracting, professional fees, insurance, business travel, and other overhead. Also included are marketing activities and promotional events, training costs and rent. We expect general and administrative expenses to increase on an absolute dollar basis in the near term as we continue to increase investments to support our growth. We also expect that our general and administrative expenses will increase in absolute dollars but may fluctuate as a percentage of our net sales from period to period. General and administrative expenses increased in 2019 compared to 2018 primarily due to an increase of approximately $0.8 million in marketing expenses; an increase of $0.6 million in subcontracted services, labor and temp fees primarily due to the use of a third-party recruiting firm, and consulting fees for the use of specialists; an increase of approximately $0.2 million in bank merchant fees due to our increased sales volume; an increase of approximately $0.7 million in computer hardware and software expenses; an increase of approximately $2.1 million in accounting expenses, which include fees to our external auditors and tax consultants; an increase of approximately $0.6 million in insurance expenses; an increase of approximately $0.8 million in professional fees related to our transition to being a public company; and an increase of approximately $0.4 million in consulting and legal fees. This increase was partially offset by a $0.5 million decrease in expenses related to our third-party logistics vendors as the Company transitioned these services in house. Depreciation and Amortization Expenses Depreciation and amortization expense increased in 2019 compared to 2018 primarily due to tangible and intangible asset additions acquired through the Pollen Gear, LLC and Conscious Wholesale acquisitions, as well as twelve months depreciation expense recognized on our corporate headquarters building located in Boca Raton, Florida, compared to two months of expense recognized at December 31, 2018, as a result of owning our headquarters for the entirety of 2019. Other Income (Expense), Net Change in fair value of convertible notes. We accounted for the convertible notes issued in December 2018 and January 2019 at fair value with changes in the fair value recognized in the consolidated statements of operations and comprehensive loss as a component of other income (expense), net. The convertible notes were converted to shares of Class A common stock in conjunction with the completion of the IPO in April 2019. Interest expense. Interest expense consists of interest incurred on our Real Estate Note, line of credit and other debt obligations, as well as debt issuance costs related to the convertible notes issued in December 2018 and January 2019. Other income, net. Other income, net consists primarily of our share of income or losses from our equity method investments, an unrealized gain on our equity securities investments, a gain resulting from the reversal of our TRA liability, as well as rental income for office space leases to third-party tenants in our corporate headquarters building in Boca Raton, Florida (acquired in October 2018). Other expense, net increased in 2019 compared to 2018 primarily due to an increase of approximately $12.1 million resulting from the change in fair value of convertible notes payable, offset by a decrease of approximately $2.2 million in interest expense, an unrealized gain of $1.5 million recognized on our equity investment in Airgraft Inc., a gain of $5.7 million resulting from the adjustment of our TRA liability during 2019, and an increase in interest income generated from our interest-bearing bank account of approximately $0.8 million, a refund of approximately $0.3 million for goods and services taxes in Canada, and an increase in rental income of approximately $0.7 million from rent collected from our corporate headquarters building tenants in 2019 as compared to 2018. Provision for Income Taxes As a result of the IPO and the related transactions (defined in "Note 1-Business Operations and Organizations" of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K), we own a portion of the Common Units of the Operating Company, which is treated as a partnership for U.S. federal and most applicable state and local income tax purposes. As a partnership, the Operating Company is not subject to U.S. federal and certain state and local income taxes. Any taxable income or loss generated by the Operating Company is passed through to, and included in the taxable income or loss of, its members, including us, in accordance with the terms of the Operating Agreement. We are subject to federal income taxes, in addition to state and local income taxes with respect to our allocable share of the Operating Company’s taxable income or loss. As discussed above, prior to the consummation of the IPO, the provision for income taxes included only income taxes on income from the Operating Company’s Canadian subsidiary, based upon an estimated annual effective tax rate of approximately 15.0%. After the consummation of the IPO, Greenlane became subject to U.S. federal, state and local income taxes with respect to Greenlane’s allocable share of the Operating Company’s taxable income or loss. Furthermore, after completing the Conscious Wholesale acquisition in September 2019, the Operating Company became subject to Dutch income taxes on income from its Netherlands-based subsidiary, based upon an estimated effective tax rate of approximately 25.0%. During 2019, management performed an assessment of the realizability of our deferred tax assets based upon which management determined that it is not more likely than not that the results of operations will generate sufficient taxable income to realize portions of the net operating loss benefits. Consequently, we established a full valuation allowance of approximately$10.0 million against our deferred tax assets, thus reducing the carrying balance to $0, and recognized a corresponding increase to the income tax provision in our consolidated statements of operations and comprehensive loss for the year ended December 31, 2019. In the event that management determines that we would be able to realize our deferred tax assets in the future in excess of their net recorded amount, an adjustment to the valuation allowance will be made which would reduce the provision for income taxes. Key Metrics and Non-GAAP Financial Measures We monitor the following key metrics to help us measure and evaluate the effectiveness of our operations, develop financial forecasts, and make strategic decisions: Non-GAAP Financial Measures Adjusted Net Income (Loss) is defined as net loss before equity-based compensation expense, changes in the fair value of our convertible notes, debt placement costs for the convertible notes, and non-recurring expenses primarily related to our transition to being a public company. The debt placement costs related to the convertible notes issued in January 2019 are reported within the "interest expense" line item in our consolidated statement of operations and comprehensive loss for the years ended December 31, 2019 and 2018. Non-recurring expenses related to our transition to being a public company, which are reported within "general and administrative expenses" in our consolidated statements of operations and comprehensive loss, represent fees and expenses primarily attributable to consulting fees and incremental audit and legal fees. Adjusted EBITDA is defined as net loss before interest expense, income tax expense, depreciation and amortization expense, equity-based compensation expense, other income, net (which includes a gain recognized on an equity investment and a gain due to the adjustment of our TRA liability), changes in fair value of our convertible notes, and non-recurring expenses primarily related to our transition to being a public company. These non-recurring expenses, which are reported within general and administrative expenses in our consolidated statements of operations and comprehensive loss, represent fees and expenses primarily attributable to consulting fees and incremental audit and legal fees. We disclose Adjusted Net Income (Loss) and Adjusted EBITDA, which are non-GAAP performance measures, because management believes these metrics assist investors and analysts in assessing our overall operating performance and evaluating how well we are executing our business strategies. You should not consider Adjusted Net Income (Loss) or Adjusted EBITDA as alternatives to net loss, as determined in accordance with U.S. GAAP, as indicators of our operating performance. Adjusted Net Income (Loss) and Adjusted EBITDA have limitations as an analytical tool. Some of these limitations are: •Adjusted EBITDA does not include interest expense, which has been a necessary element of our costs •Adjusted EBITDA does not include depreciation expense of property, plant and equipment •Adjusted EBITDA does not include amortization expense associated with our intangible assets •Adjusted EBITDA does not include provision for income taxes or future requirements for income taxes to be paid •Adjusted EBITDA does not include other income, net, which includes a gain recognized on an equity investment and a gain due to the reversal of our tax receivable agreement liability •Adjusted Net Income (Loss) and Adjusted EBITDA do not include equity-based compensation expense •Adjusted Net Income (Loss) and Adjusted EBITDA do not include the change in fair value of convertible notes •Adjusted Net Income (Loss) and Adjusted EBITDA do not include expenses incurred related to our transition to being a public company •Adjusted Net Income (Loss) does not include debt placement costs for the convertible notes issued in January 2019 Because Adjusted Net Income (Loss) and Adjusted EBITDA do not account for these items, these measures have material limitations as indicators of operating performance. Accordingly, management does not view Adjusted Net Income (Loss) or Adjusted EBITDA in isolation or as substitutes for measures calculated in accordance with U.S. GAAP. The reconciliation of our net loss to Adjusted Net Income (Loss) is as follows: (1)Debt placement costs related to the issuance of convertible notes in January 2019. (2)Includes certain non-recurring fees and expenses primarily attributable to consulting fees and incremental audit and legal fees incurred in connection with our transition to being a public company. The reconciliation of our net loss to Adjusted EBITDA is as follows: (1)Includes rental income, interest income, unrealized gains on our equity security, a gain related to the adjustment of TRA liability, and other miscellaneous income. (2)Includes certain non-recurring fees and expenses primarily attributable to consulting fees and incremental audit and legal fees incurred in connection with our transition to being a public company. Liquidity and Capital Resources Our primary requirements for liquidity and capital are working capital, debt service and general corporate needs. Historically, these cash requirements have been met through cash provided by operating activities and borrowings under our revolving line of credit. As of December 31, 2019, we had approximately $47.8 million of cash, of which $0.9 million was held in foreign bank accounts, and approximately $88.7 million of working capital, which is calculated as current assets minus current liabilities, compared with approximately $7.3 million of cash, of which $0.2 million was held in foreign bank accounts, and approximately $26.7 million of working capital as of December 31, 2018. The repatriation of cash balances from our foreign subsidiaries could have adverse tax impacts or be subject to capital controls; however, these balances are generally available to fund the ordinary business operations of our foreign subsidiaries without legal or other restrictions. In April 2019, we completed the IPO of Class A common stock, resulting in aggregate net proceeds to us of approximately $79.5 million, after deducting the underwriting discounts and commissions and offering expenses paid by us. On October 1, 2018, the Operating Company, as the borrower, entered into an amended and restated revolving credit note (the “line of credit”) with Fifth Third Bank, for a $15.0 million revolving credit loan with a maturity date of August 23, 2020. Interest on the principal balance outstanding on the line of credit is due monthly at a rate of LIBOR plus 3.50% per annum provided that no default has occurred. The line of credit borrowing base is 80% of eligible accounts receivable plus 50% of eligible inventory. There were no borrowings outstanding on our line of credit at December 31, 2019 and 2018, respectively. On October 1, 2018, one of the Operating Company’s wholly-owned subsidiaries closed on the purchase of a building for $10.0 million, which serves as our corporate headquarters. The purchase was financed through a real estate term note (the “Real Estate Note”) in the principal amount of $8.5 million, with one of the Operating Company’s wholly-owned subsidiaries as the borrower and Fifth Third Bank as the lender. Principal amounts plus any accrued interest at a rate of LIBOR plus 2.39% are due monthly. Our obligations under the Real Estate Note are secured by a mortgage on the property. In the future, we may engage in offerings of our securities or incur additional debt. Additionally, future liquidity needs may include additional public company costs, payments in respect of the redemption rights of the Common Units held by its members that may be exercised from time to time (should we elect to exchange such Common Units for a cash payment), payments under the TRA and state and federal taxes to the extent not sheltered by our tax assets, including those arising as a result of purchases, redemptions or exchanges of Common Units for Class A common stock. The members of the Operating Company may exercise their redemption right for as long as their Common Units remain outstanding. Although the actual timing and amount of any payments that may be made under the TRA will vary, the payments that we will be required to make to the members may be significant. Any payments made by us to the members under the TRA will generally reduce the amount of overall cash flow that might have otherwise been available to us or to the Operating Company 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; provided, however, that nonpayment for a specified period may constitute a material breach of a material obligation under the TRA and therefore may accelerate payments due under the TRA. We believe that our sources of liquidity and capital will be sufficient to satisfy our working capital needs, capital asset purchases, share repurchases, debt repayments and other liquidity requirements associated with our existing operations over the next 12 months. However, we cannot assure you that our cash provided by operating activities, cash provided by investing activities or cash available under our bank line of credit will be sufficient to meet our future needs. If we are unable to generate sufficient cash flows from operations in the future, and if availability under our bank line of credit is not sufficient, we may have to obtain additional financing. If we obtain additional capital by issuing equity securities, the interests of our existing stockholders will be diluted. If we incur additional indebtedness, that indebtedness may contain significant financial and other covenants that may significantly restrict our operations. We cannot assure you that we can obtain refinancing or additional financing on favorable terms, or at all, to meet our future capital needs. Cash Flows The following summary of cash flows for the periods indicated has been derived from our consolidated financial statements included in Part II, Item 8 of this Form 10-K: Net Cash Used in Operating Activities During 2019, net cash used in operating activities of approximately $36.9 million was a result of a net loss of $39.8 million offset by non-cash adjustments to net loss of $28.0 million, and a $25.1 million increase in cash consumed by working capital primarily driven by an increase in our vendor deposits, inventories, and other current assets, and a decrease in accounts payable offset by higher accrued expenses. During 2018, net cash used in operating activities of approximately $13.6 million was a result of a net loss of $5.9 million offset by non-cash adjustments to net loss of $8.9 million, and a $16.6 million increase in cash consumed by working capital primarily driven by an increase in accounts receivable, vendor deposits, inventories and deferred offering costs, offset by an increase in accounts payable, accrued expenses and customer deposits. Net Cash Used in Investing Activities During 2019, we used approximately $2.0 million of cash for capital expenditures, including computer hardware and software to support our growth and development, and to purchase warehouse supplies and equipment, including the build-out of our two retail locations. Additionally, during 2019, we completed the Pollen Gear, LLC and Conscious Wholesale business acquisitions, for which we paid approximately $1.2 million, which is net of cash acquired of approximately $0.9 million. We also made an investment in equity securities of an entity for approximately $0.5 million, which represents a 1.49% ownership interest in the entity. During 2018, cash used in investing activities was primarily for capital expenditures of approximately $10.9 million to purchase our corporate headquarters. Net Cash Provided by Financing Activities During 2019, cash provided by financing activities was primarily attributable to net proceeds of approximately $79.5 million from the sale of Class A common stock in the IPO, and proceeds from the issuance of convertible notes of approximately $8.1 million, which was primarily offset in part by the redemption of limited liability company membership interests of approximately $3.0 million, payment of approximately $3.5 million of deferred offering costs related to the IPO, payment of approximately $1.7 million of debt issuance costs related to the convertible notes issued in December 2018 and January 2019, and approximately $0.9 million of member distributions for the period. During 2018, cash provided by financing activities was primarily comprised of proceeds from the issuance of convertible notes of approximately $38.9 million and proceeds from our notes payable of approximately $8.5 million, offset in part by the redemption of limited liability company membership interests of approximately $15.1 million, member distributions of approximately $1.6 million, and payments on long-term debt of $0.6 million. 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, that have or are reasonably likely to have a current or future effect on our financial condition, changes in our financial condition, revenues, or expenses, results of operations, liquidity, capital expenditures, or capital resources that are material to investors.

<s>[INST] We are one of the largest global sellers of premium cannabis accessories and liquid nicotine products in the world. We operate as a powerful house of brands, third party brand accelerator and distribution platform for consumption devices and lifestyle brands serving the global cannabis, hempderived CBD, and liquid nicotine markets with an expansive customer base of retail locations, including licensed cannabis dispensaries, and smoke and vape shops. We continue to be wellfunded to execute upon our business transformation plans, with $47.8 million in cash as of December 31, 2019, compared to $7.3 million as of December 31, 2018. During the fourth quarter of 2019, we delivered on our strategy to move away from highvolume, lowmargin products and sales, in favor of highmargin sales and the promotion of our house brands. Specifically, the JUUL sales percentage was reduced to 15.9% for the fourth quarter 2019, compared to 45.4% for the third quarter 2019, and we improved gross margin on fourth quarter JUUL sales by 4.7%, while sales of JUUL products decreased from $20.2 million for the third quarter 2019 to $5.9 million for the fourth quarter 2019. We also continued to grow and diversify our portfolio of house brands and directtoconsumer retail operations, including the following highlights: Increased house brands share of net sales to 11.8% in the fourth quarter of 2019, equaling approximately $4.4 million dollars in net sales; Completed the construction work on Higher Standards’ third retail location in Malibu, CA during the fourth quarter and announced the opening of the store on January 23, 2020; Launched a new house brand, the K.Haring Collection, a selection of functional glass art and lifestyle products with the iconic imagery of artist Keith Haring; and Doubled sales of VIBES over every sequential quarter since launch, with the brand now present at over 1,500 B2B customers and growing. We closed on the acquisition of Pollen Gear in January 2019, a leading supplier of premium childresistant packaging to the cannabis industry. In September 2019, we also closed on the acquisition of Conscious Wholesale, thereby establishing our European operating segment. Vapor.com, the Company’s ecommerce platform, experienced sustained growth over sequential quarters, both in terms of daily store transactions and average basket size, which were up approximately 30% and 7%, respectively, from the third quarter of 2019. Furthermore, we signed new distribution and exclusive partnership agreements with leading players in the industry, including Omura, Santa Cruz Shredder, Storz & Bickel and Cookies. In December 2019, a novel strain of coronavirus known as COVID19 was reported in Wuhan, China. In March 2020, the World Health Organization declared the outbreak of COVID19 a pandemic. In response to the COVID19 pandemic, many state and local governments throughout the United States began issuing "stay at home" orders directing the closure of nonessential businesses and directing citizens to remain home unless they are conducting essential business or other prescribed activities. Similar orders have proliferated in Canada and Europe. Although we have been able to continue operations, the pandemic is impacting our sales in several ways. Since the implementation of "stay at home" orders, there has been a significant decline in sales to smoke shops, vape shops, and similar independent retailers that comprise a large portion of our customer base. Many of these customers are closed as a result of the "stay at home" orders and it is possible that some of these customers may close permanently as a result of business lost during the pandemic. Since these stay at home orders have gone into effect, average daily revenues attributable to these customers for the period of January 1, 2020 through March 14, 2020 as compared to average daily revenues attributable to these customers for the period of March 15, 2020 through April 22, 2020 declined by approximately 43%, which could be the result [/INST] Positive. </s>

PRECISION BIOSCIENCES 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 financial condition and operating results together with the section captioned “Selected Consolidated Financial Data” and our consolidated financial statements and the related notes included 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 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 life sciences company dedicated to improving life through the application of our pioneering, proprietary ARCUS genome editing platform. We leverage ARCUS in the development of our product candidates, which are designed to treat human diseases and create healthy and sustainable food and agricultural solutions. We are actively developing product candidates in three innovative areas: allogeneic CAR T cell immunotherapy, in vivo gene correction, and food. We are currently conducting a Phase 1/2a clinical trial of PBCAR0191 in adult patients with relapsed or refractory, or R/R, non-Hodgkin lymphoma, or NHL, or R/R B-cell precursor acute lymphoblastic leukemia, or B-ALL. PBCAR0191 is our first gene-edited allogeneic chimeric antigen receptor, or CAR, T cell therapy candidate targeting CD19 and is being developed in collaboration with Les Laboratoires Servier, or Servier. We have received orphan drug designation for PBCAR0191 from the U.S. Food and Drug Administration, or FDA, for the treatment of ALL. Made from donor-derived T cells modified using our ARCUS genome editing technology, PBCAR0191 recognizes the well characterized tumor cell surface protein CD19, an important and validated target in several B-cell cancers, and is designed to avoid graft-versus-host disease, or GvHD, a significant complication associated with donor-derived, cell-based therapies. We believe that this trial, which is designed to assess the safety and tolerability of PBCAR0191 at increasing dose levels, as well as to evaluate anti-tumor activity, is the first U.S.-based clinical trial to evaluate an allogeneic CAR T therapy for R/R NHL. Furthermore, we believe that our proprietary, one-step engineering process for producing allogeneic CAR T cells with a potentially optimized cell phenotype, at large scale in a cost-effective manner, will enable us to overcome the fundamental clinical and manufacturing challenges that have limited the CAR T field to date. In December 2019, we announced initial data from this ongoing Phase 1/2a clinical trial of PBCAR0191 in adult patients with R/R NHL and R/R B-ALL. A total of nine adult patients were reported in these initial Phase 1 trial results, including six with NHL (three treated at Dose Level 1 (3x105 cells/kg), or DL1, and three treated at Dose Level 2 (1x106 cells/kg), or DL2), and three with B-ALL (all treated at DL2). These data indicated no serious adverse events or dose limiting toxicities. In the NHL cohort, four of six patients demonstrated an objective tumor response by Lugano criteria at day 28, for an overall objective response rate of 67%, including three partial responses and one complete response. In the ALL cohort, one of three patients achieved a complete response at day 28 following treatment with PBCAR0191. As of December 31, 2019, dosing of patients at Dose Level 3 (3x106 cells/kg) was underway. Based on the data observed at DL1 and DL2, we filed a protocol amendment for this trial with the FDA in December 2019. The amended trial design is intended to specifically address key clinical questions. These include assessing the impact of higher total doses of cells on clinical activity and/or the impact of modified lymphodepletion on the ability to achieve durable clinical benefit with associated CAR T cell expansion and persistence. Following feedback from the FDA in late January 2020, the protocol amendment is now being implemented. In September 2019, the FDA accepted our investigational new drug, or IND, application for our second allogeneic CAR T cell therapy product candidate, PBCAR20A, for which we expect to commence a Phase 1/2a clinical trial in the first quarter of 2020. PBCAR20A is wholly owned by us and targets the validated tumor cell surface target CD20. It will be investigated in subjects with NHL, chronic lymphocytic leukemia, or CLL, and small lymphocytic lymphoma, or SLL. A subset of the NHL patients will have the diagnosis of mantle cell lymphoma, or MCL, and we have received orphan drug designation for PBCAR20A from the FDA for the treatment of this disease. Based on the adverse events observed to date with PBCAR0191, the FDA has agreed to allow us to commence dosing with PBCAR20A directly at Dose Level 2, which we expect to accelerate the timing for our expected completion of the trial. In January 2020, the FDA accepted our IND application for our third allogeneic CAR T cell therapy product candidate, PBCAR269A, for which we expect to commence a Phase 1/2a clinical trial in 2020. PBCAR269A is wholly owned by us and is designed to target the validated tumor cell surface target BCMA. It will be investigated in subjects with R/R multiple myeloma and we have received orphan drug designation from the FDA for this indication. Also in January 2020, we announced that we expect to advance a program targeting the rare genetic disease primary hyperoxaluria type 1, or PH1 as our lead wholly owned in vivo gene correction program. PH1 affects approximately 1-3 people per million in the United States and is caused by loss of function mutations in the AGXT gene, leading to the accumulation of calcium oxalate crystals in the kidneys. Patients suffer from painful kidney stones which may ultimately lead to renal failure. Using ARCUS, we are developing a potential therapeutic approach to the treatment of PH1 that involves knocking out a gene called HAO1 which acts upstream of AGXT. Suppressing HAO1 has been shown in preclinical models by us to prevent the formation of calcium oxalate. We therefore believe that a one-time administration of an ARCUS nuclease targeting HAO1 may be a viable strategy for a durable treatment of PH1 patients. In preclinical studies we have demonstrated in a mouse model of PH1 that administration of an ARCUS nuclease targeting HAO1 resulted in approximately 70% reduction in urine calcium oxalate levels. We have also demonstrated that ARCUS efficiently knocked out the HAO1 gene in non-human primates. We plan to select a clinical candidate for this program during 2020. During the fiscal year ended December 31, 2019, we opened our Manufacturing Center for Advanced Therapeutics, or MCAT, which we believe is the first in-house current good manufacturing practice, or cGMP, compliant manufacturing facility dedicated to genome-edited, off-the-shelf CAR T cell therapy product candidates in the United States. MCAT will enable in-house production of three different drug substances: allogeneic CAR T cells, messenger RNA (including formulations development) and adeno-associated viral vectors. We are currently using this new manufacturing center to create clinical trial material to be used in our BCMA targeting allogeneic CAR T clinical trials beginning in 2020. We believe MCAT confers a number of strategic advantages including cost benefits, control of our manufacturing process and strategic flexibility as we execute our clinical trials. In the longer term, we believe MCAT has the potential to be a commercial launch facility. Since our formation in 2006, we have devoted substantially all of our resources to developing ARCUS, conducting research and development activities, recruiting skilled personnel, developing manufacturing processes, establishing our intellectual property portfolio and providing general and administrative support for these operations. We have financed our operations primarily with proceeds from our IPO, the sale of our convertible preferred stock and upfront payments from licensing arrangements. On April 1, 2019, we completed our IPO of 9,085,000 shares of common stock, including the underwriters’ full exercise of their option to purchase an additional 1,185,000 additional shares of common stock, at an offering price of $16.00 per share, for net proceeds of approximately $130.5 million after deducting underwriting discounts and commissions and offering expenses payable by us. To date, we have generated approximately $475.4 million from third parties through a combination of financings including through our IPO, preferred stock and convertible note financings, an upfront payment under the Servier Agreement and additional funding from other strategic alliances and grants. Since our inception, we have incurred significant operating losses and have not generated any revenue from the sale of products. 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 or the product candidates of our collaborators for which we may receive milestone payments or royalties. Our net losses were $92.9 million and $46.0 million for the years ended December 31, 2019 and December 31, 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $177.1 million. We expect our operating expenses to increase substantially in connection with the expansion of our product development programs and capabilities. We will not generate revenue from product sales unless and until we successfully complete clinical development and obtain regulatory approval for one of our product candidates or the product candidates of our collaborators for which we may receive milestone payments or royalties. 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. In addition, we expect to continue to incur additional costs associated with operating as a public company. As a result of these anticipated expenditures, 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 cash needs through a combination of public equity, debt financings or other sources, which may include current and new collaborations with third parties. Adequate additional financing may not be available to us on acceptable terms, or at all. Our inability to raise capital as and when needed would have a negative impact on our financial condition and our ability to pursue our business strategy. We cannot assure you that we will ever generate significant revenue to achieve profitability. Because of the numerous risks and uncertainties associated with the development of therapeutic and agricultural products, 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 required to raise additional capital on terms that are unfavorable to us or we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations. We currently conduct our operations through two reportable segments: Therapeutics and Food. Our Therapeutics segment is focused on allogeneic CAR T immunotherapy and in vivo gene correction. Our Food segment focuses on applying ARCUS to develop food and nutrition products through collaboration agreements with consumer-facing companies. Collaborations Gilead In September 2018, we and Gilead entered into a collaboration and license agreement, which we refer to as the Gilead Agreement, to develop genome editing tools using ARCUS to target viral DNA associated with the Hepatitis B virus. Pursuant to the terms of the agreement, Gilead received an exclusive license to exploit the resulting synthetic nucleases and products that use them to treat the Hepatitis B virus in humans, and we are entitled to receive up to approximately $40.0 million in research funding over an initial three year term and milestone payments of up to an aggregate of $445.0 million, consisting of up to $105.0 million in development milestone payments and up to $340.0 million in commercial milestone payments. We are also entitled to receive tiered royalties ranging from the high single digit percentages to the mid-teen percentages on worldwide net sales of the products developed through the term of the agreement, subject to customary potential reductions. We recognized $13.3 million and $3.7 million in revenues under the Gilead Agreement during the years ended December 31, 2019 and December 31, 2018, respectively, and recorded $1.5 million and $2.3 million in deferred revenue as of December 31, 2019 and December 31, 2018, respectively. We did not receive any milestone payments under the Gilead Agreement during the years ended December 31, 2019 or December 31, 2018. Servier In February 2016, we entered into the Servier Agreement, pursuant to which we have agreed to develop allogeneic CAR T cell therapies for up to six unique antigen targets. One target was selected at the agreement’s inception. Upon selection of an antigen target under the agreement, we have agreed to perform early-stage research and development on individual T cell modifications for the selected target, develop the resulting therapeutic product candidates through Phase 1 clinical trials and prepare clinical trial material of such product candidates for use in Phase 2 clinical trials. We received an upfront payment of $105.0 million under the Servier Agreement. We have the ability to receive total payments, including the upfront payment, option fees and milestone payments, in the aggregate across all six targets, of up to approximately $1.6 billion. This includes up to $1.5 billion in milestone payments, consisting of up to $401.3 million in development milestone payments and up to $1.1 billion in commercial milestone payments. We are also entitled to receive tiered royalties ranging from the mid-single digit percentages to the sub-teen percentages on worldwide net sales, subject to potential customary reductions. We also have the right to participate in the development and commercialization of any licensed products resulting from the collaboration through a 50/50 co-development and co-promotion option in the United States, subject to our payment of an option fee, which is exercisable after Servier’s commercial option exercise. Under the Servier Agreement, we recognized $7.3 million and $5.8 million in revenues during the years ended December 31, 2019 and December 31, 2018, respectively. The amount recorded as deferred revenue was $80.9 million and $88.6 million as of December 31, 2019 and December 31, 2018, respectively. No development or sales-based milestones were received for the fiscal years ended December 31, 2019 or December 31, 2018. 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 product sales in the foreseeable future. We record revenue from collaboration agreements, including amounts related to upfront payments, annual fees for licenses of our intellectual property and research and development funding. 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. These include the following: • salaries, benefits and other related costs, including share-based compensation expense, for personnel engaged in research and development functions; • expenses incurred under agreements with third parties, including contract research organizations, or CROs, and other third parties that conduct preclinical research and development activities and clinical trials on our behalf; • costs of developing and scaling our manufacturing process and manufacturing drug products for use in our preclinical studies and ongoing and future clinical trials, including the costs of contract manufacturing organizations, or CMOs, and our MCAT facility that will manufacture our clinical trial material for use in our preclinical studies and ongoing and potential future clinical trials; • costs of outside consultants, including their fees and related travel expenses; • costs of laboratory supplies and acquiring, developing and manufacturing preclinical study and clinical trial materials; • license payments made for intellectual property used in research and development activities; and • facility-related expenses, which include direct depreciation costs and expenses for rent and maintenance of facilities and other operating costs if specifically identifiable to research activities. We expense research and development costs as incurred. We track external research and development costs, including the costs of laboratory supplies and services, outsourced research and development, clinical trials, contract manufacturing, laboratory equipment and maintenance and certain other development costs, by product candidate when the program IND application is accepted by the FDA. Internal and external costs associated with infrastructure resources, other research and development costs, facility related costs and depreciation and amortization that are not identifiable to a specific product candidate are included in the platform development, early-stage research and unallocated expenses category in the table below. The following table summarizes our research and development expenses by product candidate or development program for the periods presented: 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 and will comprise a larger percentage of our total expenses as we continue our Phase 1/2a clinical trial for our CD19 product candidate, commence a Phase 1/2a clinical trial for our CD20 product candidate, commence a Phase 1/2a clinical trial for our BCMA product candidate, and continue to discover and develop additional product candidates. We cannot determine with certainty the duration and costs of ongoing and future clinical trials of our CD19, CD20, and BCMA product candidates, 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 duration, costs and timing of clinical trials and development of our CD19, CD20, and BCMA product candidates, and any other our product candidate we may develop will depend on a variety of factors, including: • the scope, rate of progress, expense and results of clinical trials of our CD19, CD20, and BCMA product candidates, as well as of any future clinical trials of other product candidates and other research and development activities that we may conduct; • uncertainties in clinical trial design and patient enrollment rates; • the actual probability of success for our product candidates, including their safety and efficacy, early clinical data, competition, manufacturing capability and commercial viability; • significant and changing government regulation and regulatory guidance; • the timing and receipt of any marketing approvals; and • the expense of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights. 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 slower than expected 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 share-based compensation, for personnel in our executive, finance, business development, operations 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 expenses for rent and maintenance of facilities and other operating costs that are not specifically attributable to research activities. We expect that our general and administrative expenses will increase in the future as we increase our personnel headcount to support our continued research activities and development of 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 SEC requirements; director and officer insurance costs; and investor and public relations costs. Change in Fair Value of Convertible Notes Payable We elected on issuance to account for the convertible notes payable we issued in March 2019, or the 2019 Notes, at fair value until their settlement. The change in fair value of the 2019 Notes was recognized through the statement of operations. The 2019 Notes settled into 2,921,461 shares of common stock on the closing of our IPO on April 1, 2019. Interest Expense Interest expense consists of interest from the 2019 Notes at a rate of 6% per annum. Interest Income Interest income consists of interest income earned on our cash and cash equivalents. Income Taxes Since our inception in 2006, we have generated cumulative federal and state net operating loss and R&D credit carryforwards for which we have not recorded any net tax benefit due to the uncertainty around utilizing these tax attributes within their respective carryforward periods. As of December 31, 2019, we had federal, state, and foreign net operating loss carryforwards of $101.3 million, $101.7 million, and $0.4 million, respectively, which may be available to offset future taxable income. The U.S. federal net operating loss carryforwards of $19.7 million will begin to expire in 2030 while the remaining federal net operating loss carryforwards of $81.6 million carry forward indefinitely. The state net operating loss carryforwards begin to expire in 2025. As of December 31, 2019, we also had federal research and development tax credit carryforwards of $7.2 million, which begin to expire in 2027. As of December 31, 2019 and December 31, 2018, we had federal Orphan Drug credits of $1.8 million and $0.7 million, respectively, which begin to expire in 2038. As of December 31, 2019, we also have federal contribution carryforwards of $0.1 million, which begin to expire in 2020. We have recorded a full valuation allowance against our net deferred tax assets at each balance sheet date. On December 22, 2017, 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 a 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, 2019 and December 31, 2018 The following table summarizes our results of operations for the years ended December 31, 2019 and December 31, 2018, together with the changes in those items in dollars: Revenue Revenue for the year ended December 31, 2019 was $22.2 million, compared to $10.9 million for the year ended December 31, 2018. The increase of $11.3 million in revenue during the year ended December 31, 2019 was primarily the result of a $9.6 million increase in research revenue recognized from Gilead as 2019 was the first full year of revenue recognized under the Gilead agreement initiated in September 2018 and a $1.5 million increase in collaboration revenue recognized from Servier. Research and Development Expenses Research and development expenses for the year ended December 31, 2019 were $82.4 million, compared to $45.1 million for the year ended December 31, 2018. The increase of $37.3 million was primarily due to a $31.9 million increase in platform development, early-stage research and unallocated expenses, a $9.4 million and $4.9 million increase in direct research and development expenses related to our CD20 and BCMA programs, respectively, partially offset by a decrease in direct research and development expenses related to our CD19 program of $8.9 million. The increase in direct research and development expenses for our CD20 and BCMA programs was due to increases in lab services and CMO and research organization costs as we prepare to enter planned Phase 1/2a clinical trials in 2020. This was partially offset by a decrease in our CD19 expenses primarily due to lower spending on CMO and research organization costs. Platform development, early-stage research and unallocated expenses increased primarily due to a $11.6 million increase in employee-related costs associated with increased headcount to support our technology platform development and manufacturing capabilities, a $7.6 million increase in laboratory supplies and services, a $5.4 million increase in outsourced research and development spending and $2.4 million increase in depreciation and amortization in the year ended December 31, 2019 compared to the year ended December 31, 2018. General and Administrative Expenses General and administrative expenses were $27.0 million for the year ended December 31, 2019 compared to $13.7 million for the year ended December 31, 2018. The increase of $13.3 million was primarily due to an increase of $6.2 million in employee-related costs as we increased our general and administrative headcount, $2.7 million in consulting fees, $2.1 million in increased administrative costs, including insurance, franchise and property taxes, bank fees, and costs related to operating as a public company, and $1.4 million in facility related costs. Change in Fair Value of Convertible Notes Payable We elected on issuance to account for the 2019 Notes at fair value until their settlement. For the year ended December 31, 2019, we recognized $9.8 million of expense as changes in fair value. The 2019 Notes were settled on the closing of the IPO in April 2019. Interest Expense Interest expense of $0.2 million for the year ended December 31, 2019 consists of interest from the 2019 Notes at a rate of 6% per annum. Interest Income Interest income was $4.3 million for the year ended December 31, 2019 compared to $1.9 million for the year ended December 31, 2018. The increase of $2.4 million of interest income generated on our cash and cash equivalent balances was the result of lower interest rates and having higher cash balances invested in the year ended December 31, 2019 compared to the year ended December 31, 2018. Segment Results The following tables summarize segment revenues and segment operating loss (see Note 13 to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K for additional information regarding our segments): We evaluate the operating performance of each segment based on segment operating loss. Segment operating loss is derived by deducting operational cash expenditures, net, from GAAP revenue. Operational cash expenditures are cash disbursements made that are specifically identifiable to the reportable segment (including specifically identifiable research and development and property, equipment and software expenditures). For the year ended December 31, 2018, we allocated centralized research and development expenditures for early stage research, nuclease development and the purchase of general laboratory supplies to the Therapeutics and Food segments based on headcount. In January 2019, the Food segment moved into a new leased facility in Durham, North Carolina. We have determined that the Food segment is no longer deriving benefit from the Company’s centralized research and development expenditures, thus all these expenditures were allocated to the Therapeutics segment for the year ended December 31, 2019. The reportable segment and centralized research and development operational cash expenditures include cash disbursements for compensation, laboratory supplies, purchases of property, equipment and software and procuring services from CROs, CMOs and research organizations. We do not allocate general operational expenses or non-cash income statement amounts to our reportable segments. Therapeutics Segment Revenue for the year ended December 31, 2019 was $20.6 million, compared to $9.5 million for the year ended December 31, 2018. The increase of $11.1 million was primarily the result of a $9.6 million increase in research funding from Gilead and $1.5 million increase in revenue from Servier. Segment operational cash expenditures for the year ended December 31, 2019 were $45.9 million, compared to $35.0 million for the year ended December 31, 2018. The increase of $10.9 million in operational cash expenditures was primarily due to an increase in payments made to service providers for contract manufacturing and clinical trial research, laboratory supplies and services, employee headcount and fixed assets for the build out of our manufacturing capabilities, offset by a decrease in payments made to the University of Pennsylvania, which is early stage research and not considered specific to any one therapeutic area. As a result, these payments were classified as centralized research and development expenditures in the year ended December 31, 2019 as opposed to being classified as Therapeutics operational cash expenditures in the year ended December 31, 2018. Segment operating loss increased $12.3 million from $37.1 million for the year ended December 31, 2018 to $49.4 million for the year ended December 31, 2019 primarily due to the factors discussed above. Food Segment Revenue for the year ended December 31, 2019 was $1.6 million, compared to $1.4 million for the year ended December 31, 2018. The increase of $0.2 million was primarily attributable to $0.4 million from a new customer agreement with a collaboration partner entered into during the year ended December 31, 2019 offset by a $0.2 million decrease in revenue from a collaboration partner. Segment operational cash expenditures for the year ended December 31, 2019 were $7.0 million, compared to $9.1 million for the year ended December 31, 2018. The decrease of $2.1 million was primarily due to a decrease in leasehold improvements, which is attributable to large construction expenditures made in the year ended December 31, 2018 for work done to our leased facility that did not occur in the year ended December 31, 2019, as our Food segment moved into the facility in January 2019. This decrease in spending was offset by increases in laboratory equipment, furniture and fixtures, laboratory supplies, employee headcount and rent. Segment operating loss decreased $5.3 million from $10.7 million for the year ended December 31, 2018 to $5.4 million for the year ended December 31, 2019 primarily due to the factors discussed above. Liquidity and Capital Resources Since our inception, we have incurred significant operating losses. We expect to incur significant expenses and operating losses for the foreseeable future as we advance the preclinical and clinical development of our product candidates. We expect that our research and development and general and administrative costs will continue to increase, including in connection with conducting preclinical studies and clinical trials for our product candidates, contracting with CROs and CMOs, the addition of laboratory equipment to MCAT in support of preclinical studies and clinical trials, expanding our intellectual property portfolio and providing general and administrative support for our operations. As a result, we will need additional capital to fund our operations, which we may obtain from additional equity or debt financings, collaborations, licensing arrangements or other sources. We do not currently have any approved products and have never generated any revenue from product sales. We have financed our operations primarily with proceeds from our IPO, the sale of our convertible preferred stock and upfront payments from collaboration and licensing arrangements. On April 1, 2019, we completed our IPO of 9,085,000 shares of common stock, including the underwriters’ full exercise of their option to purchase an additional 1,185,000 additional shares of common stock, at an offering price of $16.00 per share, for net proceeds of approximately $130.5 million after deducting underwriting discounts and commissions and offering expenses payable by us. To date, we have generated approximately $475.4 million from third parties through a combination of financings including through our IPO, preferred stock and convertible note financings, an upfront payment under the Servier Agreement and additional funding from other strategic alliances and grants. In May 2019, we entered into a loan and security agreement (the “Pacific Western Loan Agreement”) with PWB pursuant to which we may request advances on a revolving line of credit of up to an aggregate principal of $50.0 million (the “Revolving Line”). The Pacific Western Loan Agreement was amended (the “PWB Amendment”) in December 2019 to allow the Company to maintain a bank account with a non-affiliated bank in the United Kingdom provided that the account balance does not exceed 1.5 million GBP or its U.S. dollar equivalent at any time. As of December 31, 2019, we had no borrowings under our Revolving Line and were in compliance with its financial covenants. Cash Flows Our cash and cash equivalents totaled $180.9 million as of December 31, 2019, compared to $103.2 million as of December 31, 2018. As of December 31, 2019, we had no borrowings under our revolving line of credit. The following table summarizes our sources and uses of cash for the periods presented: Cash Flows for the Year ended December 31, 2019 Operating Activities Net cash used in operating activities for the year ended December 31, 2019 was $71.0 million, driven primarily by our net loss of $92.9 million as we incurred expenses associated with our CD19, CD20, and BCMA programs, platform development and early-stage research, and general and administrative expenses, and a decrease in operating assets and liabilities of $2.4 million, partially offset by net non-cash expenses of $24.2 million. Investing Activities Net cash used in investing activities for the year ended December 31, 2019 was $24.7 million, which was attributable to purchases of property, equipment and software. Financing Activities Net cash provided by financing activities for the year ended December 31, 2019 was $173.4 million, consisting of $130.5 million in proceeds from our IPO, net of issuance costs, the net proceeds from the issuance of our 2019 Notes of $39.6 million, and $1.3 million in proceeds from stock option exercises. Debt Obligations In March 2019, we issued an aggregate principal amount of $39.6 million of 2019 Notes in a private placement transaction. Upon settlement, the change in fair value of the 2019 Notes was $9.8 million and the accrued interest on the 2019 Notes was $0.2 million. Pursuant to their terms, the 2019 Notes were settled in 2,921,461 shares of our common stock upon the closing of our IPO at a settlement price of $13.60 per share, which is equal to 85% of the IPO price per share. In May 2019, we entered into a loan and security agreement with Pacific Western Bank pursuant to which we may request advances on a $50.0 million revolving line of credit. Cash Flows for the Year Ended December 31, 2018 Operating Activities Net cash used in operating activities for the year ended December 31, 2018 was $51.7 million, primarily consisting of our net loss of $46.0 million as we incurred expenses associated with our CD19 program, platform development and early-stage research and general and administrative expenses. In addition, we had non-cash charges of $4.8 million for depreciation and amortization and share-based compensation expense. Net cash used in operating activities was also impacted by $10.5 million in changes in operating assets and liabilities, including $7.5 million in prepaid expenses, $3.2 million in deferred revenue, $0.5 million in accounts receivable, $0.7 million in accounts payable and $0.4 million in other current assets and other assets, which were partially offset by changes of $1.8 million in accrued expenses. Investing Activities Net cash used in investing activities for the year ended December 31, 2018 was $15.7 million, which was attributable to purchases of property, equipment and software of $14.3 million and the acquisition of intellectual property of $1.4 million. Financing Activities Net cash provided in financing activities for the year ended December 31, 2018 was $107.8 million, consisting of the net proceeds from the issuance of our Series B convertible preferred stock financing of $109.7 million, net of offering costs, and $0.2 million in proceeds from stock option exercises, partially offset by $2.1 million in payments for deferred offering costs associated with our initial public offering. Loan and Security Agreement In May 2019, we entered into the Pacific Western Loan Agreement pursuant to which we may request advances on a $50.0 million Revolving Line. The maturity date of the Revolving Line is May 15, 2022. The Revolving Line bears interest at an annual rate equal to the greater of (i) 1.25% below the prime rate then in effect, or (ii) 4.25% at all times when we maintain a daily balance of cash in our demand deposit accounts at PWB of at least $25.0 million, and the greater of (i) 0.25% above the prime rate then in effect; or (ii) 5.75% at all times when we do not maintain a daily balance of cash in demand deposit accounts at PWB of at least $25.0 million; provided that, we are permitted to maintain a bank account with a non-affiliated bank in the United Kingdom so long as the account balance does not exceed 1.5 million GBP or its U.S. dollar equivalent at any time, pursuant to the PWB Amendment. We are required to pay a fee in an amount equal to 0.50% per annum of the unused portion of the Revolving Line each quarter, or the Unused Fee. The Unused Fee shall be waived for any quarter in which we maintain a daily balance of cash in our demand deposit account at PWB of at least $25.0 million at all times during such quarter. If the Revolving Line is terminated prior to the maturity date, we are required to pay an early termination fee equal to 1.0% of the Revolving Line. Under the terms of the Pacific Western Loan Agreement, we granted PWB a security interest in substantially all of our assets, excluding any of the intellectual property now or hereafter owned, (but including any rights to payment from the sale or licensing of any such intellectual property). We must maintain an aggregate balance of unrestricted cash and cash equivalents on hand at PWB (or PWB’s affiliates) at least equal to any amounts borrowed under the Revolving Line and any other outstanding obligations the we have to PWB. The agreement was amended in December 2019 to allow a bank account with a non-affiliated bank in the United Kingdom provided that the account balance does not exceed 1.5 million GBP or its U.S. dollar equivalent at any time. The Agreement includes customary representations, warranties and covenants (affirmative and negative), and includes standard events of default, including in the event of a material adverse change. Upon the occurrence of an event of default, PWB may declare all outstanding obligations immediately due and payable and take such other actions as are set forth in the loan and security agreement and increase the interest rate otherwise applicable to the amount outstanding under the Revolving Line by an additional 3.00%. As of December 31, 2019, we had no borrowings under our Revolving Line, and we were in compliance with the financial covenants, under the Pacific Western Loan Agreement. Funding Requirements Our operating expenses increased substantially in 2019 and are expected to increase substantially in the future in connection with the initiation of additional human clinical trials and capital expenditures for MCAT. We believe our existing cash and cash equivalents, will enable us to fund our operating expenses and capital expenditure requirements into the second half of 2021. We have based these estimates on assumptions that may prove to be imprecise, and we could utilize our available capital resources sooner than we expect. Because of the numerous risks and uncertainties associated with research, development and commercialization of pharmaceutical and agricultural products, it is difficult to estimate with certainty the amount of our working capital requirements. Our future funding requirements will depend on many factors, including: • the progress, costs and results of our clinical development for our CD19, CD20, and BCMA programs as we initiate and progress clinical trials, including CRO costs; • the progress, costs and results of our additional research and preclinical development programs; • the outcome, timing and cost of meeting regulatory requirements established by the FDA and other comparable foreign regulatory authorities; • the costs and timing of internal process development and manufacturing scale-up activities and contract with CMOs associated with our CD19, CD20, and BCMA programs and other programs we advance through preclinical and clinical development; • our ability to establish and maintain strategic collaborations, licensing or other agreements and the financial terms of such agreements; • the scope, progress, results and costs of any product candidates that we may derive from ARCUS or any other product candidates we may develop alone or with collaborators; • the extent to which we in-license or acquire rights to other products, product candidates or technologies; • the costs and timing of preparing, filing and prosecuting patent applications, maintaining and protecting our intellectual property rights and defending against any intellectual property-related claims; and • the costs and timing of future commercialization activities, including product manufacturing, marketing, sales and distribution, for any product candidates for which we or our collaborators obtain marketing approval. 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 public or private equity or debt financings, collaboration agreements, other third-party funding, strategic alliances, licensing arrangements and marketing and/or distribution arrangements. To the extent that we raise additional capital through the sale of equity or convertible debt securities, shareholders’ ownership interest will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect the rights of our shareholders. 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 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, product development and 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 The following is a summary of our contractual obligations and commitments as of December 31, 2019: (1) Represents future minimum lease payments under our operating leases for office and/or lab space at the following locations: 302 East Pettigrew Street, Durham, North Carolina expiring in July 2024, 3054 Cornwallis Road, Durham, North Carolina expiring in April 2026 and 20 TW Alexander Drive, Research Triangle Park, North Carolina expiring in August 2027 (see Note 7 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for additional information on these lease agreements). (2) We have entered into a license agreement with an undisclosed licensee for intellectual property used in our research programs. The agreement requires us to pay annual license fees and milestones payments for achievement of specified clinical and commercial events. We have excluded these potential milestone payments in the contractual obligations table because the timing and likelihood of these contingent payments are not currently known and would be difficult to predict or estimate. (3) This table does not reflect principal and interest payments payable pursuant to our Pacific Western Loan Agreement. which we entered into in May 2019, pursuant to which we may request advances on a revolving line of credit of up to an aggregate principal of $50.0 million, or the Revolving Line. As of December 31, 2019, we had no borrowings under our Revolving Line. The maturity date of the Revolving Line is May 15, 2022. The Revolving Line bears interest at an annual rate equal to the greater of (i) 1.25% below the prime rate then in effect, or (ii) 4.25% at all times when we maintain a daily balance of cash in our demand deposit accounts at PWB of at least $25.0 million, and the greater of (i) 0.25% above the prime rate then in effect; or (ii) 5.75% at all times when we do not maintain a daily balance of cash in demand deposit accounts at PWB of at least $25.0 million. The Pacific Western Loan Agreement requires that we pay a quarterly fee in an amount equal to 0.50% per annum of the unused portion of the Revolving Line. The unused fee shall be waived for any quarter we maintain a daily balance in our demand deposit accounts of at least $25.0 million. If the Revolving Line is terminated prior to the maturity date, we are required to pay an early termination fee equal to 1.0% of the Revolving Line. In addition, we have entered into the Duke License, under which we are obligated to make aggregate future milestone payments of up to $0.2 million upon the achievement of specified corporate milestones as well as low-single digit percent royalty payments based on future net sales of applicable products and generally mid-teen percent royalties based on sublicensing revenue. See “Business-License and Collaboration Agreements” for more information regarding our payment obligations under the Duke License. We have not included future payments under the Duke License in the table above since the payment obligations under the Duke License are contingent upon future events, such as the achievement of specified milestones or generating product sales, and we are unable to estimate the timing or likelihood of achieving these milestones or generating future product sales. We also enter into contracts in the normal course of business with CROs, CMOs, universities 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. 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 accounting principles generally accepted in the United States (“GAAP”). 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 included 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 Our revenues are generated primarily through collaborative research, license, development and commercialization agreements. The terms of these agreements generally contain multiple elements, or deliverables, which may include (1) licenses, or options to obtain licenses, to use our technology, (2) research and development activities to be performed on behalf of the collaborative partner, and (3) in certain cases, services in connection with the manufacturing of preclinical and clinical material. Payments we receive under these arrangements typically include one or more of the following: non-refundable, upfront license fees; option exercise fees; funding of research and/or development efforts; clinical and development, regulatory, and sales milestone payments; and royalties on future product sales. We classify payments received under these agreements as revenues within our consolidated statements of operations. We adopted Accounting Standards Update, or ASU, No. 2014-09, Revenue from Contracts with Customers, or ASC 606, on January 1, 2019 using the modified retrospective transition method. Under this method, results for reporting periods beginning on January 1, 2019 are presented under ASC 606, while prior period amounts are not adjusted and continue to be reported in accordance with ASC Topic 605, Revenue Recognition (“ASC 605”). 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 evaluate the performance obligations promised in the contract that are based on goods and services that will be transferred to the customer and determine whether those obligations are both (i) capable of being distinct and (ii) distinct in the context of the contract. Goods or services that meet these criteria are considered distinct performance obligations. If both these criteria are not met, the goods and services are combined into a single performance obligation. 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 if these options provide a material right to the customer and, if so, these options are considered performance obligations. The exercise of a material right is accounted for as a contract modification for accounting purposes. We recognize 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. 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 are classified as deferred revenue within current liabilities in our consolidated balance sheets. Amounts not expected to be recognized as revenue within the 12 months following the balance sheet date are classified as deferred revenue - noncurrent. Amounts recognized as revenue, but not yet received or invoiced are generally recognized as contract assets in the Other line item in our consolidated balance sheets. Milestone Payments - If an arrangement includes development and regulatory 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 revenue reversal would not occur, the associated milestone value is included in the transaction price. 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 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 adjust consideration for the effects of the time value of money if the timing of payments provides us with a significant benefit of financing. We do not assess whether a contract has a significant financing component if the expectation at contract inception is such that the period between payment by the licensees and the transfer of the promised goods or services to the licensees will be one year or less. We assessed each of our revenue arrangements in order to determine whether a significant financing component exists and concluded that a significant financing component does not exist in any of our arrangements. Collaborative Arrangements - We have entered into collaboration agreements, which are within the scope of ASC 606, to discover, develop, manufacture and commercialize product candidates. The terms of these agreements typically contain multiple promises or obligations, which may include: (1) licenses, or options to obtain licenses, to use our technology, (2) research and development activities to be performed on behalf of the collaboration partner, and (3) in certain cases, services in connection with the manufacturing of preclinical and clinical material. Payments we receive under these arrangements typically include one or more of the following: non-refundable, upfront license fees; option exercise fees; funding of research and/or development efforts; clinical and development, regulatory, and sales milestone payments; and royalties on future product sales. We analyze our collaboration arrangements to assess whether they are within the scope of ASU No. 2018-18 Collaborative Arrangements, or 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. For collaboration arrangements within the scope of ASC 808 that contain multiple elements, we first determine which elements of the collaboration are deemed to be within the scope of ASC 808 and those that are more reflective of a vendor-customer relationship and, therefore, are within the scope of ASC 606. For elements of collaboration arrangements that are accounted for pursuant to ASC 808, an appropriate recognition method is determined and applied consistently, generally by analogy to ASC 606. For those elements of the arrangement that are accounted for pursuant to ASC 606, we apply the five-step model described above. In February 2016, we entered into the Servier Agreement for the licensing of our ARCUS proprietary genome editing platform and the research, development, and manufacturing of product for clinical trials and commercialization of products. In September 2018, we entered into a collaboration and license agreement with Gilead, which we refer to as the Gilead Agreement, to develop genome editing tools using our ARCUS proprietary genome editing platform. Both agreements use our genome editing technology for the treatment of certain diseases. Consideration we received, or may receive, under these collaboration and license agreements include upfront nonrefundable payments, research funding payments and payments based upon the achievement of certain milestones and royalties on any resulting net product sales. Under the guidance of ASC 606, certain judgments affect revenue recognition. Our primary performance obligations under our agreements consist of research and development services. Measuring the amount of time it takes for us to complete these services includes estimating our total effort to satisfy our performance obligations at the outset of the agreement and then comparing that amount to the actual effort expended for a given accounting period. In certain instances, significant judgment is required to estimate the timing of satisfying these obligations and timing may change due to efforts beyond our control, such as changes in the customer’s direction of a particular research program or changes to the contractual terms of an agreement. Accordingly, our estimates may change in the future. Such changes to estimates will result in a change in prospective revenue recognition amounts. 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 costs incurred for the services when we have not yet been invoiced or otherwise notified of the 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 our consolidated financial statements based on facts and circumstances known to us at that time. Examples of estimated accrued research and development expenses include fees paid to the following: • CROs and other third parties in connection with performing research and development activities, conducting preclinical studies and clinical trials on our behalf; • Vendors in connection with preclinical development activities; and • CMOs and other vendors in connection with product manufacturing and development and distribution of preclinical supplies. We base our expenses related to preclinical studies on our estimates of the services received and efforts expended pursuant to quotes and contracts with CROs that conduct and manage preclinical studies and clinical trials and CMOs that manufacture product for our research and development activities 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. In accruing 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 amount of 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 cause us to report amounts that are too high or too low in any particular period. To date, we have not made any material adjustments to our prior estimates of accrued research and development expenses. Share-Based Compensation We measure stock options and other share-based awards granted to our employees, directors, consultants and advisors based on the fair value on the date of the grant and recognize compensation expense for those awards, net of actual forfeitures, over the requisite service period, which is generally the vesting period of the respective award. We estimate the fair value of each stock option grant on the date of grant using the Black-Scholes option-pricing model, which 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 stock options, the risk-free interest rate for a period that approximates the expected term of our stock options and our expected dividend yield. As we have limited trading history, we estimate our expected volatility based on the historical volatility of publicly traded peer companies and expect to continue to do so until such time as we have adequate historical data regarding the volatility of our traded share price. The expected term of our options has been determined utilizing a weighted value considering actual history and estimated expected term based on the midpoint of final vest date and expiration date. 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 we have never paid cash dividends and do not expect to pay any cash dividends in the foreseeable future. Recent Accounting Pronouncements A description of recent accounting pronouncements that may potentially impact our financial position, results of operations or cash flows is disclosed in Note 1 to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-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 under SEC rules. Emerging Growth Company Status We are an “emerging growth company,” as defined in the JOBS Act, and we may take advantage of reduced reporting requirements that are otherwise applicable to public companies. Section 107 of the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies are required to comply with those standards. We have elected to take advantage of the extended transition period for complying with new or revised accounting standards. The JOBS Act also exempts us from having to provide an auditor attestation of internal control over financial reporting under Sarbanes-Oxley Act Section 404(b). We will remain an “emerging growth company” until the earliest of (1) the last day of the fiscal year in which we have total annual gross revenues of $1.07 billion or more, (2) the last day of the fiscal year following the fifth anniversary of the completion of our IPO, (3) the date on which we have issued more than $1.0 billion in nonconvertible debt during the previous three years or (4) the date on 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 held by non-affiliates exceeds $700 million as of the prior June 30th, we have been a public company for at least 12 months and have filed one Annual Report on Form 10-K.

<s>[INST] Overview We are a life sciences company dedicated to improving life through the application of our pioneering, proprietary ARCUS genome editing platform. We leverage ARCUS in the development of our product candidates, which are designed to treat human diseases and create healthy and sustainable food and agricultural solutions. We are actively developing product candidates in three innovative areas: allogeneic CAR T cell immunotherapy, in vivo gene correction, and food. We are currently conducting a Phase 1/2a clinical trial of PBCAR0191 in adult patients with relapsed or refractory, or R/R, nonHodgkin lymphoma, or NHL, or R/R Bcell precursor acute lymphoblastic leukemia, or BALL. PBCAR0191 is our first geneedited allogeneic chimeric antigen receptor, or CAR, T cell therapy candidate targeting CD19 and is being developed in collaboration with Les Laboratoires Servier, or Servier. We have received orphan drug designation for PBCAR0191 from the U.S. Food and Drug Administration, or FDA, for the treatment of ALL. Made from donorderived T cells modified using our ARCUS genome editing technology, PBCAR0191 recognizes the well characterized tumor cell surface protein CD19, an important and validated target in several Bcell cancers, and is designed to avoid graftversushost disease, or GvHD, a significant complication associated with donorderived, cellbased therapies. We believe that this trial, which is designed to assess the safety and tolerability of PBCAR0191 at increasing dose levels, as well as to evaluate antitumor activity, is the first U.S.based clinical trial to evaluate an allogeneic CAR T therapy for R/R NHL. Furthermore, we believe that our proprietary, onestep engineering process for producing allogeneic CAR T cells with a potentially optimized cell phenotype, at large scale in a costeffective manner, will enable us to overcome the fundamental clinical and manufacturing challenges that have limited the CAR T field to date. In December 2019, we announced initial data from this ongoing Phase 1/2a clinical trial of PBCAR0191 in adult patients with R/R NHL and R/R BALL. A total of nine adult patients were reported in these initial Phase 1 trial results, including six with NHL (three treated at Dose Level 1 (3x105 cells/kg), or DL1, and three treated at Dose Level 2 (1x106 cells/kg), or DL2), and three with BALL (all treated at DL2). These data indicated no serious adverse events or dose limiting toxicities. In the NHL cohort, four of six patients demonstrated an objective tumor response by Lugano criteria at day 28, for an overall objective response rate of 67%, including three partial responses and one complete response. In the ALL cohort, one of three patients achieved a complete response at day 28 following treatment with PBCAR0191. As of December 31, 2019, dosing of patients at Dose Level 3 (3x106 cells/kg) was underway. Based on the data observed at DL1 and DL2, we filed a protocol amendment for this trial with the FDA in December 2019. The amended trial design is intended to specifically address key clinical questions. These include assessing the impact of higher total doses of cells on clinical activity and/or the impact of modified lymphodepletion on the ability to achieve durable clinical benefit with associated CAR T cell expansion and persistence. Following feedback from the FDA in late January 2020, the protocol amendment is now being implemented. In September 2019, the FDA accepted our investigational new drug, or IND, application for our second allogeneic CAR T cell therapy product candidate, PBCAR20A, for which we expect to commence a Phase 1/2a clinical trial in the first quarter of 2020. PBCAR20A is wholly owned by us and targets the validated tumor cell surface target CD20. It will be investigated in subjects with NHL, [/INST] Negative. </s>

Malo Holdings Corp

2020-03-30

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation. Overview of our Business Malo Holdings Corporation was incorporated in the State of Delaware on December 27, 2018. Since inception, the Company has been engaged in organizational efforts and obtaining initial financing. The Company was formed as a vehicle to pursue a business combination through the acquisition of, or merger with, an operating business. The Company filed a registration statement on F orm 10 with the SEC on March 14, 2019, and since its effectiveness, the Company has focused its efforts to identify a possible business combination. The Company is currently considered to be a “blank check” company. The SEC defines those companies as “any development stage company that is issuing a penny stock, within the meaning of Section 3(a)(51) of the Exchange Act, and that has no specific business plan or purpose, or has indicated that its business plan is to merge with an unidentified company or companies.” Many states have enacted statutes, rules and regulations limiting the sale of securities of “blank check” companies in their respective jurisdictions. The Company is also a “shell company,” defined in Rule 12b-2 under the Exchange Act as a company with no or nominal assets (other than cash) and no or nominal operations. Management does not intend to undertake any efforts to cause a market to develop in our securities, either debt or equity, until we have successfully concluded a business combination. The Company intends to comply with the periodic reporting requirements of the Exchange Act for so long as we are subject to those requirements. In addition, the Company is an “emerging growth company,” as defined in the JOBS Act, and may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not “emerging growth companies,” including, but not limited to, the exemptions from the auditor attestation requirements of section 404(b) of the Sarbanes-Oxley Act and exemptions from the requirements of Sections 14A(a) and (b) of the Exchange Act, which require a nonbinding advisory vote of shareholders on executive compensation and any golden parachute payments not previously approved. The Company has also elected to use the extended transition period for complying with new or revised accounting standards under Section 102(b)(1) of the JOBS Act. This election allows us to 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. As a result of this election, our financial statements may not be comparable to companies that comply with public company effective dates. We will remain an “emerging growth company” until the earliest of (1) the last day of the fiscal year during which our revenues equal $1.07 billion or more, (2) the date on which we issue more than $1 billion in non-convertible debt in a three year period, (3) the last day of the fiscal year following the fifth anniversary of the date of the first sale of our common equity securities pursuant to an effective registration statement filed pursuant to the Securities Act, or (4) when the market value of our common stock that is held by non- affiliates exceeds $700 million as of the last business day of our most recently completed second fiscal quarter. To the extent that we continue to qualify as a “smaller reporting company,” under the amended definition of Rule 12b-2 under the Exchange Act, after we cease to qualify as an emerging growth company, certain of the exemptions available to us as an emerging growth company may continue to be available to us as a smaller reporting company, including: (1) not being required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes Oxley Act; (2) scaled executive compensation disclosures; and (3) the requirement to provide only two years of audited financial statements, instead of three years. The Company was organized as a vehicle to investigate and, if such investigation warrants, acquire a target company or business seeking the perceived advantages of being a publicly held corporation. The Company’s principal business objective for the next 12 months and beyond such time will be to achieve long-term growth potential through a combination with an operating business. The Company will not restrict its potential candidate target companies to any specific business, industry or geographical location and, thus, may acquire any type of business. The Company currently does not engage in any business activities that provide cash flow. During the next twelve months, we anticipate incurring costs related to: (i) filing Exchange Act reports, and (ii) investigating, analyzing and consummating an acquisition. We believe we will be able to meet these costs through the use of funds to be loaned by or invested in us by our stockholders, management or other investors. As of December 31, 2019, the Company had $224 in cash. There are no assurances that the Company will be able to secure any additional funding as needed. Currently, however, our ability to continue as a going concern is depends on our ability to generate future profitable operations and/or to obtain the necessary financing to meet our obligations and repay our liabilities arising from normal business operations when they come due. Our ability to continue as a going concern further depends on our ability to find a suitable target company and enter into a possible reverse merger with such company. Management’s plan includes obtaining additional funds by equity financing through a reverse merger transaction and/or related party advances, however, there is no assurance of additional funding being available. The Company may consider acquiring a business that has recently commenced operations, is a developing company in need of additional funds for expansion into new products or markets, is seeking to develop a new product or service, or is an established business that may be experiencing financial or operating difficulties and is in need of additional capital. In the alternative, a business combination may involve the acquisition of, or merger with, a company that does not need substantial additional capital, but that desires to establish a public trading market for its shares while avoiding, among other things, the time delays, significant expense, and loss of voting control that may occur in a public offering. Any target business that is selected may be a financially unstable company or an entity in its early stages of development or growth, including entities without established records of sales or earnings. In that event, we will be subject to numerous risks inherent in the business and operations of financially unstable and early stage or potential emerging growth companies. In addition, we may effect a business combination with an entity in an industry characterized by a high level of risk. Although our management will endeavor to evaluate the risks inherent in a particular target business, there can be no assurance that we will properly ascertain or assess all significant risks. Our management anticipates that it will likely be able to effect only one business combination, due primarily to our limited financing and the dilution of interest for present and prospective stockholders, which is likely to occur as a result of our management’s plan to offer a controlling interest to a target business in order to achieve a tax-free reorganization. This lack of diversification should be considered a substantial risk in investing in us, because it will not permit us to offset potential losses from one venture against gains from another. The Company anticipates that the selection of a business combination will be complex and extremely risky. Our management believes that there are numerous firms seeking the perceived benefits of becoming a publicly traded corporation. Such perceived benefits of becoming a publicly traded corporation include, among other things, facilitating or improving the terms on which additional equity financing may be obtained, providing liquidity for the principals of and investors in a business, creating a means for providing incentive stock options or similar benefits to key employees, and offering greater flexibility in structuring acquisitions, joint ventures and the like through the issuance of stock. Potentially available business combinations may occur in many different industries and at various stages of development, all of which will make the task of comparative investigation and analysis of such business opportunities extremely difficult and complex. As of the date of this Form 10-K, the Company has not entered into any definitive agreement with any party, nor have there been any specific discussions with any potential business combination candidate regarding business opportunities for the Company. COVID-19 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.” On March 11, 2020, the World Health Organization characterized the COVID-19 virus as a global pandemic. 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, which is 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. Liquidity and Capital Resources As of December 31, 2019, the Company had total assets equal to $224, comprised exclusively of cash. This compares with total assets of $25, comprised exclusively of a stock subscription receivable, as of December 31, 2018. The Company’s current liabilities totaled $68,683, as of December 31, 2019, which comprised of accrued expenses and amounts due to a related party. This compares to the Company’s total current liabilities of $34,548, comprised of accrued expenses and amounts due to a related party, as of December 31, 2018. The Company can provide no assurance that it can continue to satisfy its cash requirements for at least the next twelve months. The following is a summary of the Company’s cash flows provided by (used in) operating and financing activities for the year ended December 31, 2019 and for the period from December 27, 2018 (inception) to December 31, 2018: The Company has only cash assets and has generated no revenues since inception. The Company also depends on the receipt of capital investment or other financing to fund its ongoing operations and to execute its business plan of seeking a combination with a private operating company. In addition, the Company is depends on certain related parties to provide continued funding and capital resources. If continued funding and capital resources are unavailable at reasonable terms, the Company may not be able to implement its plan of operations. Issuance of Promissory Note to a Stockholder and Director On December 27, 2018, in connection with advances made in connection with costs incurred by the Company, the Company issued a promissory note to Mark Tompkins, a stockholder and director of the Company pursuant to which the Company agreed to repay Mr. Tompkins the sum of any and all amounts that Mr. Tompkins may advance to the Company on or before the date that the Company consummates a business combination with a private company or reverse takeover transaction or other transaction after which the Company would cease to be a shell company (as defined in Rule 12b-2 under the Exchange Act). Although Mr. Tompkins has no obligation to advance funds to the Company under the terms of the note, it is anticipated that he may advance funds to the Company as fees and expenses are incurred in the future. As a result, the Company issued the note in anticipation of such advances. Interest shall accrue on the outstanding principal amount of the note on the basis of a 360-day year from the date of borrowing until paid in full at the rate of six percent (6%) per annum. In the event that an Event of Default (as defined in the note) has occurred, the entire note shall automatically become due and payable (the “Default Date”), and starting from five (5) days after the Default Date, the interest rate on the note shall accrue at the rate of eighteen percent (18%) per annum. As of December 31, 2019, the total amount due was $68,683 including accrued interest of $3,173. The note is attached hereto as Exhibit 4.1. Results of Operations The Company has not conducted any active operations since inception, except for its efforts to locate suitable acquisition candidates. No revenue has been generated by the Company from December 27, 2018 (Inception), through December 31, 2019. It is unlikely the Company will have any revenues unless it is able to effect an acquisition or merger with an operating company, of which there can be no assurance. It is management’s assertion that these circumstances may hinder the Company’s ability to continue as a going concern. The Company’s plan of operation for the next twelve months shall be to continue its efforts to locate suitable acquisition candidates. For the year ended December 31, 2019 and the period from December 27, 2018 (inception) to December 31, 2018, the Company had a net loss of $33,936 and $35,023, respectively, comprised of legal, accounting, audit and other professional service fees incurred in relation to the preparation and filing of the Company’s periodic reports, general and administrative expenses, and interest expense. Off-Balance Sheet Arrangements The Company does not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. Contractual Obligations As a “smaller reporting company” defined by Item 10 of Regulation S-K, the Company is not required to provide this information. Emerging Growth Company As an “emerging growth company” under the JOBS Act, the Company has elected to use the extended transition period for complying with new or revised accounting standards under Section 102(b)(1) of the JOBS Act. This election allows us to 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. As a result of this election, our financial statements may not be comparable to companies that comply with public company effective dates. Fiscal Year Our fiscal year ends on December 31.

<s>[INST] Malo Holdings Corporation was incorporated in the State of Delaware on December 27, 2018. Since inception, the Company has been engaged in organizational efforts and obtaining initial financing. The Company was formed as a vehicle to pursue a business combination through the acquisition of, or merger with, an operating business. The Company filed a registration statement on F orm 10 with the SEC on March 14, 2019, and since its effectiveness, the Company has focused its efforts to identify a possible business combination. The Company is currently considered to be a “blank check” company. The SEC defines those companies as “any development stage company that is issuing a penny stock, within the meaning of Section 3(a)(51) of the Exchange Act, and that has no specific business plan or purpose, or has indicated that its business plan is to merge with an unidentified company or companies.” Many states have enacted statutes, rules and regulations limiting the sale of securities of “blank check” companies in their respective jurisdictions. The Company is also a “shell company,” defined in Rule 12b2 under the Exchange Act as a company with no or nominal assets (other than cash) and no or nominal operations. Management does not intend to undertake any efforts to cause a market to develop in our securities, either debt or equity, until we have successfully concluded a business combination. The Company intends to comply with the periodic reporting requirements of the Exchange Act for so long as we are subject to those requirements. In addition, the Company is an “emerging growth company,” as defined in the JOBS Act, and may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not “emerging growth companies,” including, but not limited to, the exemptions from the auditor attestation requirements of section 404(b) of the SarbanesOxley Act and exemptions from the requirements of Sections 14A(a) and (b) of the Exchange Act, which require a nonbinding advisory vote of shareholders on executive compensation and any golden parachute payments not previously approved. The Company has also elected to use the extended transition period for complying with new or revised accounting standards under Section 102(b)(1) of the JOBS Act. This election allows us to 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. As a result of this election, our financial statements may not be comparable to companies that comply with public company effective dates. We will remain an “emerging growth company” until the earliest of (1) the last day of the fiscal year during which our revenues equal $1.07 billion or more, (2) the date on which we issue more than $1 billion in nonconvertible debt in a three year period, (3) the last day of the fiscal year following the fifth anniversary of the date of the first sale of our common equity securities pursuant to an effective registration statement filed pursuant to the Securities Act, or (4) when the market value of our common stock that is held by non affiliates exceeds $700 million as of the last business day of our most recently completed second fiscal quarter. To the extent that we continue to qualify as a “smaller reporting company,” under the amended definition of Rule 12b2 under the Exchange Act, after we cease to qualify as an emerging growth company, certain of the exemptions available to us as an emerging growth company may continue to be available to us as a smaller reporting company, including: (1) not being required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes Oxley Act; (2) scaled executive compensation disclosures; and (3) the requirement to provide only two years of audited financial statements, instead of three years. The Company was organized as a vehicle to investigate and, if such investigation warrants, acquire a target company or business seeking the perceived advantages of being a publicly held corporation. The Company’s principal business objective for the next 12 months and beyond such time will be to achieve longterm growth potential through a combination with an operating business. The Company will not restrict its potential candidate target companies to any specific business, industry or geographical location and, thus, may acquire any type of business. The Company currently does not engage [/INST] Positive. </s>

SmileDirectClub, 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 results of operations should be read in conjunction with our consolidated financial statements and related notes thereto included elsewhere in this Annual Report on Form 10-K. In addition to historical consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates, and beliefs. Our actual results could differ materially from those discussed in any 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 “Risk Factors.” See “Cautionary Statement Regarding Forward-Looking Statements.” We are the industry pioneer as the first direct-to-consumer medtech platform for transforming smiles. Through our cutting-edge teledentistry technology and vertically integrated model, we are revolutionizing the oral care industry. Our direct-to-consumer model provides members with a customized clear aligner therapy treatment delivered directly to their doors. We integrate marketing, aligner manufacturing, and fulfillment, and provide a proprietary web-based teledentistry platform for the monitoring of treatment by licensed dentists and orthodontists through the completion of a member’s treatment. We are headquartered in Nashville, Tennessee and have locations throughout the U.S, Puerto Rico, Canada, Australia, New Zealand, the U.K., Ireland, Hong Kong, and Costa Rica. Key Business Metrics We review the following key business metrics to evaluate our business performance: Unique aligner order shipments For the years ended December 31, 2019 and 2018, we shipped 453,053 and 258,278 unique aligner orders, respectively. Each unique aligner order shipment represents a single contracted member. We believe that our ability to increase the number of aligner orders shipped is an indicator of our market penetration, growth of our business, consumer interest, and our member conversion. Average aligner gross sales price We define average gross sales price (‘‘ASP”) as gross revenue, before implicit price concession and other variable considerations and exclusive of sales tax, from aligner orders shipped divided by the number of unique aligner orders shipped. We believe ASP is an indicator of the value we provide to our members and our ability to maintain our pricing. Our ASP for the years ended December 31, 2019 and 2018 was $1,771 and $1,764, respectively. Our ASP is less than our standard $1,895 price as a result of discounts offered to select members. Key Factors Affecting Our Performance We believe that our future performance will depend on many factors, including those described below and in the section titled “Risk Factors” included elsewhere in this Form 10-K. Efficient acquisition of new members • Visits to our website: On average, we have approximately five million unique visitors to our website each month, and we expect to continue to invest heavily in sales and marketing to spread awareness and increase the number of individuals visiting our website. We increase our marketing spend at certain periods of the year, such as January, when members typically have a higher focus on aesthetics. • Conversions from visits to aligner orders: From our website, individuals can either sign up for a SmileShop appointment or order a doctor prescribed impression kit to evaluate and ultimately purchase our clear aligner treatment. We expect to continue to invest heavily in our proprietary technology platform, operations, and other processes to improve member conversion from website visit through SmileShop appointment booking, appointment attendance, and aligners ordered; and a similar process for our impression kits. SmilePay We offer SmilePay, a convenient monthly payment plan, to maximize accessibility and provide an affordable option for all of our members. The $250 down payment for SmilePay covers our cost of manufacturing the aligners, and the interest income generated by SmilePay helps offset the negative impact of delinquencies and cancellations. A number of factors affect delinquency and cancellation rates, including member-specific circumstances, our efforts in member service and management, and the broader macroeconomic environment. Continued investment in controlled growth We intend to continue investing in our business to support future growth by focusing on strategies that best address our large market opportunity, both domestically and internationally. Our key investment initiatives include continued advancement in automating and streamlining our manufacturing and treatment planning operations to allow us to stay ahead of consumer demand, continued discipline around marketing and selling investments, including a focus on pushing more demand through existing SmileShops, enhancing our existing product platform, and introducing new products to further differentiate our offerings. Additionally, we intend to continue to develop a suite of ancillary products for our members’ oral care needs, lengthening our relationship with our members and enhancing our recurring revenue base. As part of these key investment initiatives, we will also continue to explore collaborations with retailers and other third-party partnerships as a component of our expansion strategy. International expansion We will continue to make significant investments to expand our presence in international markets, particularly in Europe, Asia-Pacific, and other geographies. Pace of adoption for teledentistry The rate of adoption of teledentistry will impact our ability to acquire new members and grow our revenue. Components of Operating Results Revenues Our revenues are derived primarily from sales of aligners, impression kits, whitening gel, and retainers, and interest earned on SmilePay. Revenues are recorded based on the amount that is expected to be collected, which considers implicit price concessions, discounts, and returns. Revenues includes revenue recognized from orders shipped in the current period, as well as deferred revenue recognized from orders in prior periods. We offer our members the option of paying the entire $1,895 cost of their treatment upfront or enrolling in SmilePay, our convenient monthly payment plan requiring a $250 down payment and an average monthly payment of $85 for 24 months. Financing revenue includes interest earned on SmilePay aligner orders shipped in prior periods. Our average APR is approximately 17%, which is included in the $85 monthly payment. Cost of revenues Cost of revenues includes the total cost of products produced and sold. Such costs include direct materials, direct labor, overhead costs (occupancy costs, indirect labor, and depreciation), fees retained by doctors, freight and duty expenses associated with moving materials from vendors to our facilities and from our facilities to our members, and adjustments for shrinkage (physical inventory losses), lower of cost or net realizable value, slow moving product, and excess inventory quantities. We manufacture all of our aligners and retainers in our manufacturing facilities. We have built extensive supply chain mechanisms that allow us to quickly and accurately create treatment plans and manufacture aligners. Marketing and selling expenses Our marketing expenses include costs associated with an omni-channel approach supported by media mix modeling (MMM) and multitouch attribution modeling (MTA). These costs include online sources, such as social media and paid search, and offline sources, such as television, experiential events, local events, and business-to-business partnerships. We also have comprehensive strategies across search engine optimization, customer relationship management (CRM) marketing, and earned and owned marketing. We have invested significant resources into optimizing our member conversion process. Our selling costs include both labor and non-labor expenses associated with our SmileShops and costs associated with our sales and scheduling teams in our customer contact center. Non-labor costs associated with our SmileShops include rent, travel, supplies, and depreciation costs associated with digital photography equipment, furniture, and computers, among other costs. General and administrative expenses General and administrative expenses include payroll and benefit costs for corporate team members, equity-based compensation expenses, occupancy costs of corporate facilities, bank charges, costs associated with credit and debit card interchange fees, outside service fees, and other administrative costs, such as computer maintenance, supplies, travel, and lodging. Interest and other expenses Interest expense includes interest from our financing agreements and other long-term indebtedness. Other expense includes fair value adjustments on our derivative financial instruments, disposal of long-lived assets, and losses from the extinguishment of previous financing agreements. Provision for income tax expense We are subject to U.S. federal, state, and local income taxes with respect to our allocable share of any taxable income of SDC Financial, and we are taxed at the prevailing corporate tax rates. In addition to tax expenses, we also incur tax expenses related to our operations, as well as payments under the Tax Receivable Agreement. We receive a portion of any distributions made by SDC Financial. Any cash received from such distributions from our subsidiaries will first be used by us to satisfy any tax liability and then to make any payments required under the Tax Receivable Agreement. See Note 7. Adjusted EBITDA To supplement our consolidated financial statements presented in accordance with GAAP, we also present Adjusted EBITDA, a financial measure which is not based on any standardized methodology prescribed by GAAP. We define Adjusted EBITDA as net loss, plus depreciation and amortization, interest expense, income tax expense, adjusted to remove derivative fair value adjustments, loss on extinguishment of debt, equity-based compensation and certain other non-operating expenses. Adjusted EBITDA does not have a definition under GAAP, and our definition of Adjusted EBITDA may not be the same as, or comparable to, similarly titled measures used by other companies. We use Adjusted EBITDA when evaluating our performance when we believe that certain items are not indicative of operating performance. Adjusted EBITDA provides useful supplemental information to management regarding our operating performance and we believe it will provide the same to members/stockholders. We believe that Adjusted EBITDA will provide useful information to members/stockholders about our performance, financial condition, and results of operations for the following reasons: (i) Adjusted EBITDA would be among the measures used by our management team to evaluate our operating performance and make day-to-day operating decisions and (ii) Adjusted EBITDA is frequently used by securities analysts, investors, lenders, and other interested parties as a common performance measures to compare results or estimate valuations across companies in our industry. Adjusted EBITDA should not be considered in isolation from, or as a substitute for, financial information prepared in accordance with GAAP. A reconciliation of Adjusted EBITDA to net loss, the most directly comparable GAAP financial measure, is set forth below. Results of Operations The following table summarizes our historical results of operations. The period-over-period comparison of results of operations is not necessarily indicative of results for future periods. You should read this discussion of our results of operations in conjunction with our consolidated financial statements and related notes thereto included elsewhere in this Form 10-K. The following table reconciles Adjusted EBITDA to net loss, the most directly comparable GAAP financial measure. Comparison of the years ended December 31, 2019 and 2018 Revenues Revenues increased $327.2 million, or 77.3%, to $750.4 million in the year ended December 31, 2019 from $423.2 million in the year ended December 31, 2018. The increase in revenues was primarily driven by growth in unique aligner shipments of 75% for the year ended December 31, 2019 compared to the same period in 2018. Growth in unique aligner orders was primarily driven by an increase in number of website visitors and conversion thereof to aligner sales, along with an increase in sales and marketing spend. Cost of revenues Cost of revenues increased $44.4 million, or 33.2%, to $178.4 million in the year ended December 31, 2019 from $134.0 million in the year ended December 31, 2018. Cost of revenues decreased as a percentage of revenues from 32% in the year ended December 31, 2018 to 24% in the year ended December 31, 2019, primarily as a result of producing more aligners internally versus outsourcing to a contract manufacturer, as well as increased automation. As of the year ended 2019, we manufacture 100% of our aligners in-house. Gross margin increased to 76% in the year ended December 31, 2019 from 68% in the year ended December 31, 2018, primarily as a result of the factors described above. Marketing and selling expenses Marketing and selling expenses as a percentage of revenues increased to 64% in the year ended December 31, 2019 from 50% in the year ended December 31, 2018, and increased to $481.5 million in the year ended December 31, 2019 from $213.1 million in the year ended December 31, 2018, primarily due to increased digital and media advertising and branding efforts, and by expansion of SmileShop locations to prepare for growth in 2020 and beyond. General and administrative expenses General and administrative expenses increased $459.1 million, or 377%, to $580.8 million in the year ended December 31, 2019 from $121.7 million in the year ended December 31, 2018, primarily due to equity-based compensation expense of approximately $324.5 million and other employee related bonuses of $6.1 million as a result of the IPO. General and administrative expenses as a percent of revenue increased from 29% in the year ended December 31, 2018 to 77% in the year ended December 31, 2019, primarily as a result of the factors mentioned above. Interest expense Interest expense increased $2.0 million, or 15%, to $15.7 million in the year ended December 31, 2019 from $13.7 million in the year ended December 31, 2018, primarily as a result of amortization of loan costs related to our JPM Credit Facility (defined below), partially offset by lower interest rates. Borrowings and interest expense from our JPM Credit Facility is based on, among other things, the amount of eligible retail installment sale contracts. See "Indebtedness" below for additional information. Other expense Other expense decreased $15.3 million to $(0.1) million in the year ended December 31, 2019 from $15.1 million in the year ended December 31, 2018, primarily as a result of the fair value adjustment from the TCW Warrants in 2018, which converted to additional obligations from the TCW Credit Facility in December 2018. The loss on extinguishment of debt is due to the repayment of the TCW Credit Facility in June 2019. In connection with the repayment, we paid $11.9 million, related to the make-whole provision, and wrote-off $2.6 million and $15.1 million of deferred financing and debt issuance costs, respectively. Provision for income tax expense Our provision for income tax expense was $2.3 million and $0.4 million for the years ended December 31, 2019 and 2018, respectively. Comparison of the years ended December 31, 2018 and 2017 Revenues Revenues increased $277.3 million, or 190%, to $423.2 million in 2018 from $146.0 million in 2017. The increase in revenues was primarily driven by growth in unique aligner orders of 187% over the same period. Growth in unique aligner orders was primarily driven by an increase in conversion from website visitors to aligner sales in 2018, along with an increase in sales and marketing spend of $148.8 million from 2017 to 2018. Cost of revenues Cost of revenues increased $70.0 million, or 109%, to $134.0 million in 2018 from $64.0 million in 2017. Cost of revenues decreased as a percentage of revenues from 44% in 2017 to 32% in 2018 primarily as a result of producing more aligners internally versus outsourcing to a contract manufacturer. Gross margin increased to 68% in 2018 from 56% in 2017, primarily as a result of the factors described above. Marketing and selling expenses Marketing and selling expenses as a percentage of revenues increased to 50% in 2018 from 44% in 2017, and increased to $213.1 million in 2018 from $64.2 million in 2017, primarily due to increased digital and media advertising and branding efforts, and by expansion of SmileShop locations to prepare for growth in 2019 and beyond. General and administrative expenses General and administrative expenses increased $73.5 million, or 153%, to $121.7 million in 2018 from $48.2 million in 2017, primarily as a result of $29.7 million in salaries and wages from the expansion of our team member headcount, $13.0 million in equity-based compensation expenses, and $10.2 million legal expenses. General and administrative expenses as a percent of revenue decreased from 33% in 2017 to 29% in 2018, due to improved leveraging of our fixed costs. Interest expense Interest expense increased $11.6 million, or 538%, to $13.7 million in 2018 from $2.1 million in 2017, primarily as a result of our entry into the TCW Credit Facility in February 2018 and borrowings thereunder. Other expense Other expense increased $15.1 million to $15.1 million in 2018 from $0.0 million in 2017, primarily as a result of the increase in the fair value of the TCW Warrants, which converted to additional obligations from the TCW Credit Facility in December 2018. Provision for income tax expense Our provision for income tax expense was $0.4 million and $0.1 million for the years ended December 31, 2018 and 2017, respectively, primarily related to state income tax in certain jurisdictions. Liquidity and Capital Resources As of December 31, 2019, SDC Inc. had an accumulated deficit of $114.5 million and had working capital of $383.6 million. Our operations have been financed primarily through net proceeds from the sale of our equity securities and borrowings under our debt instruments. Our short-term liquidity needs primarily include working capital, international expansion, innovation, research and development, and debt service requirements. We believe that our current liquidity, including net proceeds received in connection with the IPO, will be sufficient to meet our projected operating, investing, and debt service requirements 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 levels of revenue, the expansion of sales and marketing activities, market acceptance of our clear aligners, the results of research and development and other business initiatives, the timing of new product introductions, 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 additional debt financing would result in debt service obligations, and any future instruments governing such debt could provide for operating and financing covenants that would restrict our operations. SDC Inc. is a holding company with no operations of our own and, as such, we depend on our subsidiaries for cash to fund all of our operations and expenses. We depend on the payment of distributions by our subsidiaries, and such distributions may be restricted as a result of regulatory restrictions, state and international laws regarding distributions, or contractual agreements, including agreements governing indebtedness. For a discussion of those restrictions, see “Risk Factors-Risks Related to Our Organization and Structure-We are a holding company. Our sole material asset is our equity interest in SDC Financial, and as such, we depend on our subsidiaries for cash to fund all of our expenses, including taxes and payments under the Tax Receivable Agreement.” We currently anticipate that such restrictions will not impact our ability to meet our cash obligations. Cash flows The following table sets forth a summary of our cash flows for the periods indicated. Comparison of the years ended December 31, 2019 and 2018 As of December 31, 2019, we had $318.5 million in cash, an increase of $4.5 million compared to $313.9 million as of December 31, 2018. Cash used in operating activities increased to $333.2 million during the year ended December 31, 2019 compared to $114.8 million in the year ended December 31, 2018, or an increase of $218.4 million, primarily resulting from an increase in accounts receivable associated with our SmilePay offering and increased net loss during the period. One-time cash compensation expense of approximately $83.6 million for the payment of cash bonus amounts pursuant to the IBAs was incurred in October 2019. Cash used in investing activities increased to $106.4 million during the year ended December 31, 2019, compared to $41.8 million in the year ended December 31, 2018, primarily resulting from an increase in the number of SmileShop locations, along with an increase in purchases of manufacturing automation equipment and computer and software equipment. Cash provided by financing activities decreased to $444.1 million during the year ended December 31, 2019, compared to $466.5 million in the year ended December 31, 2018. This decrease is primarily due to the use of net proceeds received in our IPO to repurchase Class A shares and LLC units and principal payments we made on long-term debt in the year ended December 31, 2019 (see-Indebtedness-TCW financing agreement, warrants, and warrant repurchase obligations) compared to net proceeds from the sale of Preferred Units in the year ended December 31, 2018. Comparison of the years ended December 31, 2018 and 2017 As of December 31, 2018, we had $313.9 million in cash, an increase of $309.8 million compared to $4.1 million as of December 31, 2017. Cash used in operating activities increased to $114.8 million during 2018, compared to $30.3 million in 2017, an increase of $84.5 million, primarily resulting from an increase in accounts receivable associated with our SmilePay offering. Cash used in investing activities increased to $41.8 million during 2018, compared to $10.0 million in 2017, primarily resulting from an increase in the number of SmileShop locations from 41 to 188, along with an increase in purchases of manufacturing automation equipment and computer and software equipment. Cash provided by financing activities increased to $466.5 million during 2018, compared to $38.0 million in 2017, primarily resulting from the proceeds of $400.2 million we received from our 2018 Private Placement and an increase in our long-term borrowings to $117.4 million in 2018 compared to $36.0 million in 2017. This was offset by the repayment of Align Loan (as defined herein) of $30.0 million in February 2018. Tax Receivable Agreement Our purchase of LLC Units from SDC Financial, coupled with SDC Financial’s purchase and cancellation of LLC Units from the Pre-IPO Investors in connection with the IPO and any future exchanges of LLC Units for our Class A common stock or cash are expected to result in increases in our allocable tax basis in the assets of SDC Financial that otherwise would not have been available to us. These increases in tax basis are expected to provide us with certain tax benefits that can reduce the amount of cash tax that we otherwise would be required to pay in the future. We and SDC Financial are parties to the Tax Receivable Agreement with the Continuing LLC Members, pursuant to which SDC Inc. is obligated to pay the Continuing LLC Members 85% of the cash savings, if any, in U.S. federal, state, and local income tax or franchise tax that SDC Inc. actually realize as a result of (a) the increases in tax basis attributable to exchanges by Continuing LLC Members and (b) tax benefits related to imputed interest deemed to be paid by SDC Inc. as a result of the Tax Receivable Agreement. The amounts to be recorded for both the deferred tax assets and the liability for our obligations under the Tax Receivable Agreement will be estimated at the time of an exchange of LLC Units. All of the effects of changes in any of our estimates after the date of the exchange will be included in net income. Similarly, the effect of subsequent changes in the enacted tax rates will be included in net income. Because SDC Inc. is the managing member of SDC Financial, which is the managing member of SDC LLC, which is the managing member of SDC Holding, we have the ability to determine when distributions (other than tax distributions) will be made by SDC Holding to SDC LLC and by SDC LLC to SDC Financial and the amount of any such distributions, subject to limitations imposed by applicable law and contractual restrictions (including pursuant to our debt instruments). Any such distributions will then be distributed to all holders of LLC Units, including us, pro rata based on holdings of LLC Units. The cash received from such distributions will first be used by us to satisfy any tax liability and then to make any payments required under the Tax Receivable Agreement. We expect that such distributions will be sufficient to fund both our tax liability and the required payments under the Tax Receivable Agreement. Indebtedness TCW financing agreement, warrants, and warrant repurchase obligations We were party to a credit facility with TCW Direct Funding (the "TCW Credit Facility"), which provided for $55.0 million Term Loan and the potential to draw up to an additional $70.0 million under the Delayed Draw Facility. The Term Loan and the Delayed Draw Facility matured February 2023 and bore interest at an annual rate of LIBOR or a reference rate, as defined in the agreement, plus an applicable margin based on our leverage (8% margin on LIBOR for the year ending December 31, 2018). The TCW Credit Facility also included make-whole provisions in case of termination of the facility. The TCW Credit Facility was secured by a first mortgage and lien on our real property and related personal and intellectual property. As of December 31, 2018, we had $55.0 million outstanding under the Term Loan and $65.5 million outstanding under the Delayed Draw Facility. In September 2019, we repaid in full all amounts outstanding under the Term Loan and Delayed Draw Facility, including an approximately $11.9 million make whole payment. We had issued two classes of TCW Warrants, Class W-1 and Class W-2 warrants, in connection with the TCW Credit Facility to the lenders thereunder. In June 2019, we repurchased the TCW Warrants for approximately $32.6 million, including $0.7 million of accrued interest, pursuant to the Warrant Repurchase Obligation undertaken in connection with a December 2018 amendment to the TCW Credit Facility. Revolving credit facility In June 2019, we and SDC U.S. SmilePay SPV (the ‘‘SPV”), our wholly owned special purpose subsidiary, entered into a loan and security agreement with JPMorgan Chase Bank, N.A., as the administrative agent, the collateral agent and a lender providing a secured revolving credit facility to the SPV in an initial aggregate maximum principal amount of $500 million with the potential to increase the aggregate principal amount that may be borrowed up to an additional $250 million with the consent of the lenders participating in such increase. Availability under the JPM Credit Facility is based on, among other things, the amount of eligible retail installment sale contracts owned by the SPV in connection with out SmilePay financing option. The JPM Credit Facility provides for interest on the outstanding principal balance of a spread above prevailing commercial paper rates or, to the extent the advance is not funded by a conduit lender through the issuance of commercial paper, LIBOR. The JPM Credit Facility also provides for an unused fee based on the unused portion of the total aggregate commitment. There is no amortization schedule. Upon expiration of the JPM Credit Facility on December 14, 2020 (unless earlier terminated or extended in accordance with its terms), any outstanding principal will continue to be reduced monthly through available collections beginning the month following this expiration. As of December 31, 2019, we had $150.4 million of outstanding borrowings under the JPM Credit Facility at an interest rate of three-month LIBOR plus 320 basis points in addition to 75 basis points on unused commitments. The proceeds of the JPM Credit Facility were used to repay all outstanding amounts under the TCW Credit Facility, including repurchasing the TCW Warrants, for working capital and other corporate purposes. We are required to maintain on a consolidated basis specified minimum tangible net worth and liquidity and are also subject to a maximum leverage ratio. The JPM Credit Facility is secured by, among other assets, a first priority security interest in certain receivables conveyed by us to the SPV and certain of our intellectual property. Promissory notes Promissory notes to majority member and related parties: We were the obligor under three promissory notes payable to David Katzman and certain affiliated trusts. As of December 31, 2018, the balance of these notes was $11.7 million. Interest on these notes accrued at a rate of 10% per annum. These notes were repaid in full in the first quarter of 2019. Promissory notes on unitholder redemption: We had two outstanding promissory notes to unitholders due to repurchases of membership units. The notes were payable over 24 to 36 monthly payments plus interest at 1.7% to 3% annually. As of December 31, 2018 and 2017, the outstanding balances on these notes payable were $6.2 million and $9.0 million, respectively. These notes were repaid in full in the third quarter of 2019. Contractual obligations Our principal commitments consisted of obligations under our outstanding term loans and operating leases for equipment and office facilities. The following table summarizes our commitments to settle contractual obligations in cash as of the dates presented. The payments that we may be required to make under the Tax Receivable Agreement to the Continuing LLC Members may be significant and are not reflected in the contractual obligations table set forth above as they are dependent upon future taxable income. See “Certain Relationships and Related Party Transactions-Tax Receivable Agreement.” Off-Balance Sheet Arrangements We did not have any off-balance sheet arrangements during the periods presented. Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which we have prepared in accordance with GAAP. The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that impact the reported amounts. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition and equity-based compensation, among others. Each of these estimates varies in regard to the level of judgment involved and its potential impact on our financial results. Estimates are considered critical either when a different estimate could have reasonably been used, or where changes in the estimate are reasonably likely to occur from period to period, and such use or change would materially impact our financial condition, results of operations, or cash flows. Actual results could differ from those estimates. While our significant accounting policies are more fully described in Note 2 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K, we believe that the following accounting policy and estimates are most critical to a full understanding and evaluation of our reported financial results. Revenue recognition As discussed in Note 2 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K, we have implemented ASC 606, “Revenue from Contracts with Customers,” as of January 1, 2017 using the full retrospective method. Our revenue is generated through sales of aligners, retainers, and other products. Our aligner sales commitment contains multiple promises which may include (i) initial aligners, (ii) mid-course corrections, (iii) refinement aligners, and (iv) retainers for international sales only. Our members are eligible for modified or refinement aligners at any point during their treatment plan or immediately following their original treatment plan (which is typically between five and ten months), in each case, upon the direction of, and pursuant to a prescription from, the treating dentist or orthodontist. Under ASC 606, we evaluate whether the initial aligners, mid-course corrections, and refinement aligners represent separate or combined performance obligations. We have determined that these promises, within the aligner sales commitment, represent separate performance obligations. The terms of the aligner and retainer sales include member rights to cancel the orders and return unopened aligner, impression kit, or retainer boxes for a refund of any consideration paid related to the returned products. The rights of return create variability in the amount of transaction consideration, and in turn, revenue we can recognize for fulfilling related performance obligations. We recognize revenue based on the amount of consideration to which we expect to be entitled, which excludes consideration received for products expected to be returned. Accordingly, we are required to make estimates of expected returns and related refund liabilities. We estimate expected returns based upon our assessment of historical and expected cancellations. We offer our members the option of paying for the entire cost of their aligners upfront or enrolling in SmilePay, a convenient monthly payment plan that requires a $250 down payment, with the remaining consideration due over a period up to 24 months. Approximately 65% of our members elect to purchase our aligners using SmilePay. The amount of contract consideration we estimate to be collectible from our SmilePay members results in an implicit price concession. We estimate the amount of implicit price concession based upon our assessment of historical write-offs and expected net collections, business and economic conditions, and other collection indicators. We believe our analysis provides reasonable estimates of our revenues and valuations of our accounts receivable. Revenue is recognized for mid-course corrections and refinement aligners when the promised goods are transferred to the member. Mid-course corrections and refinement aligners represent a promise to transfer goods to members, and not all members order mid-course corrections or refinement aligners. We make our best estimate of mid-course correction and refinement aligner member usage rates, which we use to determine the amount of revenue to allocate to those performance obligations at inception of our aligner sales commitment. Our process for estimating usage rates requires significant judgment and evaluation of inputs, including historical data and forecasted usages. Any material changes to usage rates could impact the timing of revenue recognition, which may have a material effect on our financial position and result of operations. Amounts received prior to satisfying the above revenue recognition criteria are recorded as deferred revenue in our historical consolidated balance sheets. Equity-based compensation Prior to the IPO, we issued equity-based compensation awards to team members and non-team members through granting of incentive units. There have been no significant changes to this critical accounting policy from that disclosed in our Final IPO Prospectus. Following the IPO, we have two types of equity-based compensation awards outstanding: options and restricted stock units (“RSUs”), including those issued pursuant to incentive bonus agreements (“IBAs”). We account for equity-based compensation for team members in accordance with ASC 718, “Compensation-Stock Compensation.” In accordance with ASC 718, compensation cost is measured at estimated fair value on grant date and is included as compensation expense over the vesting period during which a team member provides service in exchange for the award. We used the Black-Scholes Option Pricing Method to allocate the total equity fair value to outstanding Options. The Black-Scholes Option Pricing Method includes various assumptions, including the expected life of Options, the expected volatility, and the expected risk-free interest rate. These assumptions reflect our best estimates, but they involve inherent uncertainties based on market conditions generally outside our control. As a result, if other assumptions had been used, equity-based compensation cost could have been materially impacted. Furthermore, if we use different assumptions for future grants, equity-based compensation cost could be materially impacted in future periods. The fair value of RSUs is determined by our stock price on the date of grant and related compensation expense is generally recognized over the requisite service period. Income tax expense SDC Inc. is the managing member of SDC Financial and, as a result, consolidates the financial results of SDC Financial. SDC Financial and its subsidiaries are limited liability companies and have elected to be taxed as partnerships for income tax purposes except for a subsidiary, SDC Holding, that is treated like a corporation. As such, SDC Financial does not pay any federal income taxes, as any income or loss will be included in the tax returns of the individual members. SDC Financial does pay state income tax in certain jurisdictions, and the Company’s income tax provision in the consolidated financial statements reflects the income taxes for those states. Additionally, certain wholly-owned entities are required to be looked at on a stand-alone basis resulting in federal income taxes, and such federal income taxes are included in the consolidated financial statements. We use the asset and liability method to account for income taxes and apply the principles of ASC 740 in determining when our tax positions should be recognized. Under this method, deferred income 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. 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. If a net operating loss carryforward exists, we make a determination as to whether that net operating loss carryforward will be utilized in the future. A valuation allowance will be established for certain net operating loss carryforwards and other deferred tax assets where the recoverability is deemed to be uncertain. The carrying value of the net deferred tax assets is based upon estimates and assumptions related to our ability to generate sufficient future taxable income in certain tax jurisdictions. If these estimates and related assumptions change in the future, we will be required to adjust our deferred tax valuation allowances. In connection with the IPO, we entered into the Tax Receivable Agreement with certain of the Continuing LLC Members that provides for the payment by us of 85% of the amount of any tax benefits that SDC Inc. actually realizes, or in some cases is deemed to realize, as a result of (i) increases in SDC Inc.’s share of the tax basis in the net assets of SDC Financial resulting from any redemptions or exchanges of LLC Units, (ii) tax basis increases attributable to payments made under the Tax Receivable Agreement, and (iii) deductions attributable to imputed interest pursuant to the Tax Receivable Agreement (the “TRA Payments”). We expect to benefit from the remaining 15% of any of cash savings, if any, that we realize. The amounts payable under the Tax Receivable Agreement will vary depending upon a number of factors, including the amount, character, and timing of the taxable income of SDC Inc. in the future. If the valuation allowance recorded against the deferred tax assets applicable to the tax attributes referenced above is released in a future period, the Tax Receivable Agreement liability may be considered probable at that time and recorded within earnings. Recent Accounting Pronouncements For a discussion of new accounting pronouncements recently adopted and not yet adopted, see Note 2 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K.

<s>[INST] See “Cautionary Statement Regarding ForwardLooking Statements.” We are the industry pioneer as the first directtoconsumer medtech platform for transforming smiles. Through our cuttingedge teledentistry technology and vertically integrated model, we are revolutionizing the oral care industry. Our directtoconsumer model provides members with a customized clear aligner therapy treatment delivered directly to their doors. We integrate marketing, aligner manufacturing, and fulfillment, and provide a proprietary webbased teledentistry platform for the monitoring of treatment by licensed dentists and orthodontists through the completion of a member’s treatment. We are headquartered in Nashville, Tennessee and have locations throughout the U.S, Puerto Rico, Canada, Australia, New Zealand, the U.K., Ireland, Hong Kong, and Costa Rica. Key Business Metrics We review the following key business metrics to evaluate our business performance: Unique aligner order shipments For the years ended December 31, 2019 and 2018, we shipped 453,053 and 258,278 unique aligner orders, respectively. Each unique aligner order shipment represents a single contracted member. We believe that our ability to increase the number of aligner orders shipped is an indicator of our market penetration, growth of our business, consumer interest, and our member conversion. Average aligner gross sales price We define average gross sales price (‘‘ASP”) as gross revenue, before implicit price concession and other variable considerations and exclusive of sales tax, from aligner orders shipped divided by the number of unique aligner orders shipped. We believe ASP is an indicator of the value we provide to our members and our ability to maintain our pricing. Our ASP for the years ended December 31, 2019 and 2018 was $1,771 and $1,764, respectively. Our ASP is less than our standard $1,895 price as a result of discounts offered to select members. Key Factors Affecting Our Performance We believe that our future performance will depend on many factors, including those described below and in the section titled “Risk Factors” included elsewhere in this Form 10K. Efficient acquisition of new members Visits to our website: On average, we have approximately five million unique visitors to our website each month, and we expect to continue to invest heavily in sales and marketing to spread awareness and increase the number of individuals visiting our website. We increase our marketing spend at certain periods of the year, such as January, when members typically have a higher focus on aesthetics. Conversions from visits to aligner orders: From our website, individuals can either sign up for a SmileShop appointment or order a doctor prescribed impression kit to evaluate and ultimately purchase our clear aligner treatment. We expect to continue to invest heavily in our proprietary technology platform, operations, and other processes to improve member conversion from website visit through SmileShop appointment booking, appointment attendance, and aligners ordered; and a similar process for our impression kits. SmilePay We offer SmilePay, a convenient monthly payment plan, to maximize accessibility and provide an affordable option for all of our members. The $250 down payment for SmilePay covers our cost of manufacturing the aligners, and the interest income generated by SmilePay helps offset the negative impact of delinquencies and cancellations. A number of factors affect delinquency and cancellation rates, including memberspecific circumstances, our efforts in member service and management, and the broader macroeconomic environment. Continued investment in controlled growth We intend to continue investing in our business to support future growth by focusing on strategies that best address our large market opportunity, both domestically and internationally. Our key investment initiatives include continued advancement in automating and streamlining our manufacturing and treatment planning operations to allow us to stay ahead of consumer demand, continued discipline around marketing and selling investments, including a focus on pushing more demand through existing SmileShops, enhancing our existing product platform, and introducing new products to further differentiate our offerings. Additionally, we intend to continue to develop a suite of ancillary products for our members’ oral care needs, lengthening our relationship with our members and enhancing our recurring revenue base. As part of these key investment initiatives, we will also continue to explore collaborations with retailers and other [/INST] Negative. </s>

Silvergate Capital Corp

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 results of our operations should be read in conjunction with the consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. In addition to historical consolidated financial information, this discussion contains forward-looking statements that involve risks uncertainties and assumptions. Certain risks, uncertainties and other factors, including but not limited to 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 in the forward-looking statements. We assume no obligation to update any of these forward-looking statements Principal Factors Affecting Our Results of Operations Net Income. Net income is calculated by taking interest and noninterest income and subtracting our costs to do business, such as interest, salaries, taxes and other operational expenses. We evaluate our net income based on measures that include net interest margin, return on average assets and return on average equity. Net Interest Income. Net interest income represents interest income, less interest expense. We generate interest income from interest, dividends and fees received on interest earning assets, including loans, interest earning deposits in other banks and investment securities we own. We incur interest expense from interest paid on interest bearing liabilities, including interest bearing deposits, borrowings and other forms of indebtedness. Net interest income typically is the most significant contributor to our net income. To evaluate net interest income, we measure and monitor: (i) yields on our loans, interest earning deposits in other banks and other interest earning assets; (ii) the costs of our deposits and other funding sources; (iii) our net interest spread; and (iv) our net interest margin. Net interest spread is the difference between rates earned on interest earning assets and rates paid on interest bearing liabilities. Net interest margin is a ratio calculated as net interest income divided by average interest earning assets for the same period. 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 and interest we earn on interest earning assets or pay on interest bearing liabilities, as well as the volume and types of our interest earning assets, interest bearing and noninterest bearing liabilities and shareholders’ equity, usually have the largest impact on periodic changes in our net interest spread, net interest margin and net interest income. We measure net interest income before and after our provision for loan losses. Provision for Loan Losses. Provision for loan losses is the amount of expense that, based on our management’s judgment, is required to maintain our allowance for loan losses at an adequate level to absorb probable losses inherent in our loan portfolio at the applicable balance sheet date and that, in our management’s judgment, is appropriate under relevant accounting guidance. Determination of the allowance for loan losses is complex and involves a high degree of judgment and subjectivity. For a description of the factors considered by our management in determining the allowance for loan losses see “-Financial Condition-Allowance for Loan Losses.” Noninterest Income. Noninterest income consists of, among other things: (i) mortgage warehouse fee income; (ii) service fees related to off-balance sheet deposits; (iii) deposit related fees; (iv) gain on sale of loans; and (v) other noninterest income. Service fees related to off-balance sheet deposits are fees earned for off-balance sheet deposit placements, primarily for our digital currency customers. The placements are facilitated under agreements we have entered into with customers and nationally recognized third party service providers that, in accordance with customer instructions, allow us to sweep customer funds into deposit accounts at other insured depository institutions. In connection with such sweeps and placements, the Bank earns noninterest income based on the difference between the gross interest earned on such deposit placements and the net interest the Bank agreed to pay on such swept funds (if any). Deposit related fees include cash management fees, such as analyzed checking fees, account maintenance fees, insufficient funds fees, overdraft fees, stop payment fees, foreign exchange fee income, domestic and foreign wire transfer fees, SEN related fees and card processing fee income. Noninterest Expense. Noninterest expense includes, among other things: (i) salaries and employee benefits; (ii) occupancy and equipment expense; (iii) communications and data processing fees (iv) professional services fees; (v) federal deposit insurance; (vi) correspondent bank charges; and (vii) other general and administrative expenses. Salaries and employee benefits include compensation, stock-based compensation, employee benefits and tax expenses for our personnel. Occupancy and equipment expense includes depreciation expense, lease expense on our leased properties and other occupancy-related expenses. Equipment expense includes expenses related to our furniture, fixtures, equipment and software. Communications expense includes costs for telephone and internet. Data processing fees include expenses paid to our third-party data processing system provider and other data service providers. Professional fees include legal, accounting, consulting and other outsourcing arrangements. Federal deposit insurance expense relates to FDIC assessments based on the level of our deposits. Correspondent bank charges include wire transfer fees, transaction fees and service charges related to transactions settled with correspondent relationships. Other general and administrative expenses include expenses associated with travel, meals, advertising, promotions, sponsorships, training, supplies, postage, insurance and other expenses related to being a public company. Noninterest expenses generally increase as we grow our business. Noninterest expenses have increased as we have grown organically and as we have expanded and modernized our operational infrastructure and implemented our plan to build an efficient, technology-driven banking operation with significant capacity for growth. In addition, we have expanded our information technology and security division to support enhancements in our technology infrastructure. Financial Condition The primary factors we use to evaluate and manage our financial condition include asset quality, capital and liquidity. Asset Quality. We manage the diversification and quality of our assets based on 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 our loan and investment portfolios, the extent of counterparty risks, credit risk concentrations and other factors. Capital. Financial institution regulators have established guidelines for minimum capital ratios for banks and bank holding companies. The Bank’s capital ratios at December 31, 2019 exceeded all current well capitalized regulatory requirements. We manage capital based upon factors that include: (i) the level and quality of capital and our overall financial condition; (ii) the trend and volume of problem assets; (iii) the adequacy of reserves; (iv) the level and quality of earnings; (v) the risk exposures in our balance sheet; (vi) the levels of Tier 1 and total capital; (vii) the Tier 1 risk-based capital ratio, the total risk-based capital ratio, the Tier 1 leverage ratio, and the common equity Tier 1 capital ratio; (viii) the state of local and national economic conditions; and (ix) other factors including our asset growth rate, as well as certain liquidity ratios. Liquidity. We manage liquidity based on factors that include the amount of core deposits as a percentage of total 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 undue loss, the amount of cash, interest earning deposits in other banks and liquid securities we hold, the re-pricing characteristics and maturities of our assets when compared to the re-pricing characteristics of our liabilities and other factors. We maintain high levels of liquidity for our customers who operate in the digital currency industry, as these deposits are subject to potentially dramatic fluctuations due to certain factors that may be outside of our control. As a result, the Bank deploys its customer deposits into interest earning deposits in other banks and securities, as well as into specialized lending opportunities. Results of Operations Net Income The following table sets forth the principal components of net income for the periods indicated. Net income for the year ended December 31, 2019 was $24.8 million, an increase of $2.5 million or 11.3% from net income of $22.3 million for the year ended December 31, 2018. The increase was primarily due to an increase of $1.3 million or 1.9% in net interest income and an increase of $8.2 million, or 108.3% in noninterest income, partially offset by a $4.2 million or 8.6% increase in noninterest expense and an increase of $1.8 million, or 21.8% in income tax expense, all as described below. Net Interest Income and Net Interest Margin Analysis We analyze our ability to maximize income generated from interest earning assets and control the interest expenses of our liabilities, measured as net interest income, through our net interest margin and net interest spread. Net interest income is the difference between the interest and fees earned on interest earning assets, such as loans, interest earning deposits in other banks and securities, and the interest expense incurred on interest bearing liabilities, such as deposits and borrowings, which are used to fund those assets. 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 shareholders’ equity, are usually the largest drivers of periodic changes in net interest income, net interest margin and net interest spread. 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 the Southern California region, developments affecting the real estate, technology, hospitality, tourism and financial services sectors within our target markets and throughout the Southern California region, the volume and availability of residential loan pools and non-qualified residential loans and mortgage banker relationships. Our ability to respond to changes in these factors by using effective asset-liability management techniques is critical to maintaining the stability of our net interest income and net interest margin as our primary sources of earnings. The following tables show the average outstanding balance of each principal category of our assets, liabilities and shareholders’ equity, together with the average yields on our assets and the average costs of our liabilities for the periods indicated. Such yields and cost are calculated by dividing income or expense by the average daily balances of the associated assets or liabilities for the same period. AVERAGE BALANCE SHEET AND NET INTEREST ANALYSIS ________________________ (1)Net interest margin is a ratio calculated as net interest income divided by average interest earning assets for the same period. (2)Interest income includes amortization of deferred loan fees, net of deferred loan costs. (3)Net interest spread is the difference between interest rates earned on interest earning assets and interest rates paid on interest bearing liabilities. (4)Net interest margin is a ratio calculated as annualized net interest income divided by average interest earning assets for the same period. Information regarding the dollar amount of changes in interest income and interest expense for the periods indicated for each major component of interest earning assets and interest bearing liabilities and distinguishes between the changes attributable to changes in volume and changes attributable to changes in interest rates. For purposes of this table, changes attributable to both rate and volume that cannot be segregated have been proportionately allocated to both volume and rate. ANALYSIS OF CHANGES IN NET INTEREST INCOME Net interest income increased $1.3 million to $71.0 million for the year ended December 31, 2019 compared to $69.6 million for the year ended December 31, 2018, due to an increase of $8.3 million in interest income partially offset by an increase of $6.9 million in interest expense. In March 2019, we implemented a hedging strategy that includes purchases of interest rate floors and commercial mortgage-backed securities, primarily funded by callable brokered certificates of deposit. The implementation of this hedging strategy positively impacted interest income earned on securities which was partially offset by interest expense incurred on the callable brokered certificates of deposit. In addition, in the fourth quarter of 2019, we called and reissued a portion of these certificates of deposit, which resulted in the recognition of a $1.6 million premium amortization in interest expense. For a further discussion of our hedging strategy, see “-Financial Condition-Securities.” Average total interest earning assets increased $50.8 million, or 2.5%, from $2.00 billion for the year ended December 31, 2018 to $2.05 billion for the year ended December 31, 2019. This increase was primarily due to an increase in the average balance of loans and securities, partially offset by a decrease in interest earning deposits . The average balance of interest earning deposits decreased by $461.6 million, or 54.2% from $851.3 million for the year ended December 31, 2018 to $389.7 million for the year ended December 31, 2019. Securities increased $438.3 million, or 166.1% from $263.9 million for the year ended December 31, 2018 to $702.2 million for the year ended December 31, 2019. The increase in securities was driven by the net purchases of $558.7 million in fixed-rate commercial mortgage-backed securities and adjustable rate residential mortgage-backed securities. The shift from interest earning deposits to securities was due to our hedging strategy and the use of such deposits to fund the purchase of higher yielding securities. The increase in the average balance of loans was primarily driven by an increase in mortgage warehouse and multi-family loans, partially offset by a decrease in commercial loans related to the sale of the San Marcos branch in the first quarter of 2019. The average yield on total interest earning assets increased from 3.65% for the year ended December 31, 2018 to 3.96% for the year ended December 31, 2019 due primarily to the increases in higher yielding securities relative to interest earning deposits. Average interest bearing liabilities increased $126.0 million or 44.7% for the year ended December 31, 2019 as compared to 2018 primarily due to an increase in interest bearing deposits and borrowings between periods. The increase in interest bearing deposits was primarily due to the issuance of callable brokered certificates of deposits, which were used to fund the fixed-rate commercial mortgage-backed securities, both associated with our hedging strategy. The average rate on total interest bearing liabilities increased to 2.47% for the year ended December 31, 2019 compared to 1.11% for the same period in 2018 primarily due to interest on callable brokered certificates deposits associated with our hedging strategy. The average balance of noninterest bearing deposits decreased from $1.6 billion for the year ended December 31, 2018 to $1.4 billion for the year ended December 31, 2019. As of December 31, 2019, noninterest bearing deposits amounted to $1.3 billion or 74.0% of total deposits. For the year ended December 31, 2019, the net interest spread was 1.49% and the net interest margin was 3.47% compared to 2.54% and 3.49%, respectively, for 2018. The decreases in the year ended December 31, 2019 were primarily due to the callable brokered certificates of deposits associated with our hedging strategy, as described above. Provision for Loan Losses The provision for loan losses is a charge to income to bring our allowance for loan losses to a level deemed appropriate by management. For a description of the factors considered by our management in determining the allowance for loan losses see “-Financial Condition-Allowance for Loan Losses” and “-Critical Accounting Policies-Allowance for Loan Losses.” We recorded a reversal of provision for loan losses of $0.4 million compared to a reversal of $1.5 million for the year ended December 31, 2019 and 2018, respectively. The net reversal for the year ended December 31, 2019 was due to improvements in qualitative factors related to the loan portfolio and the continued low charge-off rates. The reversal for the year ended December 31, 2018 was primarily due to reclassifying $125.2 million in loans held-for-investment as loans held-for-sale in connection with the Company’s November 2018 agreement to sell the Bank’s business loan portfolio. The allowance for loan losses to total gross loans held-for-investment was 0.93% at December 31, 2019 compared to 1.13% at December 31, 2018. Noninterest Income The following table presents, for the periods indicated, the major categories of noninterest income: NONINTEREST INCOME ________________________ N/M-Not meaningful Noninterest income for the year ended December 31, 2019 was $15.8 million, an increase of $8.2 million or 108.3% compared to noninterest income of $7.6 million for the year ended December 31, 2018. This increase was primarily due to a pre-tax gain on sale of $5.5 million for our San Marcos branch and business loan portfolio that was completed in March 2019, a $2.9 million increase in deposit related fees and a $0.7 million gain on sale of securities, offset by a $0.8 million decrease in service fees related to off-balance sheet deposits. Service fees related to off-balance sheet deposits decreased due to lower average balances in off-balance sheet deposit placements for our digital currency customers in addition to a decrease in the spread earned on those deposits. Deposit related fees increased primarily due to increases in cash management, foreign exchange, and SEN related fees associated with our digital currency initiative. During the year ended December 31, 2019, we sold a total of $42.0 million in securities and realized a net gain on sale of $0.7 million. Noninterest Expense The following table presents, for the periods indicated, the major categories of noninterest expense: NONINTEREST EXPENSE Noninterest expense increased $4.2 million or 8.6% for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to increases in salaries and employee benefits, communications and data processing expense, and occupancy and equipment, partially offset by decreases in professional services and federal deposit insurance expense. The increase of $4.0 million or 13.4% in salaries and employee benefits was due to increased staffing related to the growth of the Bank. The Bank’s average full-time equivalent employees grew from 195 for the year ending December 31, 2018 to 208 for 2019 with increases in the Bank’s project management, software development, operations and compliance divisions offset by decreases in branch, lending and administration divisions. In March 2019, we sold the San Marcos branch resulting in the reduction of 12 employees. Occupancy and equipment increased $0.5 million or 17.7%% primarily due to expansion of the corporate headquarters. Communications and data processing increased $1.5 million or 49.2% primarily due to updating our IT infrastructure and expansion projects to support our digital currency initiative offset by capitalized costs related to software implementation for our foreign currency platform enhancements. In 2018, we committed to expanding our banking platform with a cloud-based API-enabled payment hub to complement our API-enabled SEN. In addition, we are implementing a customer-facing foreign exchange platform. The decrease of $1.4 million or 23.9% in professional services fees was primarily related to lower consulting, external audit and legal services. Consulting fees were higher in 2018 as a result of numerous Bank initiatives designed to support infrastructure growth including technology improvements and enhanced internal control processes. Consulting fees for these projects were higher in 2018, due to bringing some of the support in-house and capitalizing software related costs. External audit services were higher in 2018 as the Company prepared for complying with enhanced audit standards in connection with the IPO. The decrease of $0.8 million or 66.3% in federal deposit insurance payments was due to an FDIC assessment credit as well as a reduction in the multiplier based on significant asset growth for the prior fiscal year relative to the current comparable period. Income Tax Expense Income tax expense was $9.8 million for the year ended December 31, 2019 compared to $8.1 million for the year ended December 31, 2018. The increase was primarily related to increased pre-tax income and an increase in the effective tax rate. Our effective tax rates for the year ended December 31, 2019 and 2018 were 28.3% and 26.5%, respectively. The increase in the effective tax rate was primarily related to higher blended state taxes, lower excess benefit from stock-based compensation and an increase in non-deductible expenses compared to 2018. Financial Condition As of December 31, 2019, our total assets increased to $2.1 billion compared to $2.0 billion as of December 31, 2018. Shareholders’ equity increased $39.8 million, or 20.8%, to $231.0 million at December 31, 2019 compared to $191.2 million at December 31, 2018. A summary of the individual components driving the changes in total assets, total liabilities and shareholders' equity is discussed below. Interest Earning Deposits in Other Banks Interest earning deposits in other banks decreased from $670.2 million at December 31, 2018 to $132.0 million at December 31, 2019. The decrease was due to lower balances with the FRB and purchases of securities particularly during the first half of 2019 as the Bank implemented its hedging strategy, discussed below. Securities We use our securities portfolio to provide a source of liquidity, provide an appropriate return on funds invested, manage interest rate risk, meet collateral requirements and meet regulatory capital requirements. Management classifies investment securities as either held-to-maturity or available-for-sale based on our intentions and the Company’s ability to hold such securities until maturity. In determining such classifications, securities that management has the positive intent and the Company has the ability to hold until maturity are classified as held to maturity and carried at amortized cost. All other securities are designated as available-for-sale and carried at estimated fair value with unrealized gains and losses included in shareholders’ equity on an after-tax basis. For the years presented, substantially all securities were classified as available-for-sale. Our securities available-for-sale increased $540.6 million, or 151.3%, from $357.2 million at December 31, 2018 to $897.8 million at December 31, 2019. To supplement interest income earned on our loan portfolio, we invest in high quality mortgage-backed securities, collateralized mortgage obligations and asset backed securities. Our securities portfolio has grown substantially due to the implementation of a hedging strategy and utilizing cash to purchase high quality available-for-sale securities. In March 2019, we implemented a hedging strategy that includes purchases of interest rate floors and commercial mortgage-backed securities, primarily funded by callable brokered certificates of deposit. We entered into repurchase agreements to temporarily fund the purchase of securities while waiting for executed callable brokered certificates of deposit to settle. This hedging strategy is intended to reduce our exposure to a decline in earnings in a declining interest rate environment with a minimal impact on current earnings. As of December 31, 2019, we had purchased $400.0 million in notional amount of interest rate floors, $350.4 million in fixed-rate commercial mortgage-backed securities and issued $325.0 million of callable brokered certificates of deposit related to this hedging strategy. The callable brokered certificates of deposit had an unamortized premium of $2.6 million and an average life of 4.6 years as of December 31, 2019. These certificates of deposit are initially callable within three to six months after issuance and monthly thereafter. The call dates for all callable brokered certificates of deposit are from December 2019 through March 2020. In the fourth quarter of 2019, we called $237.5 million of callable brokered certificates of deposit and reissued new callable brokered certificates of deposit at lower rates. The premium expense associated with calling these certificates was $1.6 million. This premium expense will be offset in the future as a result of the newly issued certificates at lower rates. During the year ended December 31, 2019, we sold a total of $42.0 million of fixed-rate commercial mortgage-backed securities and realized a net gain on sale of $0.7 million, which partially offset the premium expense associated with calling the brokered certificates of deposit. During the year ended December 31, 2019, we purchased a total of $600.0 million in securities, including the securities purchased as part of the hedging strategy. In the first quarter of 2020, the Company executed several transactions related to the hedging strategy discussed above. See “Note 21-Subsequent Events” in our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for more information. The following tables summarize the contractual maturities and weighted-average yields of investment securities at December 31, 2019 and the amortized cost and carrying value of those securities as of the indicated dates. SECURITIES Loan Portfolio Our primary source of income is derived from interest earned on loans. Our loan portfolio consists primarily of loans secured by real estate and mortgage warehouse loans. Our loan customers primarily consist of small- to medium-sized businesses, professionals, real estate investors, small residential builders and individuals. Our owner-occupied and investment commercial real estate loans, multi-family loans and commercial and industrial loans provide us with higher risk-adjusted returns, relatively shorter maturities and more sensitivity to interest rate fluctuations, and are complemented by our relatively lower risk residential real estate loans to individuals. Our commercial real estate, multi-family real estate, construction and commercial and industrial lending activities are primarily directed to our market area of Southern California. Our one-to-four family residential loans and warehouse loans are sourced throughout the United States. The following table summarizes our loan portfolio by loan segment as of the dates indicated: COMPOSITION OF LOAN PORTFOLIO The repayment of loans is a source of additional liquidity for us. The following table details maturities and sensitivity to interest rate changes for our loans held-for-investment at December 31, 2019: LOAN MATURITY AND SENSITIVITY TO CHANGES IN INTEREST RATES Nonperforming Assets Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on nonaccrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on nonaccrual status regardless of whether such loans are actually past due. In general, we place loans on nonaccrual status when they become 90 days past due. We also place loans on nonaccrual status if they are less than 90 days past due if the collection of principal or interest is in doubt. When interest accrual is discontinued, all unpaid accrued interest is reversed from income. Interest income is subsequently recognized only to the extent cash payments received exceed principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are, in management’s opinion, reasonably assured. Any loan which the Bank deems to be uncollectible, in whole or in part, is charged off to the extent of the anticipated loss. Loans that are past due for 180 days or more are charged off unless the loan is well secured and in the process of collection. We believe our disciplined lending approach and focused management of nonperforming assets has resulted in sound asset quality and timely resolution of problem assets. We have several procedures in place to assist us in maintaining the overall quality of our loan portfolio. We have established underwriting guidelines to be followed by our loan officers, and we also monitor our delinquency levels for any negative or adverse trends. There can be no assurance, however, that our loan portfolio will not become subject to increasing pressures from deteriorating borrower credit due to general economic conditions. Nonperforming loans decreased to $5.9 million, or 0.88% of total loans, at December 31, 2019 compared to $8.3 million, or 1.39% of total loans, at December 31, 2018. The decrease in nonperforming loans during the year ended December 31, 2019 was primarily due to payoffs and loan principal repayments offset by higher average balances on one-to-four family loans. Other real estate owned increased to $128,000 as of December 31, 2019 compared to $31,000 as of December 31, 2018 due to foreclosure on one reverse mortgage loan at the end of the year. Total nonperforming assets were $6.0 million and $8.3 million at December 31, 2019 and 2018, respectively, or 0.28% and 0.42%, respectively, of total assets. The following table presents information regarding nonperforming assets at the dates indicated: NONPERFORMING ASSETS ________________________ (1)Total loans exclude loans held-for-sale at each of the dates presented. Loans Grading From a credit risk standpoint, we grade watchlist and problem loans into 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 credits regularly. Ratings are adjusted regularly to reflect the degree of risk and loss that our management believes to be appropriate for each credit. Our methodology is structured so that specific 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). The Bank uses the following definitions for watch list risk ratings: • Pass. Loans in all classes that are not adversely rated, are contractually current as to principal and interest, and are otherwise in compliance with the contractual terms of the loan agreement. Management believes that there is a low likelihood of loss related to those loans that are considered pass. • Special Mention. A special mention loan has potential weaknesses deserving of management’s close attention. If uncorrected, such weaknesses may result in deterioration of the repayment prospects for the asset or in our credit position at some future date. • Substandard. A substandard loan is inadequately protected by the current financial condition 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 we will sustain some loss if deficiencies are not corrected. • Doubtful. A doubtful loan has all weaknesses inherent in one classified as substandard, with the added characteristic that weaknesses make collection or liquidation in full, on the basis of existing facts, conditions, and values, highly questionable and improbable. • Loss. Credits rated as loss are charged-off. We have no expectation of the recovery of any payments in respect of credits rated as loss. The following table presents the loan balances by segment as well as risk rating. No assets were classified as loss during the periods presented. LOAN CLASSIFICATION Loan Reviews and Problem Loan Management Our credit administration staff conducts meetings at least four times a year to review asset quality and loan delinquencies. The Bank’s Lending and Collection Policy requires that we perform annual reviews of every loan of $500,000 or more not rated special mention or adversely classified. Individual loan reviews encompass a loan’s payment status and history, current and projected paying capacity of the borrower and/or guarantor(s), current condition and estimated value of any collateral, sufficiency of credit and collateral documentation, and compliance with Bank and regulatory lending standards. Loan reviewers assign an overall loan risk rating from one of the Bank’s loan rating categories and prepare a written report summarizing the review. Once a loan is identified as a problem loan or a loan requiring a workout, the Bank makes an evaluation and develops a plan for handling the loan. In developing such a plan, management reviews all relevant information from the loan file and any loan review reports. We have a conversation with the borrower and update current and projected financial information (including borrower global cash flows when possible) and collateral valuation estimates. Following analysis of all available relevant information, management adopts an action plan from the following alternatives: (a) continuation of loan collection efforts on their existing terms, (b) a restructure of the loan’s terms, (c) a sale of the loan, (d) a charge off or partial charge off, (e) foreclosure on pledged collateral, or (f) acceptance of a deed in lieu of foreclosure. Impaired Loans and TDRs. Impaired loans also include certain loans that have been modified as troubled debt restructurings, or TDRs. As of December 31, 2019 the Company held nine loans amounting to $1.8 million, which were TDRs, compared to seven loans amounting to $0.5 million at December 31, 2018. The increase from the prior year was due to the TDR status for two Non-QM loans and one commercial and industrial loan with higher balances. Two of these loans are in compliance with their restructured terms while the third loan with an outstanding balance of approximately $0.5 million at December 31, 2019 is not performing in accordance with its restructured terms. A loan is identified as a TDR when a borrower is experiencing financial difficulties and, for economic or legal reasons related to these difficulties, the Company grants a concession to the borrower in the restructuring that it would not otherwise consider. The Company has granted a concession when, as a result of the restructuring, it does not expect to collect all amounts due or within the time periods originally due under the original contract, including one or a combination of the following: a reduction of the stated interest rate of the loan; an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk; or a temporary forbearance with regard to the payment of principal or interest. All troubled debt restructurings are reviewed for potential impairment. Generally, a nonaccrual loan that is restructured remains on nonaccrual status for a minimum period of six months to demonstrate that the borrower can perform under the restructured terms. If the borrower’s performance under the new terms is not reasonably assured, the loan remains classified as a nonaccrual loan. Loans classified as TDRs are reported as impaired loans. Allowance for Loan Losses We maintain an allowance for loan losses that represents management’s best estimate of the loan losses and risks inherent in our 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 our 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. See “Critical Accounting Policies-Allowance for Loan Losses.” In reviewing 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 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; • for commercial and multi-family mortgage 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 loans, the perceived feasibility of the project including the ability to sell improvements constructed for resale, the quality and nature of contracts for presale, if any, experience and ability of the builder, loan-to-cost ratio and loan-to-value ratio; • for commercial and industrial loans, the debt service coverage ratio (income from the business exceeding operating expenses compared to loan repayment requirements), the operating results of the commercial 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; and • for mortgage warehouse loans held-for-investment, despite our negligible loss history, we provide a loss allowance factor subject to quarterly adjustment. Mortgage warehouse loans held-for-sale are not subject to any loan loss allowance. The following table presents a summary of changes in the allowance for loan losses for the periods and dates indicated: ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES Our allowance for loan losses at December 31, 2019 and 2018 was $6.2 million and $6.7 million, respectively, or 0.93% and 1.13% of loans for each respective period-end. We had $93,000 in charge-offs for the year ended December 31, 2019 and no recoveries compared to charge-offs of $6,000 and $91,000 of recoveries for the year ended December 31, 2018. Although we believe that we have established our allowance for loan losses in accordance with GAAP and that the allowance for loan losses was adequate to provide for known and inherent losses in the portfolio at all times shown above, future provisions for loan losses will be subject to ongoing evaluations of the risks in our loan portfolio. The following table shows the allocation of the allowance for loan losses among loan categories and certain other information as of the dates indicated. The total allowance is available to absorb losses from any loan category. ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES ________________________ (1)Loan category as a percentage of total gross loans. Deposits Deposits are the major source of funding for the Company. We offer a variety of deposit products including interest and noninterest bearing demand accounts, money market and savings accounts and certificates of deposit, all of which we market at competitive pricing. We generate deposits from our customers on a relationship basis and through the efforts of our commercial lending officers. Deposits remained flat at $1.8 billion at December 31, 2019 compared to December 31, 2018. Noninterest bearing deposits totaled $1.3 billion (representing approximately 74.0% of total deposits) at December 31, 2019, compared to $1.6 billion (representing approximately 88.7% of total deposits) at December 31, 2018. At December 31, 2019, deposits by foreign depositors amounted to $481.5 million or 26.5% of total deposits. Total deposits increased slightly due to the issuance of $325.0 million in callable brokered certificates of deposit associated with the implementation of a hedging strategy, offset by the sale of the San Marcos branch, which reduced total deposits by $74.5 million. The decrease in noninterest bearing deposits reflect changes in deposit levels of our digital currency customers. While deposits may fluctuate in the ordinary course of business, we continue to add new digital currency customers each quarter. The following table presents a breakdown of our digital currency customer base and the deposits held by such customers at the dates noted below: ________________________ (1) Total deposits may not foot due to rounding. We segment our deposits based on their potential volatility, which drives our choices regarding the assets we fund with such deposits. Deposits attributable to digital currency exchange and investor funds have the highest potential volatility. We invest these funds primarily in interest earning deposits in other banks and adjustable rate securities available-for-sale. Our cost of total deposits and our cost of funds was 0.43% and 0.54%, respectively, for the year ended December 31, 2019 as compared to 0.10% and 0.17%, respectively, for the year ended December 31, 2018. The increase in the weighted average cost of deposits compared to the prior period was driven by the addition of new callable brokered certificates of deposit associated with a hedging strategy, as discussed in “Financial Condition-Securities” above. For the year ended December 31, 2019, the hedging strategy increased the cost of deposits by 36 basis points due to the funding of the strategy with callable brokered certificates of deposit. The following table presents the average balances and average rates paid on deposits for the periods indicated: COMPOSITION OF DEPOSITS The following table presents the maturities of our certificates of deposit as of December 31, 2019: MATURITIES OF CERTIFICATES OF DEPOSIT Borrowings We primarily utilize short-term and long-term borrowings to supplement deposits to fund our lending and investment activities, each of which is discussed below. FHLB Advances. The FHLB allows us to borrow up to 35% of the Bank’s assets on a blanket floating lien status collateralized by certain securities and loans. As of December 31, 2019, approximately $875.9 million in real estate loans were pledged as collateral for our FHLB borrowings. We utilize these borrowings to meet liquidity needs and to fund certain fixed rate loans in our portfolio. As of December 31, 2019, we had $554.6 million in available borrowing capacity from the FHLB. At December 31, 2019, we had $49.0 million in outstanding FHLB advances. The following table sets forth certain information on our FHLB borrowings during the periods presented: FHLB ADVANCES Federal Reserve Bank of San Francisco. The FRB has an available borrower in custody arrangement that allows us to borrow on a collateralized basis. The Company’s borrowing capacity under the Federal Reserve’s discount window program was $7.5 million as of December 31, 2019. Certain commercial loans are pledged under this arrangement. We maintain this borrowing arrangement to meet liquidity needs pursuant to our contingency funding plan. No advances were outstanding under this facility as of December 31, 2019. The Company has also issued subordinated debentures, obtained a term loan, entered into repurchase agreements and purchased federal funds. At December 31, 2019, these borrowings amounted to $19.5 million. Notes Payable. On January 29, 2016, the Company obtained a term loan from a commercial bank with a single principal advance of $8.0 million due to mature on January 29, 2021. Loan interest and principal is payable quarterly commencing April 2016 and accrues interest at an annual rate equal to 2.60% plus the greater of zero percent and the one-month LIBOR rate. As of December 31, 2019, the one-month LIBOR rate was 1.76%. The proceeds were used to redeem preferred stock and can be prepaid at any time. The outstanding principal at December 31, 2019 was $3.7 million. Annual principal payments on outstanding borrowings are $1.1 million in 2020 and $2.6 million in 2021. Subordinated Debentures. A trust formed by the Company issued $12.5 million of floating rate trust preferred securities in July 2001 as part of a pooled offering of such securities. The Company issued subordinated debentures to the trust in exchange for its proceeds from the offering. The debentures and related accrued interest represent substantially all the assets of the trust. The subordinated debentures bear interest at six-month LIBOR plus 375 basis points, which adjusts every six months in January and July of each year. Interest is payable semiannually. At December 31, 2019, the interest rate for the Company’s next scheduled payment was 5.94%, based on six-month LIBOR of 2.19%. On any January 25 or July 25 the Company may redeem the 2001 subordinated debentures at 100% of principal amount plus accrued interest. The 2001 subordinated debentures mature on July 25, 2031. A second trust formed by the Company issued $3.0 million of trust preferred securities in January 2005 as part of a pooled offering of such securities. The Company issued subordinated debentures to the trust in exchange for its proceeds from the offering. The debentures and related accrued interest represent substantially all the assets of the trust. The subordinated debentures bear interest at three-month LIBOR plus 185 basis points, which adjusts every three months. Interest is payable quarterly. At December 31, 2019, the interest rate for the Company’s next scheduled payment was 3.74%, based on three-month LIBOR of 1.89%. On the 15th day of any March, June, September, or December, the Company may redeem the 2005 subordinated debentures at 100% of principal amount plus accrued interest. The 2005 subordinated debentures mature on March 15, 2035. The Company also retained a 3% minority interest in each of these trusts which is included in subordinated debentures. The balance of the equity in the trusts is comprised of mandatorily redeemable preferred securities. The subordinated debentures may be included in Tier I capital (with certain limitations applicable) under current regulatory guidelines and interpretations. The Company has the right to defer interest payments on the subordinated debentures from time to time for a period not to exceed five years. Other Borrowings. At December 31, 2019, the Company had no outstanding balance of repurchase agreements or federal funds purchased and had available lines of credit of $32.0 million with other correspondent banks. Liquidity and Capital Resources Liquidity Liquidity is defined as the Bank’s capacity to meet its cash and collateral obligations at a reasonable cost. Maintaining an adequate level of liquidity depends on the Bank’s ability to meet both expected and unexpected cash flows and collateral needs efficiently without adversely affecting either daily operations or the financial condition of the Bank. Liquidity risk is the risk that we will be unable to meet our obligations as they become due because of an inability to liquidate assets or obtain adequate funding. The Bank’s obligations, and the funding sources used to meet them, depend significantly on our business mix, balance sheet structure and the cash flow profiles of our on- and off-balance sheet obligations. In managing our cash flows, management regularly confronts situations that can give rise to increased liquidity risk. These include funding mismatches, market constraints on the ability to convert assets into cash or in accessing sources of funds (i.e., market liquidity) and contingent liquidity events. Changes in economic conditions or exposure to credit, market, operation, legal and reputational risks also could affect the Bank’s liquidity risk profile and are considered in the assessment of liquidity and asset/liability management. We maintain high levels of liquidity for our customers who operate in the digital currency industry, as these deposits are subject to potentially dramatic fluctuations due to certain factors that may be outside of our control. As a result, our investment portfolio is comprised primarily of mortgage-backed securities backed by government-sponsored entities, collateralized mortgage obligations and asset-backed securities. Management has established a comprehensive management process for identifying, measuring, monitoring and controlling liquidity risk. Because of its critical importance to the viability of the Bank, liquidity risk management is fully integrated into our risk management processes. Critical elements of our liquidity risk management include: effective corporate governance consisting of oversight by the board of directors and active involvement by management; appropriate strategies, policies, procedures, and limits used to manage and mitigate liquidity risk; comprehensive liquidity risk measurement and monitoring systems (including assessments of the current and prospective cash flows or sources and uses of funds) that are commensurate with the complexity and business activities of the Bank; active management of intraday liquidity and collateral; an appropriately diverse mix of existing and potential future funding sources; adequate levels of highly liquid marketable securities free of legal, regulatory or operational impediments, that can be used to meet liquidity needs in stressful situations; comprehensive contingency funding plans that sufficiently address potential adverse liquidity events and emergency cash flow requirements; and internal controls and internal audit processes sufficient to determine the adequacy of the institution’s liquidity risk management process. The movement of funds on our balance sheet among different SEN deposit customers does not reduce the Bank’s deposits and thus does not present liquidity issues or require any borrowing by the Company or the Bank. In addition, to the extent that SEN participants fully withdraw funds from the Bank, no material liquidity issues or borrowing needs would be presented since the majority of SEN deposit funds are held in cash or other short duration liquid assets. We expect funds to be available from basic banking activity sources, including the core deposit base, the repayment and maturity of loans and investment security cash flows. Other potential funding sources include borrowings from the FHLB, the FRB, other lines of credit and brokered certificates of deposit. As of December 31, 2019, we had $554.6 million of available borrowing capacity from the FHLB, $7.5 million of available borrowing capacity from the FRB and available lines of credit of $32.0 million with other correspondent banks. Cash and cash equivalents at December 31, 2019 were $133.6 million. At December 31, 2019, the Company had $49.0 million in outstanding FHLB advances and no borrowings outstanding with the FRB. Accordingly, our liquidity resources were at sufficient levels to fund loans and meet other cash needs as necessary. Capital Resources Shareholders’ equity increased $39.8 million to $231.0 million at December 31, 2019 compared to $191.2 million at December 31, 2018. The increase in shareholders’ equity was primarily due to net income for the year ended December 31, 2019, which amounted to $24.8 million, an increase in accumulated other comprehensive income of $8.5 million and an increase of $6.5 million in connection with our IPO. The increase in accumulated other comprehensive income was primarily due to unrealized gains in the securities purchased in connection with the Bank’s hedging strategy. 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 material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of its assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum ratios of common equity Tier 1, Tier 1, and total capital as a percentage of assets and off-balance sheet exposures, adjusted for risk weights ranging from 0% to 1,250%. The Bank is also required to maintain capital at a minimum level based on quarterly average assets, which is known as the leverage ratio. In July 2013, federal bank regulatory agencies issued a final rule that revised their risk-based capital requirements and the method for calculating risk-weighted assets to make them consistent with certain standards that were developed by Basel III and certain provisions of the Dodd-Frank Act. The final rule currently applies to all depository institutions and bank holding companies and savings and loan holding companies with total consolidated assets of more than $3 billion. The Company has total consolidated assets of less than $3 billion and is currently exempt from the consolidated capital requirements. As of December 31, 2019, the Bank was in compliance with all applicable regulatory capital requirements to which it was subject, and was classified as “well capitalized” for purposes of the prompt corrective action regulations. As we deploy our capital and continue to grow our operations, our regulatory capital levels may decrease depending on our level of earnings. However, we intend to monitor and control our growth to remain in compliance with all regulatory capital standards applicable to us. The following table presents the regulatory capital ratios for the Company (assuming minimum capital adequacy ratios were applicable to the Company) and the Bank as of the dates indicated: Contractual Obligations We have contractual obligations to make future payments on debt and lease agreements. While our liquidity monitoring and management consider both present and future demands for and sources of liquidity, the following table of contractual commitments focuses only on future obligations and summarizes our contractual obligations as of December 31, 2019. CONTRACTUAL OBLIGATIONS Off-Balance Sheet Items In the normal course of business, we enter into various transactions, which, in accordance with GAAP, are not included in our consolidated statements of financial condition. We enter into these transactions to meet the financing needs of our customers. These transactions include commitments to extend credit and issue letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk exceeding the amounts recognized in our consolidated statements of financial condition. Our exposure to credit loss is represented by the contractual amounts of these commitments. The same credit policies and procedures are used in making these commitments as for on-balance sheet instruments. We are not aware of any accounting loss to be incurred by funding these commitments; however, we maintain an allowance for off-balance sheet credit risk which is recorded in other liabilities on the consolidated statements of financial condition. Our commitments associated with outstanding letters of credit and commitments to extend credit expiring by period as of the date indicated are summarized below. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements. CREDIT EXTENSION COMMITMENTS Unfunded lines of credit represent unused credit facilities to our current borrowers that represent no change in credit risk that exist in our portfolio. Lines of credit generally have variable interest rates. Letters of credit are conditional commitments issued by us to guarantee the performance of a customer to a third party. In the event of nonperformance by the customer in accordance with the terms of the agreement with the third party, we would be required to fund the commitment. The maximum potential amount of future payments we could be required to make is represented by the contractual amount of the commitment. If the commitment is funded, we would be entitled to seek recovery from the client from the underlying collateral, which can include commercial real estate, physical plant and property, inventory, receivables, cash and/or marketable securities. Our policies generally require that letter of credit arrangements contain security and debt covenants like those contained in loan agreements and our credit risk associated with issuing letters of credit is essentially the same as the risk involved in extending loan facilities to our customers. We minimize our exposure to loss under letters of credit and credit commitments by subjecting them to the same credit approval and monitoring procedures as we do for on-balance sheet instruments. The effect on our revenue, expenses, cash flows and liquidity of the unused portions of these letters of credit commitments cannot be precisely predicted because there is no guarantee that the lines of credit will be used. Commitments to extend credit are agreements to lend funds to a customer, if there is no violation of any condition established in the contract, for a specific purpose. Commitments generally have variable interest rates, 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 fully drawn, the total commitment amounts disclosed above do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if considered necessary by us, upon extension of credit is based on management’s credit evaluation of the customer. Critical Accounting Policies and Estimates The preparation of our consolidated financial statements in accordance with GAAP requires us to make estimates and judgments that affect our reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under current circumstances, results of which form the basis for making judgments about the carrying value of certain assets and liabilities that are not readily available from other sources. We evaluate our estimates on an ongoing basis. Actual results may differ from these estimates under different assumptions or conditions. Accounting policies, as described in detail in the notes to our consolidated financial statements, included elsewhere in this Annual Report on Form 10-K, are an integral part of our financial statements. A thorough understanding of these accounting policies is essential when reviewing our reported results of operations and our financial position. We believe that the critical accounting policies and estimates discussed below require us to make difficult, subjective or complex judgments about matters that are inherently uncertain. Changes in these estimates, which are likely to occur from period to period, or use of different estimates that we could have reasonably used in the current period, would have a material impact on our financial position, results of operations or liquidity. See “Note 1-Nature of Business and Summary of Significant Accounting Policies” in our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for more information. Allowance for Loan Losses. The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loans that are deemed to be uncollectible are charged off and deducted from the allowance for loan losses. The provision for loan losses and recoveries on loans previously charged off are credited to the allowance for loan losses. The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties, are considered TDRs and classified as impaired. The general component covers loans that are collectively evaluated for impairment and loans that are not individually identified for impairment evaluation. The general component is based on historical loss experience adjusted for current factors and includes actual loss history experienced for the preceding rolling twelve year period or less, if twelve years of data is not available. This actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment. These economic factors include consideration of the following: levels and trends in delinquencies and impaired loans (including TDRs); levels and trends in charge-offs and recoveries, trends in volumes and terms of loans; migration of loans to the classification of special mention, substandard, or doubtful; effects of any change in risk selection and underwriting standards; other changes in lending policies and procedures; national and local economic trends and conditions; and effects of changes in credit concentrations. Management estimates the allowance balance required using past loan loss experience, current economic conditions, the nature and volume of the portfolio, information about specific borrower situations, estimated collateral values 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 group of loans. Management groups loans into different categories based on loan type to determine the appropriate allowance for each loan group. A loan is considered impaired when full payment under the loan terms is not expected. Impairment is evaluated on an individual loan basis for all loans that meet the criteria for specifically evaluated impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net of the present value of estimated future cash flows using the loan’s original effective rate or at the fair value of collateral less estimated costs to sell if repayment is expected solely from the collateral. Factors considered in determining impairment include payment status, collateral value and the probability of collecting all amounts when due. Large groups of smaller-balance homogeneous loans such as residential real estate loans are collectively evaluated for impairment and, accordingly, they are not separately identified for impairment disclosures. Loans that experience insignificant payment delays and payment shortfalls are generally not classified as impaired. Management considered the significance of payment delays on a case by case basis, taking into consideration all the circumstances of the loan and borrower, including the length of delay, the reasons for the delay, the borrower’s prior payment record, the amount of the shortfall in relation to principal and interest owed. Loans are reported as TDRs when the Company grants concessions to a borrower experiencing financial difficulties that it would not otherwise consider. Examples of such concessions include forgiveness of principal or accrued interest, extending the maturity date, or providing a lower interest rate than would be normally available for a transaction of similar risk. As a result of these concessions, restructured loans are impaired as the Company will not collect all amounts due, both principal and interest, in accordance with the terms of the original loan agreement. TDRs are individually evaluated for impairment and included in separately identified impairment disclosures. TDRs are measured at the present value of estimated cash flows using the loan’s effective rate at inception. If a TDR is determined to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral. For TDRs that subsequently default, the Company determined the amount of the allowance on the loan in accordance with the accounting policy for the allowance for loan losses on loans individually identified as impaired. The Company incorporates recent historical experience related to TDRs, including the performance of TDRs that subsequently defaulted, into the allowance calculation by loan portfolio segment. Fair Value Measurement. The Company measures and presents fair values in accordance with FASB ASC Topic 820, Fair Value Measurement, that defines fair value, establishes a framework for measuring fair value, and requires disclosures about fair value measurements. This standard establishes a fair value hierarchy about the assumptions used to measure fair value and clarifies assumptions about risk and the effect of a restriction on the sale or use of an asset. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. This standard’s fair value hierarchy requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value: Level 1-Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date. Level 2-Significant observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data. Level 3-Significant unobservable inputs that reflect a Company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability. Income Taxes. Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are recognized for the future tax amounts attributable to differences between the financial statement carrying amounts of assets and liabilities and their respective tax bases, computed using enacted tax rates. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.

<s>[INST] Principal Factors Affecting Our Results of Operations Net Income. Net income is calculated by taking interest and noninterest income and subtracting our costs to do business, such as interest, salaries, taxes and other operational expenses. We evaluate our net income based on measures that include net interest margin, return on average assets and return on average equity. Net Interest Income. Net interest income represents interest income, less interest expense. We generate interest income from interest, dividends and fees received on interest earning assets, including loans, interest earning deposits in other banks and investment securities we own. We incur interest expense from interest paid on interest bearing liabilities, including interest bearing deposits, borrowings and other forms of indebtedness. Net interest income typically is the most significant contributor to our net income. To evaluate net interest income, we measure and monitor: (i) yields on our loans, interest earning deposits in other banks and other interest earning assets; (ii) the costs of our deposits and other funding sources; (iii) our net interest spread; and (iv) our net interest margin. Net interest spread is the difference between rates earned on interest earning assets and rates paid on interest bearing liabilities. Net interest margin is a ratio calculated as net interest income divided by average interest earning assets for the same period. 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 and interest we earn on interest earning assets or pay on interest bearing liabilities, as well as the volume and types of our interest earning assets, interest bearing and noninterest bearing liabilities and shareholders’ equity, usually have the largest impact on periodic changes in our net interest spread, net interest margin and net interest income. We measure net interest income before and after our provision for loan losses. Provision for Loan Losses. Provision for loan losses is the amount of expense that, based on our management’s judgment, is required to maintain our allowance for loan losses at an adequate level to absorb probable losses inherent in our loan portfolio at the applicable balance sheet date and that, in our management’s judgment, is appropriate under relevant accounting guidance. Determination of the allowance for loan losses is complex and involves a high degree of judgment and subjectivity. For a description of the factors considered by our management in determining the allowance for loan losses see “Financial ConditionAllowance for Loan Losses.” Noninterest Income. Noninterest income consists of, among other things: (i) mortgage warehouse fee income; (ii) service fees related to offbalance sheet deposits; (iii) deposit related fees; (iv) gain on sale of loans; and (v) other noninterest income. Service fees related to offbalance sheet deposits are fees earned for offbalance sheet deposit placements, primarily for our digital currency customers. The placements are facilitated under agreements we have entered into with customers and nationally recognized third party service providers that, in accordance with customer instructions, allow us to sweep customer funds into deposit accounts at other insured depository institutions. In connection with such sweeps and placements, the Bank earns noninterest income based on the difference between the gross interest earned on such deposit placements and the net interest the Bank agreed to pay on such swept funds (if any). Deposit related fees include cash management fees, such as analyzed checking fees, account maintenance fees, insufficient funds fees, overdraft fees, stop payment fees, foreign exchange fee income, domestic and foreign wire transfer fees, SEN related fees and card processing fee income. Noninterest Expense. Noninterest expense includes, among other things: (i) salaries and employee benefits; (ii) occupancy and equipment expense; (iii) communications and data processing fees (iv) professional services fees; (v) federal deposit insurance; (vi) correspondent bank charges; and (vii) other general and administrative expenses. Salaries and employee benefits include compensation, stockbased compensation, employee benefits and tax expenses for our personnel. Occupancy and equipment expense includes depreciation expense, lease expense on our leased properties and other occupancyrelated expenses. Equipment expense includes expenses related to our furniture [/INST] Negative. </s>

Mediaco Holding Inc.

2020-03-27

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. GENERAL The following discussion pertains to MediaCo Holding Inc. and its subsidiaries (collectively, “MediaCo” or the “Company”). We own and operate two radio stations located in New York City and outdoor advertising businesses geographically focused in Southern Georgia and Eastern Kentucky. Our revenues are mostly affected by the advertising rates our entities charge, as advertising sales represent approximately two-thirds of our consolidated revenues. These rates are in large part based on our radio stations’ ability to attract audiences in demographic groups targeted by their advertisers and the number of persons exposed to our billboards. The Nielsen Company generally measures radio station ratings weekly for markets measured by the Portable People Meter™, which includes all of our radio stations. Because audience ratings in a station’s local market are critical to the station’s financial success, our strategy is to use market research, advertising and promotion to attract and retain audiences in each station’s chosen demographic target group. Our revenues vary throughout the year. Revenue and operating income are usually lowest in the first calendar quarter for both our radio and outdoor advertising segments, partly because retailers cut back their advertising spending immediately following the holiday shopping season. In addition to the sale of advertising time for cash, stations typically exchange advertising time for goods or services, which can be used by the station in its business operations. These barter transactions are recorded at the estimated fair value of the product or service received. We generally confine the use of such trade transactions to promotional items or services for which we would otherwise have paid cash. In addition, it is our general policy not to preempt advertising spots paid for in cash with advertising spots paid for in trade. The following table summarizes the sources of our revenues for the year ended February 28, 2019 and the ten-month period ended December 31, 2019. The category “Non Traditional” principally consists of ticket sales and sponsorships of events our stations and magazines conduct in their local markets. The category “Other” includes, among other items, revenues related to network revenues and barter. A significant portion of our expenses varies in connection with changes in revenue. These variable expenses primarily relate to costs in our sales department, such as salaries, commissions and bad debt. Our costs that do not vary as much in relation to revenue are mostly in our programming and general and administrative departments, such as talent costs, syndicated programming fees, utilities, billboard site lease fees, office expenses and salaries. Lastly, our costs that are highly discretionary are costs in our marketing and promotions department, which we primarily incur to maintain and/or increase our audience and market share. KNOWN TRENDS AND UNCERTAINTIES The U.S. radio industry is a mature industry and its growth rate has stalled. Management believes this is principally the result of two factors: (1) new media, such as various media distributed via the Internet, telecommunication companies and cable interconnects, as well as social networks, have gained advertising share against radio and other traditional media and created a proliferation of advertising inventory and (2) the fragmentation of the radio audience and time spent listening caused by satellite radio, audio streaming services and podcasts has led some investors and advertisers to conclude that the effectiveness of radio advertising has diminished. Along with the rest of the radio industry, our stations have deployed HD Radio®. HD Radio offers listeners advantages over standard analog broadcasts, including improved sound quality and additional digital channels. In addition to offering secondary channels, the HD Radio spectrum allows broadcasters to transmit other forms of data. We are participating in a joint venture with other broadcasters to provide the bandwidth that a third party uses to transmit location-based data to hand-held and in-car navigation devices. The number of radio receivers incorporating HD Radio has increased in the past year, particularly in new automobiles. It is unclear what impact HD Radio will have on the markets in which we operate. The Company has also aggressively worked to harness the power of broadband and mobile media distribution in the development of emerging business opportunities by developing highly interactive websites with content that engages our listeners, deploying mobile applications and streaming our content, and harnessing the power of digital video on our websites and YouTube channels. The results of our radio operations are solely dependent on the results of our stations in the New York market. Some of our competitors that operate larger station clusters in the New York market are able to leverage their market share to extract a greater percentage of available advertising revenue through packaging a variety of advertising inventory at discounted unit rates. Market revenues in New York as measured by Miller Kaplan Arase LLP (“Miller Kaplan”), an independent public accounting firm used by the radio industry to compile revenue information, were down 2.0% for the twelve months ended February 28, 2019, but up 2.6% for the ten months ended December 31, 2019, as compared to the same period of the prior year. During these periods, revenues for our New York cluster were down 3.4% and up 9.5%, respectively. Our underperformance in the twelve months ended February 28, 2019 was largely attributable to lower ticket sales revenue for our largest concert, Summer Jam. Poor weather on the day of the concert in June 2018 negatively impacted ticket sales. However, our outperformance in the ten months ended December 31, 2019 was principally due to record-setting ticket sales associated with the concert in June 2019. As part of our business strategy, we continually evaluate potential acquisitions of businesses that we believe hold promise for long-term appreciation in value and leverage our strengths. However, MediaCo’s long-term debt agreements substantially limit our ability to make acquisitions. We also regularly review our portfolio of assets and may opportunistically dispose of assets when we believe it is appropriate to do so. The Company has been actively monitoring the COVID-19 situation and its impact globally, as well as domestically and in the markets we serve. Our priority has been the safety of our employees and those employees that we lease from EOC, as well as the informational needs of the communities that we serve. Through the first quarter of 2020, the disease became widespread around the world, and on March 11, 2020, the World Health Organization declared a pandemic. In an effort to mitigate the continued spread of COVID-19, federal, state and local governments, including New York Governor Andrew Cuomo, have mandated various restrictions, including travel restrictions, restrictions on non-essential businesses and services, restrictions on public gatherings and quarantining of people who may have been exposed to the virus. As a consequence of outbreaks of COVID-19, the current and any future responses by federal, state and local governments, and any general desire by the public to avoid large gatherings, it is likely that we will see a decline in attendance at our live events or such events could also be postponed or cancelled as a precautionary measure. Furthermore, if the resulting downturn of the United States economy continues or worsens, we may see a decline in advertising revenue generated by our radio broadcasting and outdoor advertising businesses. While it is still too early to estimate the effect that the spread of COVID-19 will have on our results of operations, if the spread of COVID-19 continues and public and private entities continue to implement restrictive measures, we could experience a material adverse effect on our business, results of operations, financial condition and cash flows. CRITICAL ACCOUNTING POLICIES Critical accounting policies are defined as those that encompass significant judgments and uncertainties, and potentially derive materially different results under different assumptions and conditions. We believe that our critical accounting policies are those described below. Revenue Recognition Broadcasting revenue is recognized as advertisements are aired and outdoor revenue is recognized over the life of the applicable lease of each billboard. Both broadcasting revenue and outdoor revenue recognition is subject to meeting certain conditions such as persuasive evidence that an arrangement exists and collection is reasonably assured. These criteria are generally met at the time the advertisement is aired for broadcasting revenue or displayed for outdoor revenue. Broadcasting advertising revenues presented in the financial statements are reflected on a net basis, after the deduction of advertising agency fees, usually at a rate of 15% of gross revenues. FCC Licenses We have made acquisitions in the past for which a significant amount of the purchase price was allocated to FCC licenses and goodwill assets. As of December 31, 2019, we have recorded approximately $63.3 million in FCC licenses, which represents approximately 38% of our total assets. In the case of our radio stations, we would not be able to operate the properties without the related FCC license for each property. FCC licenses are renewed every eight years; consequently, we continually monitor our stations’ compliance with the various regulatory requirements. Historically, all of our FCC licenses have been renewed at the end of their respective periods, and we expect that all FCC licenses will continue to be renewed in the future. We consider our FCC licenses to be indefinite-lived intangibles. We do not amortize indefinite-lived intangible assets, but rather test for impairment at least annually or more frequently if events or circumstances indicate that an asset may be impaired. When evaluating our radio broadcasting licenses for impairment, the testing is performed at the unit of accounting level as determined by Accounting Standards Codification (“ASC”) Topic 350-30-35. In our case, radio stations in a geographic market cluster are considered a single unit of accounting. In the ten-month period ended December 31, 2019, we completed our annual impairment test on November 25, 2019, the date the stations were transferred by Emmis. Going forward we will complete our annual impairment tests on October 1 of each year and perform additional interim impairment testing whenever triggering events suggest such testing is warranted. Valuation of Indefinite-lived Broadcasting Licenses Fair value of our FCC licenses is estimated to be 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. To determine the fair value of our FCC licenses, the Company considered both income and market valuation methods when it performed its impairment tests. Under the income method, the Company projects cash flows that would be generated by each of its units of accounting assuming the unit of accounting was commencing operations in its respective market at the beginning of the valuation period. This cash flow stream is discounted to arrive at a value for the FCC license. The Company assumes the competitive situation that exists in each market remains unchanged, with the exception that its unit of accounting commenced operations at the beginning of the valuation period. In doing so, the Company extracts the value of going concern and any other assets acquired, and strictly values the FCC license. Major assumptions involved in this analysis include market revenue, market revenue growth rates, unit of accounting audience share, unit of accounting revenue share and discount rate. Each of these assumptions may change in the future based upon changes in general economic conditions, audience behavior, consummated transactions, and numerous other variables that may be beyond our control. The projections incorporated into our license valuations take current economic conditions into consideration. Under the market method, the Company uses recent sales of comparable radio stations for which the sales value appeared to be concentrated entirely in the value of the license, to arrive at an indication of fair value. Below are some of the key assumptions used in our income method annual impairment assessments. In recent years, we have reduced long-term growth rates in the New York market in which we operate based on recent industry trends and our expectations for the market going forward. Valuation of Goodwill As a result of the Fairway Acquisition, the Company has preliminarily recorded $11.4 million of goodwill. This accounts for all goodwill on the consolidated and combined balance sheets as of December 31, 2019. ASC Topic 350-20-35 requires the Company to test goodwill for impairment at least annually. The Fairway Acquisition closed on December 13, 2019 and all assets acquired and liabilities assumed were valued as of that date, resulting in a preliminary goodwill valuation of $11.4 million. There have been no indicators of impairment that have arisen since that date that would require us to assess the goodwill for impairment. The Company will conduct its impairment test on October 1 of each fiscal year, unless indications of impairment exist during an interim period. The purchase price allocation described in Note 7 is preliminary and subject to adjustment. Any adjustment to the purchase price allocation may directly impact the value of goodwill. Sensitivity Analysis Based on the results of our November 25, 2019 annual impairment assessment, the fair value of our broadcasting licenses was approximately $90.3 million, which was in excess of the $63.3 million carrying value by $27 million, or 42.8%. Should our estimates or assumptions worsen, or should negative events or circumstances occur in the units that have limited fair value cushion, additional license impairments may be needed. If we were to assume a 100 basis point change in any of our three key assumptions (a reduction in the long-term revenue growth rate, a reduction in local commercial share or an increase in the discount rate) used to determine the fair value of our broadcasting licenses under the income method on December 1, 2018, fair value of the FCC licenses would still exceed carrying value. Deferred Taxes The Company accounts for income taxes under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequence of events that have been recognized in the Company’s financial statements or income tax returns. Income taxes are recognized during the year in which the underlying transactions are reflected in the consolidated statements of operations. Deferred taxes are provided for temporary differences between amounts of assets and liabilities recorded for financial reporting purposes as compared to amounts recorded for income tax purposes. After determining the total amount of deferred tax assets, the Company determines whether it is more likely than not that some portion of the deferred tax assets will not be realized. If the Company determines that a deferred tax asset is not likely to be realized, a valuation allowance will be established against that asset to record it at its expected realizable value. RESULTS OF OPERATIONS YEAR ENDED FEBRUARY 28, 2019 COMPARED TO TEN MONTHS ENDED DECEMBER 31, 2019 Net revenues: Radio net revenues decreased because the ten months ended December 31, 2019 contains two fewer months as compared to the year ended February 28, 2019. We typically monitor the performance of our stations against the performance of the New York radio market based on reports for the periods prepared by Miller Kaplan. Miller Kaplan reports are generally prepared on a gross revenues basis and exclude revenues from barter arrangements. A summary of market revenue performance and MediaCo’s revenue performance in the New York market for the ten-month period ended December 31, 2019 is presented below: Our outperformance as compared to the overall market revenue performance in the ten months ended December 31, 2019 was largely driven by record-setting ticket sales associated with our largest concert, Summer Jam, which occurred in June 2019. We acquired two outdoor advertising businesses principally located in Southern Georgia and Eastern Kentucky on December 13, 2019, so there are no comparable results in the year ended February 28, 2019. Operating expenses excluding depreciation and amortization expense: Operating expenses excluding depreciation and amortization expense for our radio division decreased because the ten months ended December 31, 2019 contains two fewer months as compared to the year ended February 28, 2019. We acquired two outdoor advertising businesses principally located in Southern Georgia and Eastern Kentucky on December 13, 2019, so there are no comparable results in the year ended February 28, 2019. Corporate expenses excluding depreciation and amortization expense: Corporate expenses excluding depreciation and amortization expense for the ten months ended December 31, 2019 mostly relate to transaction fees and expenses associated with the acquisition of two radio stations in New York and two outdoor advertising businesses during the period. Depreciation and amortization: Radio depreciation and amortization expense decreased because the ten months ended December 31, 2019 contains two fewer months as compared to the year ended February 28, 2019. Additionally, a number of assets became fully depreciated during the ten months ended December 31, 2019. We acquired two outdoor advertising businesses principally located in Southern Georgia and Eastern Kentucky on December 13, 2019, so there are no comparable results in the year ended February 28, 2019. Operating income (loss): Radio operating income increased principally due to improved financial performance of our largest concert, Summer Jam, which occurred in June 2019. Interest expense: For the year ended February 28, 2019 there was no interest expense allocated to MediaCo from Emmis in connection with the carved-out financial statements. During the ten-month period ended December 31, 2019, the Company entered into numerous debt instruments to finance SG Broadcasting’s acquisition of a controlling interest in the Company from Emmis in November 2019 and two outdoor advertising businesses in December 2019. Provision for income taxes: Our effective income tax rate was 32% and 44% for the year ended February 28, 2019 and ten months ended December 31, 2019, respectively. Our effective income tax rate increased in the ten months ended December 31, 2019 due to a change in our state income tax rate resulting from the Fairway Acquisition and the application of the new rate to existing deferred tax balances. Our effective income tax rates differ from the statutory rates primarily due to the impact of permanent differences and state income taxes. Consolidated net income: The decrease in consolidated net income is principally due to transaction fees and expenses associated with the acquisition of two radio stations in New York and two outdoor advertising businesses during the ten months ended December 31, 2019. LIQUIDITY AND CAPITAL RESOURCES On November 25, 2019, the Company entered into a $50.0 million, five-year senior secured term loan agreement (the “Senior Credit Facility”) with GACP Finance Co., LLC, a Delaware limited liability company, as administrative agent and collateral agent. The Senior Credit Facility provides for initial borrowings of up to $50.0 million, of which net proceeds of $48.3 million after debt discount of $1.7 million, were paid concurrently to Emmis in connection with SG Broadcasting’s acquisition of a controlling interest in the Company, as well as one tranche of additional borrowings of $25.0 million. The Senior Credit Facility bears interest at a rate equal to the London Interbank Offered Rate ("LIBOR"), plus 7.5%, with a 2.0% LIBOR floor. The Senior Credit Facility requires interest payments on the first business day of each calendar month, and quarterly payments on the principal in an amount equal to one and one quarter percent of the initial aggregate principal amount are due on the last day of each calendar quarter. The Senior Credit Facility includes covenants pertaining to, among other things, the ability to incur indebtedness, restrictions on the payment of dividends, minimum Liquidity (as defined in the Senior Credit Facility) of $2.0 million for the period from the effective date until November 25, 2020, $2.5 million for the period from November 26, 2020 until November 25, 2021, and $3.0 million for the period thereafter, collateral maintenance, minimum Consolidated Fixed Charge Coverage Ratio (as defined in the Senior Credit Facility) of 1.10:1.00, and other customary restrictions. The Company borrowed $23.4 million of the remaining available borrowings to fund the Fairway Acquisition on December 13, 2019. Proceeds received were $22.6 million, net of a debt discount of $0.8 million. The Senior Credit Facility is carried net of a total unamortized discount of $2.4 million at December 31, 2019. On March 27, 2020, the Company amended and restated its Senior Credit Facility, in order to, among other things, (i) reduce the required Consolidated Fixed Charge Coverage Ratio to 1.00x from June 30, 2020 to December 31, 2020, (ii) reduce the minimum Liquidity requirement to $1.0 million through September 30, 2020, (iii) permit equity contributions and loans during calendar year 2020 under the SG Broadcasting Promissory Note, as amended and restated, to count toward Consolidated EBITDA (as defined in the Senior Credit Facility) for purposes of the Consolidated Fixed Charge Coverage Ratio calculation, and (iv) increase the maximum aggregate principal amount issuable under the SG Broadcasting Promissory Note, as amended and restated, to $20.0 million. In connection with this amendment, the Company incurred an amendment fee of approximately $0.2 million, which was added to the principal amount of the Senior Credit Facility then outstanding. On November 25, 2019, as part of the consideration owed to Emmis in connection with SG Broadcasting’s acquisition of a controlling interest in the Company, the Company issued to Emmis the Emmis Convertible Promissory Note in the amount of $5.0 million. The Emmis Convertible Promissory Note carries interest at a base rate equal to the interest on any senior credit facility, or if no senior credit facility is outstanding, of 6.0%, plus an additional 1.0% on any payment of interest in kind and, without regard to whether the Company pays such interest in kind, an additional increase of 1.0% following the second anniversary of the date of issuance and additional increases of 1.0% following each successive anniversary thereafter. Because the Senior Credit Facility prohibits the Company from paying interest in cash on the Emmis Convertible Promissory Note, the Company has been accruing interest since inception using the rate applicable if the interest will be paid in kind. The Emmis Convertible Promissory Note is convertible, in whole or in part, into MediaCo Class A common stock at the option of Emmis beginning six months after issuance and at a strike price equal to the thirty day volume weighted average price of the MediaCo Class A common stock on the date of conversion. The Emmis Convertible Promissory Note matures on November 25, 2024. On November 25, 2019, the Company issued the SG Broadcasting Promissory Note, a subordinated convertible promissory note payable by the Company to SG Broadcasting, in return for which SG Broadcasting contributed to MediaCo $6.3 million for working capital and general corporate purposes. The SG Broadcasting Promissory Note carries interest at a base rate equal to the interest on any senior credit facility, or if no senior credit facility is outstanding, of 6.0%, and an additional increase of 1.0% following the second anniversary of the date of issuance and additional increases of 1.0% following each successive anniversary thereafter. The SG Broadcasting Promissory Note matures on May 25, 2025. Additionally, interest under the SG Broadcasting Promissory Note is payable in kind through maturity, and is convertible into MediaCo Class A common stock at the option of SG Broadcasting beginning six months after issuance and at a strike price equal to the thirty day volume weighted average price of the MediaCo Class A common stock on the date of conversion. On February 28, 2020, the Company and SG Broadcasting amended and restated the SG Broadcasting Promissory Note such that the maximum aggregate principal amount issuable under the note was increased from $6.3 million to $10.3 million. On March 27, 2020, the Company and SG Broadcasting further amended and restated the SG Broadcasting Promissory Note such that the maximum aggregate principal amount issuable under the note was increased from $10.3 million to $20.0 million. As of March 27, 2020, SG Broadcasting had loaned $11.3 million to the Company pursuant to the SG Broadcasting Promissory Note, as amended and restated, and is expected to lend additional amounts under the note from time to time. On December 13, 2019, in connection with the Fairway Acquisition, the Company issued to SG Broadcasting 220,000 shares of MediaCo Series A Convertible Preferred Stock. The MediaCo Series A Convertible Preferred Stock ranks senior in preference to the MediaCo Class A common stock, MediaCo Class B common stock, and the MediaCo Class C common stock. Pursuant to our Articles of Amendment, the ability of the Company to make distributions with respect to, or make a liquidation payment on, any other class of capital stock in the Company designated to be junior to, or on parity with, the MediaCo Series A Convertible Preferred Stock, will be subject to certain restrictions, including that (i) the MediaCo Series A Convertible Preferred Stock shall be entitled to receive the amount of dividends per share that would be payable on the number of whole common shares of the Company into which each share of MediaCo Series A Convertible Preferred Stock could be converted when such conversion becomes active, and (ii) the MediaCo Series A Convertible Preferred Stock, upon any liquidation, dissolution or winding up of the Company, shall be entitled to a preference on the assets of the Company. Issued and outstanding shares of MediaCo Series A Convertible Preferred Stock shall accrue cumulative dividends, payable in kind, at an annual rate equal to the interest rate on any senior credit facility of the Company, or if no senior debt is outstanding, 6.0%, plus additional increases of 1.0% on December 12, 2020 and each anniversary thereof. As part of the acquisition of SG Broadcasting’s controlling interest in the Company from Emmis on November 25, 2019, Emmis retained the working capital of the stations, but the Company was permitted to collect and use, for a period of nine months, the first $5.0 million of net working capital attributable to the stations as of the closing date. This amount is due to Emmis on the nine month anniversary of the closing date, or August 25, 2020. This right to $5.0 million of retained net working capital was satisfied in January 2020 and used in the operations of the business. MediaCo does not believe it will generate $5.0 million of excess cash from operations by August 25, 2020 to repay this amount to Emmis, but Standard General has guaranteed this payment to Emmis in the event MediaCo is unable to make the payment when due. SOURCES OF LIQUIDITY Our primary sources of liquidity are cash provided by operations and cash available through borrowings under the SG Broadcasting Promissory Note. Our primary uses of capital have been, and are expected to continue to be, capital expenditures, working capital, debt service requirements and acquisitions. At December 31, 2019, we had cash and cash equivalents of $2.1 million and net working capital of ($4.7) million. At February 28, 2019, we had no cash and cash equivalents and net working capital of $5.9 million. The decrease in net working capital is largely due to the fact that Emmis retained the working capital of the stations upon consummation of the Transaction. The Company continually projects its anticipated cash needs, which include its operating needs, capital needs, and principal and interest payments on its indebtedness. As of the filing of this Form 10-K, management believes the Company can meet its liquidity needs through the end of 2020 with cash and cash equivalents on hand, projected cash flows from operations, and reliance on the $5.0 million guarantee by Standard General previously discussed. Based on these projections, management also believes the Company will be in compliance with its debt covenants through the end of 2020. Operating Activities Cash flows provided by operating activities were $3.6 million for the ten months ended December 31, 2019 versus cash flows provided by operating activities of $8.7 million for the year ended February 28, 2019. The decrease in cash flows provided by operating activities was mostly attributable to lower net income in the ten months ended December 31, 2019. Investing Activities Cash flows used in investing activities of $43.2 million for the ten months ended December 31, 2019 consisted of $43.1 million used to purchase Fairway Outdoor and $0.1 million used for capital expenditures. Cash flows used in investing activities of $0.2 million for the year ended February 28, 2019 was attributable to capital expenditures. Financing Activities Cash provided by financing activities of $41.7 million for the ten months ended December 31, 2019 primarily consisted of proceeds of debt of $29.4 million and proceeds from the issuance of stock of $22.0 million. This was partially offset by net transactions with Emmis of $6.3 million and payments of debt related costs of $2.5 million. Cash used in financing activities of $8.5 million for the year ended February 28, 2019 related solely to net transactions with Emmis. As of December 31, 2019, MediaCo had outstanding $72.5 million of borrowings under the Senior Credit Facility, of which $3.7 million is current. As of December 31, 2019, the borrowing rate under our Senior Credit Facility was 9.5%. Additionally, MediaCo had $5.0 and $6.3 million of promissory notes outstanding at December 31, 2019 to Emmis and SG Broadcasting, respectively, none of which is current. The debt service requirements of MediaCo over the next twelve-month period are expected to be $10.6 million related to our Senior Credit Facility ($3.7 million of principal repayments and $6.9 million of interest payments). The Senior Credit Facility bears interest at a variable rate. The Company estimates interest payments by using the amounts outstanding as of December 31, 2019 and then-current interest rates. There are no debt service requirements over the next twelve months for either the Emmis Convertible Promissory Note or the SG Broadcasting Promissory Note. As part of our business strategy, we continually evaluate potential acquisitions of businesses that we believe hold promise for long-term appreciation in value and leverage our strengths. However, our Senior Credit Facility substantially limits our ability to make acquisitions. INTANGIBLES As of December 31, 2019, approximately 38% of our total assets consisted of FCC licenses, the value of which depends significantly upon the operational results of our businesses. In the case of our radio stations, we would not be able to operate the properties without the related FCC license for each property. FCC licenses are renewed every eight years; consequently, we continually monitor the activities of our stations for compliance with regulatory requirements. Historically, all of our FCC licenses have been renewed (or a waiver has been granted pending renewal) at the end of their respective eight-year periods, and we expect that all of our FCC licenses will continue to be renewed in the future. SEASONALITY Our results of operations are usually subject to seasonal fluctuations, which result in higher second quarter revenues and operating income. For our radio operations, this seasonality is largely due to the timing of our largest concert in June of each year. Results are typically lowest in the first calendar quarter. INFLATION The impact of inflation on operations has not been significant to date. However, there can be no assurance that a high rate of inflation in the future would not have an adverse effect on operating results, particularly since our Senior Credit Facility is comprised entirely of variable-rate debt. OFF-BALANCE SHEET FINANCINGS AND LIABILITIES Other than legal contingencies incurred in the normal course of business, and contractual commitments to purchase goods and services, all of which are discussed in Note 11 to the consolidated financial statements, which is incorporated by reference herein, the Company does not have any material off-balance sheet financings or liabilities. The Company does not have any majority-owned and controlled subsidiaries that are not included in the consolidated financial statements, nor does the Company have any interests in or relationships with any “special-purpose entities” that are not reflected in the consolidated financial statements or disclosed in the Notes to Consolidated Financial Statements.

<s>[INST] The following discussion pertains to MediaCo Holding Inc. and its subsidiaries (collectively, “MediaCo” or the “Company”). We own and operate two radio stations located in New York City and outdoor advertising businesses geographically focused in Southern Georgia and Eastern Kentucky. Our revenues are mostly affected by the advertising rates our entities charge, as advertising sales represent approximately twothirds of our consolidated revenues. These rates are in large part based on our radio stations’ ability to attract audiences in demographic groups targeted by their advertisers and the number of persons exposed to our billboards. The Nielsen Company generally measures radio station ratings weekly for markets measured by the Portable People Meter™, which includes all of our radio stations. Because audience ratings in a station’s local market are critical to the station’s financial success, our strategy is to use market research, advertising and promotion to attract and retain audiences in each station’s chosen demographic target group. Our revenues vary throughout the year. Revenue and operating income are usually lowest in the first calendar quarter for both our radio and outdoor advertising segments, partly because retailers cut back their advertising spending immediately following the holiday shopping season. In addition to the sale of advertising time for cash, stations typically exchange advertising time for goods or services, which can be used by the station in its business operations. These barter transactions are recorded at the estimated fair value of the product or service received. We generally confine the use of such trade transactions to promotional items or services for which we would otherwise have paid cash. In addition, it is our general policy not to preempt advertising spots paid for in cash with advertising spots paid for in trade. The following table summarizes the sources of our revenues for the year ended February 28, 2019 and the tenmonth period ended December 31, 2019. The category “Non Traditional” principally consists of ticket sales and sponsorships of events our stations and magazines conduct in their local markets. The category “Other” includes, among other items, revenues related to network revenues and barter. A significant portion of our expenses varies in connection with changes in revenue. These variable expenses primarily relate to costs in our sales department, such as salaries, commissions and bad debt. Our costs that do not vary as much in relation to revenue are mostly in our programming and general and administrative departments, such as talent costs, syndicated programming fees, utilities, billboard site lease fees, office expenses and salaries. Lastly, our costs that are highly discretionary are costs in our marketing and promotions department, which we primarily incur to maintain and/or increase our audience and market share. KNOWN TRENDS AND UNCERTAINTIES The U.S. radio industry is a mature industry and its growth rate has stalled. Management believes this is principally the result of two factors: (1) new media, such as various media distributed via the Internet, telecommunication companies and cable interconnects, as well as social networks, have gained advertising share against radio and other traditional media and created a proliferation of advertising inventory and (2) the fragmentation of the radio audience and time spent listening caused by satellite radio, audio streaming services and podcasts has led some investors and advertisers to conclude that the effectiveness of radio advertising has diminished. Along with the rest of the radio industry, our stations have deployed HD Radio®. HD Radio offers listeners advantages over standard analog broadcasts, including improved sound quality and additional digital channels. In addition to offering secondary channels, the HD Radio spectrum allows broadcasters to transmit other forms of data. We are participating in a joint venture with other broadcasters to provide the bandwidth that a third party uses to transmit locationbased data to handheld and incar navigation devices. The number of radio receivers incorporating HD Radio has increased in the past year, particularly in new automobiles. It is unclear what impact HD Radio will have on the markets in which we operate. The Company has also aggressively worked to harness the power of broadband and mobile media distribution in the development of emerging business opportunities by developing highly interactive websites with content that engages our listeners, deploying mobile applications and streaming our content, and harnessing the power of digital video on our websites and YouTube channels. The results of our radio operations are solely dependent on the results of our stations in the New York [/INST] Negative. </s>

Juniper Industrial Holdings, Inc.

2020-03-30

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations References to the “Company,” “Juniper Industrial Holdings, Inc.” “our,” “us” or “we” refer to Juniper Industrial Holdings, Inc. 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 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 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 in Delaware on August 12, 2019 for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses (the “Business Combination”). Although the Company is not limited to a particular industry, sector or geographical location for purposes of consummating a Business Combination, the Company intends to focus its search for a target business in the industrial sector. We are an early stage and emerging growth company and, as such, we are subject to all of the risks associated with early stage and emerging growth companies. Our sponsor Juniper Industrial Sponsor, LLC, a Delaware limited liability company (the “Sponsor”). The registration statement for our initial public offering (the “Initial Public Offering”) was declared effective on November 7, 2019. We consummated our Initial Public Offering of 34,500,000 units (the “Units” and, with respect to the Class A common stock included in the Units being offered, the “Public Shares”), including 4,500,000 additional Units to cover over-allotments (the “Over-Allotment Units”), at $10.00 per Unit, generating gross proceeds of $345.00 million, and incurring offering costs of approximately $19.59 million, inclusive of approximately $12.08 million in deferred underwriting commissions. Simultaneously with the closing of the Initial Public Offering, we consummated the private placement (“Private Placement”) of 10,150,000 warrants (each, a “Private Placement Warrant” and collectively, the “Private Placement Warrants”) at a price of $1.00 per Private Placement Warrant in a private placement to our Sponsor, generating proceeds of $10.15 million. Upon the closing of the Initial Public Offering and the Private Placement, $345.00 million ($10.00 per Unit) of the net proceeds of the Initial Public Offering and certain of the proceeds of the Private Placement was placed in a trust account (the “Trust Account”), located in the United States with Continental Stock Transfer & Trust Company acting as trustee, and invested only in U.S. “government securities,” within the meaning set forth in Section 2(a)(16) of the Investment Company Act, with a maturity of 185 days or less, or in money market funds meeting the conditions of paragraphs (d)(2), (d)(3) and (d)(4) of Rule 2a-7 under the Investment Company Act of 1940, as amended (the “Investment Company Act”), which invest only in direct U.S. government treasury obligations, as determined by the Company, until the earlier of: (i) the completion of a Business Combination and (ii) the distribution of 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 sale of Private Placement Warrants, although all of the net proceeds of the Initial Public Offering and certain of the proceeds of the sale of the Private Placement Warrants are intended to be applied generally 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 November 13, 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 (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 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 the Company’s remaining stockholders and its board of directors, dissolve and liquidate, subject in each case to the Company’s obligations under Delaware 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, 2019, we had approximately $2.5 million in cash, and working capital of approximately $2.5 million (not taken into account franchise and income tax obligations), and approximately $715,000 of interest available to pay for our taxes. Our liquidity needs prior to the consummation of the Initial Public Offering were satisfied through the proceeds of $25,000 from the sale of the Founders Shares, and loans from our Sponsor of approximately $97,000. The loan was repaid in full on November 15, 2019. Subsequent from the consummation of the Initial Public Offering, our liquidity has been satisfied through the net proceeds received from the consummation of the Initial Public Offering and the Private Placement. Based on the foregoing, management believes that we will have sufficient working capital and borrowing capacity to meet its needs through the earlier of the consummation of a Business Combination or one year from this filing. Over this time period, we will be using these funds for paying existing accounts payable, identifying and evaluating prospective initial Business Combination candidates, performing due diligence on prospective target businesses, paying for travel expenditures, selecting the target business to merge with or acquire, and structuring, negotiating and consummating the Business Combination. Results of Operations Our entire activity since inception up to December 31, 2019 was in preparation for our formation and the Initial Public Offering and, since the closing of the Initial Public Offering, a search for a business combination candidate. We will not be generating any operating revenues until the closing and completion of our initial Business Combination. For the period from August 12, 2019 (inception) through December 31, 2019, we had net income of approximately $322,000, which consisted of approximately $715,000 generated from interest income earned in operating account, interest earned on marketable securities held in Trust Account, and unrealized gain on marketable securities held in Trust Account, offset by approximately $187,000 in general and administrative expenses, approximately $77,000 in franchise tax expenses and approximately $129,000 in income tax expenses. Related Party Transactions Founder Shares On August 29, 2019, our Sponsor purchased 8,625,000 shares (the “Founder Shares”) of our Class B common stock, par value $0.0001 per share, for an aggregate price of $25,000. On October 10, 2019, our Sponsor transferred 35,000 Founder Shares to each of our independent directors. The initial stockholders agreed to forfeit up to 1,125,000 Founder Shares to the extent that the over-allotment option was not exercised in full by the underwriter. The forfeiture would be adjusted to the extent that the over-allotment option was not exercised in full by the underwriter so that the Founder Shares would represent 20.0% of our issued and outstanding shares after the Initial Public Offering. The underwriter exercised its over-allotment option in full on November 13, 2019; thus, the Founder Shares were no longer subject to forfeiture. The initial stockholders have agreed, subject to limited exceptions, not to transfer, assign or sell any of the Founder Shares until one year after the consummation of the initial Business Combination or earlier if, subsequent to the initial Business Combination, (i) the last sale price of our Class A 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 (ii) we consummate a subsequent liquidation, merger, stock exchange or other similar transaction which 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 On November 13, 2019, we sold 10,150,000 Private Placement Warrants at a price of $1.00 per Private Placement Warrant to the Sponsor, generating gross proceeds of $10.15 million. Each Private Placement Warrant is exercisable for one share of Class A common stock 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 net proceeds from the Initial Public Offering held in the Trust Account. If we do not complete a Business Combination within the Combination Period, the Private Placement Warrants will expire worthless. The Private Placement Warrants are non-redeemable under certain redemption scenarios 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 have 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 August 29, 2019, 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 upon the completion of the Initial Public Offering. Prior to the consummation of the Initial Public Offering, we borrowed approximately $97,000 under the Note. We repaid this Note in full on November 15, 2019. 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 consummated, 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 $1.00 per warrant. The warrants would be identical to the Private Placement Warrants. To date, we had no Working Capital Loans outstanding. Administrative Services Agreement Upon closing of the Initial Public Offering and continuing until the earlier of our consummation of a Business Combination or our liquidation, we agreed to pay our Sponsor $10,000 per month for office space, utilities, secretarial support and administrative services. We incurred $20,000 in expenses in connection with such services and recorded in general and administrative expenses in the Statement of Operations for the period from August 12, 2019 (inception) through December 31, 2019. As of December 31, 2019, we had $20,000 in accrued expenses for related party in connection with such services in the accompanying Balance Sheet. Our Sponsor and our officers and directors, or any of their respective affiliates, will be reimbursed for any out-of-pocket expenses incurred in connection with activities on our behalf, such as identifying potential target businesses and performing due diligence on suitable Business Combinations. Our audit committee will review on a quarterly basis all payments that were made to our Sponsor or our officers, directors or their affiliates and will determine which expenses and the amount of expenses that will be reimbursed. There is no cap or ceiling on the reimbursement of out-of-pocket expenses incurred by such persons in connection with activities on our behalf. Contractual Obligations Registration and Stockholder Rights The holders of Founder Shares, Private Placement Warrants and warrants that may be issued upon conversion of Working Capital Loans, if any, (and any shares of Class A common stock issuable upon the exercise of the Private Placement Warrants and warrants that may be issued upon conversion of Working Capital Loans and upon conversion of the Founder Shares) will be entitled to registration rights pursuant to a registration and stockholder rights agreement entered into in connection with the consummation of the Initial Public Offering. These holders will be entitled to certain demand and “piggyback” registration rights. However, the registration and stockholder 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 The underwriter was entitled to an underwriting discount of $0.20 per unit, or $6.9 million in the aggregate, paid upon the closing of the Initial Public Offering. In addition, $0.35 per unit, or approximately $12.08 million in the aggregate will be payable to the underwriter for deferred underwriting commissions. The deferred fee will become payable to the underwriter 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. The Underwriter has agreed to reimburse us $315,000 for expenses under certain circumstances. We received such reimbursement on November 14, 2019. Critical Accounting Policies Class A common stock subject to possible redemption We account for our Class A common stock subject to possible redemption in accordance with the guidance in ASC Topic 480 “Distinguishing Liabilities from Equity.” Class A common stock subject to mandatory redemption (if any) is classified as liability instruments and are measured at fair value. Conditionally redeemable Class A common stock (including Class A 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) are classified as temporary equity. At all other times, Class A common stock is 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, 33,024,303 shares of Class A common stock subject to possible redemption is presented as temporary equity, outside of the stockholders’ equity section of our balance sheet. Net Loss Per Share of Common Stock Net loss per share is computed by dividing net loss by the weighted-average number of shares of common stock outstanding during the period. An aggregate of 33,024,303 shares of common stock subject to possible redemption at December 31, 2019 has been excluded from the calculation of basic loss per share of common stock, since such shares, if redeemed, only participate in their pro rata share of the trust earnings. We have not considered the effect of the warrants sold in the Initial Public Offering (including the consummation of the Over-allotment) and Private Placement to purchase an aggregate of 27,400,000 shares of our common stock in the calculation of diluted loss per share, since they are not yet exercisable. Recent Accounting Pronouncements Our management does not believe that there are any recently issued, but not yet effective, accounting pronouncements, if currently adopted, that would have a material effect 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. 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 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 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 in Delaware on August 12, 2019 for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses (the “Business Combination”). Although the Company is not limited to a particular industry, sector or geographical location for purposes of consummating a Business Combination, the Company intends to focus its search for a target business in the industrial sector. We are an early stage and emerging growth company and, as such, we are subject to all of the risks associated with early stage and emerging growth companies. Our sponsor Juniper Industrial Sponsor, LLC, a Delaware limited liability company (the “Sponsor”). The registration statement for our initial public offering (the “Initial Public Offering”) was declared effective on November 7, 2019. We consummated our Initial Public Offering of 34,500,000 units (the “Units” and, with respect to the Class A common stock included in the Units being offered, the “Public Shares”), including 4,500,000 additional Units to cover overallotments (the “OverAllotment Units”), at $10.00 per Unit, generating gross proceeds of $345.00 million, and incurring offering costs of approximately $19.59 million, inclusive of approximately $12.08 million in deferred underwriting commissions. Simultaneously with the closing of the Initial Public Offering, we consummated the private placement (“Private Placement”) of 10,150,000 warrants (each, a “Private Placement Warrant” and collectively, the “Private Placement Warrants”) at a price of $1.00 per Private Placement Warrant in a private placement to our Sponsor, generating proceeds of $10.15 million. Upon the closing of the Initial Public Offering and the Private Placement, $345.00 million ($10.00 per Unit) of the net proceeds of the Initial Public Offering and certain of the proceeds of the Private Placement was placed in a trust account (the “Trust Account”), located in the United States with Continental Stock Transfer & Trust Company acting as trustee, and invested only in U.S. “government securities,” within the meaning set forth in Section 2(a)(16) of the Investment Company Act, with a maturity of 185 days or less, or in money market funds meeting the conditions of paragraphs (d)(2), (d)(3) [/INST] Negative. </s>

Axcella Health Inc.

2020-03-23

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion of the financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and the related notes thereto included elsewhere in this Annual Report. In addition to historical information, this discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. We caution you that forward-looking statements are not guarantees of future performance, and that our actual results of operations, financial condition and liquidity, and the developments in our business and the industry in which we operate, may differ materially from the results discussed or projected in the forward-looking statements contained in this Annual Report. We discuss risks and other factors that we believe could cause or contribute to these potential differences elsewhere in this Annual Report, including under Part I, Part I, Item 1A. “Risk Factors” and under “Special Note Regarding Forward-Looking Statements.” In addition, even if our results of operations, financial condition and liquidity, and the developments in our business and the industry in which we operate are consistent with the forward-looking statements contained in this Annual Report, they may not be predictive of results or developments in future periods. We caution readers not to place undue reliance on any forward-looking statements made by us, which speak only as of the date they are made. We disclaim any obligation, except as specifically required by law and the rules of the SEC to publicly update or revise any such statements to reflect any change in our expectations or in events, conditions or circumstances on which any such statements may be based, or that may affect the likelihood that actual results will differ from those set forth in the forward-looking statements. Overview We are a clinical-stage biotechnology company focused on leveraging endogenous metabolic modulators, or EMMs, to pioneer a new approach for treating complex diseases and improving health. Our product candidates are comprised of multiple EMMs that are engineered in distinct combinations and ratios with the goal of simultaneously impacting multiple biological pathways. Our pipeline includes lead therapeutic candidates for non-alcoholic steatohepatitis, or NASH, and the reduction in risk of overt hepatic encephalopathy, or OHE, recurrence. Additional muscle- and blood-related programs are in earlier-stage development. Using our development platform, we have efficiently designed a pipeline of product candidates that are comprised of amino acids and their derivatives. These orally administered compositions are designed to have the potential for multifactorial effects, and their constituents have a general history of safe use. To date, we have funded our operations with proceeds from the sale of preferred stock, the sale of common stock in our initial public offering, or our IPO, and borrowing of debt. Through December 31, 2019, we had received gross proceeds of $197.8 million from the sale of preferred stock, gross proceeds of $71.4 million from the sale of common stock in our IPO and $26.0 million from borrowings under our loan and security agreement. 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. Our net losses were $59.0 million and $36.1 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $216.1 million. We expect to continue to incur significant expenses for at least the next several years as we continue to develop our 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 a combination of equity offerings, debt financings, strategic alliances and marketing and 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 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 $92.1 million. We believe that our existing cash and cash equivalents as of December 31, 2019 will enable us to fund our operating expenses, capital expenditure requirements and debt service payments for at least the next 12 months following the filing date of this Annual Report on Form 10-K. 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 significantly beyond that point, we will need to raise additional capital, which cannot be assured. The recent outbreak of COVID-19 has spread globally, including to the United States and European countries, which has resulted in significant governmental measures being implemented to control the spread of the virus, including quarantines, travel restrictions and business shutdowns. Although we cannot presently predict the scope and severity of COVID-19, these developments and measures could materially and adversely affect our business, our results of operation and financial condition, particularly if the COVID-19 outbreak adversely impacts our ability to conduct and complete our ongoing Clinical Studies and planned Clinical Trials in a timely manner or at all due to patient or principal investigator recruitment or availability challenges, clinical trial site shutdowns or other interruptions and potential limitations on the quality, completeness and interpretability of data we are able to collect; we or our key third-party service providers are not able to complete key program and product development milestones on time or at all; market volatility and conditions limit our ability to raise additional capital to finance our business plans on attractive terms or at all; our business continuity plans are not effective at limiting operational disruptions or delays; we suffer negative impacts to operations that may be vulnerable as a result of government or company measures taken to control the spread of COVID-19; potential shutdowns of government agencies such as the SEC or FDA, which may limit our ability to raise capital and negatively impact our product development timelines; the passage of new legislation that may increase our operating costs or limit our operations, such as the Families First Coronavirus Response Act; we suffer negative consequences due to vulnerabilities that emerge as a result of our limited operations, such as a cybersecurity incident; or one of our key executives, scientists or other personnel becomes incapacitated by COVID-19. The extent to which COVID-19 impacts our business, operations or financial results will depend on future developments, which are highly uncertain and cannot be predicted with confidence, such as the duration of the outbreak, new information that may emerge concerning the severity of COVID-19 or the nature or effectiveness of actions to contain COVID-19 or treat its impact, among others. We cannot presently predict the scope and severity of any potential business shutdowns or disruptions. If we or any of the third parties with whom we engage, however, were to experience shutdowns or other business disruptions, our ability to conduct our business in the manner and on the timelines presently planned could be materially and negatively affected, which could have a material adverse impact on our business, results of operation and financial condition. 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 we execute license or collaboration agreements with third parties, we may generate revenue in the future from product sales, payments from collaborations or license agreements that we may enter into with third parties, or any combination thereof. Operating Expenses Research and Development Expenses Our research and development expenses consist primarily of costs incurred in connection with our research activities, including our drug discovery efforts, and the development of our product candidates, which include: •direct external research and development expenses, including fees, reimbursed materials and other costs paid to consultants, contractors, contract manufacturing organizations, or CMOs and clinical research organizations, or CROs in connection with our clinical and preclinical development and manufacturing activities; •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 any Clinical Studies, planned Clinical Trials and other research programs, including under agreements with third parties, such as consultants, contractors and CROs; •the cost of developing and scaling our manufacturing process and manufacturing products for use in our preclinical studies, Clinical Studies and Clinical Trials, including under agreements with third parties, such as consultants, contractors and CMOs; and •facilities, depreciation and other expenses, which include direct and allocated expenses for rent and maintenance of facilities and insurance. We expense research and development costs as incurred. We often contract with CROs and CMOs to facilitate, coordinate and perform agreed-upon research, design, development, and manufacturing of our product candidates. To ensure that research and development costs are expensed as incurred, we record monthly accruals for clinical studies and manufacturing costs based on the work performed under the contract. These CRO and CMO contracts typically call for the payment of fees for services at the initiation of the contract and/or upon the achievement of certain clinical or manufacturing milestones. In the event that we prepay CRO or CMO fees, we record the prepayment as a prepaid asset and amortize the asset into research and development expense over the period of time the contracted research and development or manufacturing services are performed. Most professional fees, including project and clinical management, data management, monitoring and manufacturing fees are incurred throughout the contract period. These professional fees are expensed based on their estimated percentage of completion at a particular date. Our CRO and CMO contracts generally include pass through fees. Pass through fees include, but are not limited to, regulatory expenses, investigator fees, travel costs and other miscellaneous costs and raw materials. We expense the costs of pass through fees under our CRO and CMO contracts as they are incurred, based on the best information available to us at the time. A significant portion of our research and development costs are not tracked by project as they benefit multiple projects or our technology platform, and, as such, are not separately classified. Research and development expenses may fluctuate from period to period depending upon the stage of certain projects and the level of clinical and preclinical activities. Many factors can affect the cost and timing of our Clinical Studies and planned Clinical Trials, including slow patient enrollment, the availability of supplies and real or perceived lack of effect on biology or safety of our product candidates. In addition, the development of all of our product candidates may be subject to extensive governmental regulation. These factors make it difficult for us to predict the timing and costs of the further development of our product candidates. We may never succeed in achieving regulatory approval for any of our product candidates. We may obtain unexpected results from our Clinical Studies and planned Clinical Trials. We may elect to discontinue, delay or modify development 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 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 additional Clinical Studies, 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 Studies or 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, Clinical Studies 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. See “Risk Factors” for further discussion of these and additional risks and uncertainties associated with product development and commercialization that may significantly affect the timing and cost of our research and development expenses and our ability to obtain regulatory approval for and successfully commercialize our product candidates. We expect research and development expenses to increase as we advance existing product candidates into additional Clinical Trials and Clinical Studies and develop new product candidates. General and Administrative Expenses General and administrative expenses consist primarily of salaries, 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 and development of our product candidates. We also anticipate that we will incur increased finance, accounting, audit, legal, regulatory, compliance, director and officer insurance costs as well as investor and public relations expenses associated with operating as 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 expense as a result of our preparation for commercial operations, especially as it relates to the sales and marketing of our product candidate. 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, 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 NOLs, carryforwards and tax credits will not be realized. 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): The increase of $3.2 million in salary and benefits-related costs results from our hiring of additional personnel in research and development to support our development programs. Stock-based compensation expense grew by $1.4 million due to an increase in the number of awards and per share fair value of awards granted. Clinical research and outside services costs increased by $11.7 million due to increased product candidate development efforts, including execution of Clinical Studies for AXA1665, AXA1125, AXA1957 and AXA4010. General and Administrative Expenses The following table summarizes our general and administrative expenses incurred during the years ended December 31, 2019 and 2018 (in thousands): Salary and benefits-related costs grew by $1.4 million due to the hiring of additional personnel in our general and administrative functions to support our operations. The increase in stock-based compensation expense of $1.7 million was driven by an increase in the number of awards and per share fair value of awards granted. Other contract services and outside costs increased by $4.0 million, driven by increases of $2.3 million in professional fees, largely as a result of activities related to becoming a public company, and $1.3 million in consulting expense. Other Income (Expense), net Other income (expense), net was a net expense of $1.6 million for the year ended December 31, 2019, compared to a net expense of $2.2 million for the year ended December 31, 2018. The decrease in other expense of $0.6 million was driven by higher interest income of $1.3 million due to our higher cash and cash equivalent position, partially offset by an increase of $0.6 million of interest expense related to increased borrowings under our loan and security agreement. 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, the sale of common stock in our IPO and borrowings under our loan and security agreement. 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 $51.0 million of cash and cash equivalents, resulting from our net loss of $59.0 million, partially offset by net non-cash charges of $7.1 million, primarily consisting of stock-based compensation expense, and net cash provided by changes in our operating assets and liabilities of $1.0 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2019 consisted primarily of a $1.6 million increase in accounts payable and accrued expenses and other current liabilities, partially offset by a $0.7 million increase in prepaid expenses and other current assets. The increases in accounts payable and accrued expenses and other current liabilities were primarily due to ongoing research and development work and an increase in incentive bonus accrual as of December 31, 2019. The increase in prepaid expenses and other current assets was primarily due to a $0.7 million increase in prepayments for research and development costs. During the year ended December 31, 2018, operating activities used $30.7 million of cash and cash equivalents, primarily resulting from our net loss of $36.1 million, partially offset by net non-cash charges of $4.4 million, primarily consisting of stock-based compensation expense, and net cash provided by changes in our operating assets and liabilities of $1.0 million. Net cash provided by changes in our operating assets and liabilities for the year ended December 31, 2018 consisted primarily of a $1.6 million increase in accounts payable and accrued expenses, partially offset by a $0.6 million increase in prepaid expenses and other current assets. The increases in accounts payable and accrued expenses were primarily due increases in accrued legal and board fees as of December 31, 2018. The increase in prepaid expenses and other current assets consists of a prepayment to one of our vendors for development work. Investing Activities During the years ended December 31, 2019 and 2018, we used $0.1 million and $0.6 million, respectively, of cash and cash equivalents in investing activities primarily consisting of purchases of property and equipment. Financing Activities During the year ended December 31, 2019, net cash provided by financing activities was $63.7 million, primarily consisting of net cash proceeds of $64.5 million from our IPO, partially offset by a $1.2 million payment of the success fee payable upon completion of our IPO pursuant to our loan and security agreement. During the year ended December 31, 2018, net cash provided by financing activities was $63.9 million, primarily consisting of net cash proceeds of $58.9 million from our issuance of Series E preferred stock in November 2018 and borrowings of $6.0 million under our loan and security agreement. Loan and Security Agreement At December 31, 2019, we had $26.0 million in outstanding long term debt pursuant to our loan and security agreement. Upon completion of the IPO in May 2019, the interest only period was extended through January 2021 and the maturity date was extended to January 2023. Monthly principal payments of $1.1 million will commence February 2021 for 24 months. The terminal interest fee of 5.35%, or $1.4 million, is due with the final principal payment of the loan. We granted the lender a first priority security interest in all of our assets, excluding intellectual property and granted a negative pledge on such intellectual property. There are no financial covenants under our loan and security agreement. Funding Requirements We believe that our existing cash and cash equivalents as of December 31, 2019 will be adequate to satisfy our capital needs for at least the next twelve months from the filing date of this Annual Report with the 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 expect. We expect our expenses to increase substantially in connection with our ongoing activities, particularly as we advance existing product candidates into additional Clinical Trials and Clinical Studies and develop new product candidates. Our cash requirements depend on numerous factors, including expenditures in connection with our research development programs, including with respect to the timing and progress of Clinical Trials, Clinical Studies and preclinical development activities; payments to CROs, CMOs and other third-party providers; the cost of filing, prosecuting, defending and enforcing patent claims and other intellectual property rights; our ability to raise additional equity or debt financing; potential repayments of our long-term debt; and our ability to enter into collaboration or license agreements and our receipt of any upfront, milestone or other payments thereunder. Changes in our research and development plans or other changes affecting our operating expenses may result in changes in the timing and amount of expenditures of our capital resources. See “Risk Factors” for further discussion of these and additional risks and uncertainties that may significantly affect the timing and amount of expenditures of our capital resources. 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, strategic alliances and marketing and 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, including as a result of market volatility following the COVID-19 outbreak. 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. We also intend to continue to evaluate options to refinance our outstanding long-term debt. The amounts involved in any such transactions, individually or in the aggregate, may be material. 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 Annual 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 CROs and CMOs for research and development services. We base our expenses related to research and development on our estimates of the services received and efforts expended pursuant to quotes and contracts with CROs that conduct and manage Clinical Trials, Clinical Studies and preclinical development activities 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 or subjects and the completion of clinical 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 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. For stock options with service-based vesting conditions, we record the expense for these awards using the straight-line method. For stock options with performance-based vesting conditions, we record the expense for these awards over the requisite service period using an accelerated attribution method to the extent the achievement of the performance condition is probable. 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. In the periods prior to the IPO, the determination of fair value of our common stock required significant judgment. In the periods following the IPO, 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. Off-Balance Sheet Arrangements We did not have during the periods presented, and we do not have, any off-balance sheet arrangements, as defined under applicable SEC rules and regulations. 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 elsewhere in this Annual Report. 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.

<s>[INST] Part I, Item 1A. “Risk Factors” and under “Special Note Regarding ForwardLooking Statements.” In addition, even if our results of operations, financial condition and liquidity, and the developments in our business and the industry in which we operate are consistent with the forwardlooking statements contained in this Annual Report, they may not be predictive of results or developments in future periods. We caution readers not to place undue reliance on any forwardlooking statements made by us, which speak only as of the date they are made. We disclaim any obligation, except as specifically required by law and the rules of the SEC to publicly update or revise any such statements to reflect any change in our expectations or in events, conditions or circumstances on which any such statements may be based, or that may affect the likelihood that actual results will differ from those set forth in the forwardlooking statements. Overview We are a clinicalstage biotechnology company focused on leveraging endogenous metabolic modulators, or EMMs, to pioneer a new approach for treating complex diseases and improving health. Our product candidates are comprised of multiple EMMs that are engineered in distinct combinations and ratios with the goal of simultaneously impacting multiple biological pathways. Our pipeline includes lead therapeutic candidates for nonalcoholic steatohepatitis, or NASH, and the reduction in risk of overt hepatic encephalopathy, or OHE, recurrence. Additional muscle and bloodrelated programs are in earlierstage development. Using our development platform, we have efficiently designed a pipeline of product candidates that are comprised of amino acids and their derivatives. These orally administered compositions are designed to have the potential for multifactorial effects, and their constituents have a general history of safe use. To date, we have funded our operations with proceeds from the sale of preferred stock, the sale of common stock in our initial public offering, or our IPO, and borrowing of debt. Through December 31, 2019, we had received gross proceeds of $197.8 million from the sale of preferred stock, gross proceeds of $71.4 million from the sale of common stock in our IPO and $26.0 million from borrowings under our loan and security agreement. 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. Our net losses were $59.0 million and $36.1 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $216.1 million. We expect to continue to incur significant expenses for at least the next several years as we continue to develop our 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 a combination of equity offerings, debt financings, strategic alliances and marketing and 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 or delay our pursuit of potential inlicenses 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 $92.1 million. We believe that our existing cash and cash equivalents as of December 31, 2019 will enable us to fund our operating expenses, capital expenditure requirements and debt service [/INST] Negative. </s>

SC Health Corp

2020-03-23

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 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. Certain information contained in the discussion and analysis 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 “Special Note Regarding Forward-Looking Statements,” “Item 1A. Risk Factors” and elsewhere in this Annual Report on Form 10-K. Overview We are a blank check company incorporated on December 10, 2018 as a Cayman Islands exempted company and incorporated 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 complete our Business Combination using cash from the proceeds from our Initial Public Offering and the sale of the Private Placement Warrants, our shares, debt or a combination of cash, equity and debt. The issuance of additional shares in a business combination, including the issuance of the forward purchase shares: • may significantly dilute the equity interest of investors in this offering, which dilution would increase if the anti-dilution provisions in the Class B ordinary shares resulted in the issuance of Class A ordinary shares on a greater than one-to-one basis upon conversion of the Class B ordinary shares; • may subordinate the rights of holders of Class A ordinary shares if preference shares are issued with rights senior to those afforded our Class A ordinary shares; • could cause a change in control if a substantial number of our Class A ordinary shares 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 share ownership or voting rights of a person seeking to obtain control of us; and • may adversely affect prevailing market prices for our Class A ordinary shares and/or warrants. Similarly, if we issue debt securities or otherwise incur significant debt, 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 Class A ordinary shares; • 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 Class A ordinary shares 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. 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, 2019 were organizational activities, those necessary to prepare for the Initial Public Offering, described below, and, after the Initial Public Offering, 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 net income of $958,107, which consisted of interest earned on marketable securities held in the Trust Account of $1,397,911, offset by operating expenses of $439,804. For the period from December 10, 2018 (inception) through December 31, 2018, we had a net loss of $2,500, which consisted of operating expenses of $2,500. Liquidity and Capital Resources Until the consummation of the Initial Public Offering, the Company’s only source of liquidity was an initial purchase of Class B ordinary shares by our Sponsor and loans from our Sponsor. On July 16, 2019, we consummated the Initial Public Offering of 15,000,000 Units at a price of $10.00 per Unit, generating gross proceeds of $150,000,000. Simultaneously with the closing of the Initial Public Offering, we consummated the sale of an aggregate of 5,000,000 Private Placement Warrants to our Sponsor at a price of $1.00 per warrant, generating gross proceeds of $5,000,000. On August 2, 2019, in connection with the underwriters’ full exercise of their over-allotment option, we consummated the sale of an additional 2,250,000 Units and the sale of an additional 450,000 Private Placement Warrants, generating total gross proceeds of $22,950,000. Following the Initial Public Offering, the exercise of the over-allotment option and the sale of the Private Placement Warrants, a total of $172,500,000 was placed in the Trust Account. We incurred $10,224,407 in transaction costs, including $3,450,000 of underwriting fees, $6,037,500 of deferred underwriting fees and $736,907 of other costs in connection with the Initial Public Offering and the sale of the Private Placement Warrants. For the year ended December 31, 2019, net cash used in operating activities was $515,847. Net income of $958,107 was offset by interest earned on marketable securities of $1,397,911. Changes in operating assets and liabilities used $76,043 of cash from operating activities. At December 31, 2019, we had cash and marketable securities held in the Trust Account of $173,897,911. 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 (if applicable) and deferred underwriting commissions) to complete our Business Combination. To the extent that our shares 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 post-Business Combination entity, make other acquisitions and pursue our growth strategies. At December 31, 2019, we had cash of $772,413 held outside of 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, properties 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 $2,000,000 of such loans may be convertible into warrants identical to the Private Placement Warrants, at a price of $1.00 per warrant 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 and consummating 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. Going Concern Management has determined that the mandatory liquidation date of January 16, 2021 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 as described below. We entered into an agreement to pay our Sponsor a monthly fee of $10,000 for office space, secretarial and administrative support to the Company. We began incurring these fees on July 16, 2019 and will continue to incur these fees on a monthly basis until the earlier of the completion of the Business Combination and the Company’s liquidation. We have an agreement to pay the underwriters a deferred fee of $6,037,500, which will become payable to them from the amounts held in the Trust Account solely in the event that the Company completes a Business Combination, subject to the terms of the underwriting agreement. Additionally, SC Health Group Limited, an affiliate of our Sponsor, entered into a forward purchase agreement with us which provides for the purchase by SC Health Group Limited of an aggregate of 5,000,000 Class A ordinary shares, plus an aggregate of 1,250,000 redeemable warrants, each to purchase one Class A ordinary share at $11.50 per share, for an aggregate purchase price of $50,000,000, or $10.00 per Class A ordinary share and accompanying fraction of a warrant in a private placement to close concurrently with the closing of a Business Combination. The obligations under the forward purchase agreement do not depend on whether any Class A ordinary shares are redeemed by our public shareholders. 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: Ordinary shares subject to possible redemption We account for our ordinary shares subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Ordinary shares subject to mandatory redemption is classified as a liability instrument and is measured at fair value. Conditionally redeemable ordinary shares (including ordinary shares that features redemption rights that is 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, 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, ordinary shares subject to possible redemption is presented as temporary equity, outside of the shareholders’ equity section of our balance sheet. Net income (loss) per ordinary share We apply the two-class method in calculating earnings per share. Net income per ordinary share, basic and diluted for Class A redeemable ordinary shares is calculated by dividing the interest income earned on the Trust Account by the weighted average number of Class A redeemable ordinary shares outstanding since original issuance. Net loss per common share, basic and diluted for Class B non-redeemable ordinary shares is calculated by dividing the net income (loss), less income attributable to Class A redeemable ordinary shares, by the weighted average number of Class B non-redeemable ordinary shares outstanding for the periods presented. Recent Accounting Pronouncements In July 2017, the FASB issued Accounting Standards Update (“ASU”) 2017-11, “Earnings Per Share (Topic 260), Distinguishing Liabilities from Equity (Topic 480) and Derivatives and Hedging (Topic 815): Part I. Accounting for Certain Financial Instruments with Down Round Features; Part II. Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception.” Part I of this update addresses the complexity of accounting for certain financial instruments with down round features. Down round features are features of certain equity-linked instruments (or embedded features) that result in the strike price being reduced on the basis of the pricing of future equity offerings. Also, entities must adjust their basic Earnings per Share (“EPS”) calculation for the effect of the down round provision when triggered (that is, when the exercise price of the related equity-linked financial instrument is adjusted downward because of the down round feature). That effect is treated as a dividend and as a reduction of income available to common shareholders in basic EPS. An entity will also recognize the effect of the trigger within equity. The guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company adopted this guidance during the year ended December 31, 2019. The adoption of this guidance enabled the Company to record the warrants as equity instruments and is not expected to have a material impact on the Company’s financial position, results of operations, cash flows or disclosures moving forward until a trigger event occurs. Part II of this update addresses the difficulty of navigating Topic 480, Distinguishing Liabilities from Equity, because of the existence of extensive pending content in the FASB Accounting Standards Codification. This pending content is the result of the indefinite deferral of accounting requirements about mandatorily redeemable financial instruments of certain nonpublic entities and certain mandatorily redeemable noncontrolling interests. The amendments in Part II of this update are not expected to have an impact on the Company. 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] 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. Certain information contained in the discussion and analysis set forth below includes forwardlooking statements. Our actual results may differ materially from those anticipated in these forwardlooking statements as a result of many factors, including those set forth under “Special Note Regarding ForwardLooking Statements,” “Item 1A. Risk Factors” and elsewhere in this Annual Report on Form 10K. Overview We are a blank check company incorporated on December 10, 2018 as a Cayman Islands exempted company and incorporated 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 complete our Business Combination using cash from the proceeds from our Initial Public Offering and the sale of the Private Placement Warrants, our shares, debt or a combination of cash, equity and debt. The issuance of additional shares in a business combination, including the issuance of the forward purchase shares: may significantly dilute the equity interest of investors in this offering, which dilution would increase if the antidilution provisions in the Class B ordinary shares resulted in the issuance of Class A ordinary shares on a greater than onetoone basis upon conversion of the Class B ordinary shares; may subordinate the rights of holders of Class A ordinary shares if preference shares are issued with rights senior to those afforded our Class A ordinary shares; could cause a change in control if a substantial number of our Class A ordinary shares 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 share ownership or voting rights of a person seeking to obtain control of us; and may adversely affect prevailing market prices for our Class A ordinary shares and/or warrants. Similarly, if we issue debt securities or otherwise incur significant debt, 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 Class A ordinary shares; 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 Class A ordinary shares 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. 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, 2019 were organizational activities, those necessary to prepare for the Initial Public Offering, described below, and, after the Initial Public Offering, identifying a target company for a Business Combination. We do not expect to generate any operating revenues until after the completion [/INST] Negative. </s>

IGM Biosciences, Inc.

2020-03-26

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 appearing 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 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. Overview We are a biotechnology company pioneering the development of engineered IgM antibodies for the treatment of cancer patients. IgM antibodies have inherent properties that we believe may enable them to bind more strongly to cancer cells than comparable IgG antibodies. We have created a proprietary IgM antibody technology platform that we believe is particularly well suited for developing T cell engagers, receptor cross-linking agonists and targeted cytokines. Our lead product candidate, IGM-2323, is a bispecific T cell engaging IgM antibody targeting CD20 and CD3 proteins, and in October 2019 we announced the dosing of the first patient in our Phase 1 clinical trial for the treatment of relapsed/refractory B cell Non-Hodgkin’s lymphoma (NHL) patients. Our second product candidate, IGM-8444 is an IgM antibody targeting Death Receptor 5 (DR5) proteins, and we plan to file an investigational new drug application (IND) for the treatment of patients with solid and hematologic malignancies in 2020. Our third product candidate, IGM-7354, is a bispecific IgM antibody delivering interleukin-15 (IL-15) cytokines to PD-L1 expressing cells, and we plan to file an IND for the treatment of patients with solid and hematologic malignancies in 2021. We believe that we have the most advanced research and development program focused on engineered therapeutic IgM antibodies. We have created a portfolio of patents and patent applications, know-how and trade secrets directed to our platform technology, product candidates and manufacturing capabilities, and we retain worldwide commercial rights to all of our product candidates and the intellectual property related thereto. Since the commencement of our operations, we have focused substantially all of our resources on conducting research and development activities, including drug discovery, preclinical studies and clinical trials, establishing and maintaining our intellectual property portfolio, the manufacturing of clinical and research material, developing our in-house manufacturing capabilities, hiring personnel, raising capital and providing general and administrative support for these operations. Since 2010, such activities have exclusively related to the research, development and manufacture of IgM antibodies and to building our proprietary IgM antibody technology platform. We do not have any products approved for sale, and we have not generated any revenue from product sales. We have incurred significant net losses to date. Our ability to generate product revenue sufficient to achieve profitability will depend on the successful development and eventual commercialization of one or more of our current or future product candidates. Our net losses were $43.1 million, $22.7 million, and $11.1 million for the years ended December 31, 2019, 2018 and 2017, respectively. As of December 31, 2019, we had an accumulated deficit of $107.2 million. These losses have resulted primarily from costs incurred in connection with research and development activities and general and administrative costs associated with our operations. We expect to continue to incur significant expenses and increasing operating losses for the foreseeable future, and our net losses may fluctuate significantly from period to period, depending on the timing of and expenditures on our planned research and development activities. In addition, we expect to incur additional costs associated with operating as a public company. We expect our expenses and capital requirements will increase substantially in connection with our ongoing activities as we: ▪ advance the development of IGM-2323, IGM-8444 and IGM-7354; ▪ expand our pipeline of IgM antibody product candidates; ▪ continue to invest in our IgM antibody technology platform; ▪ build out and expand our in-house manufacturing capabilities; ▪ maintain, protect and expand our intellectual property portfolio, including patents, trade secrets and know-how; ▪ seek marketing approvals for any product candidates that successfully complete clinical trials; ▪ establish a sales, marketing, and distribution infrastructure to commercialize any product candidate for which we may obtain marketing approval and related commercial manufacturing build-out; ▪ implement operational, financial and management information systems; and ▪ attract, hire and retain additional clinical, scientific, management and administrative personnel. We plan to continue to use third-party service providers, including clinical research organizations (CROs) and clinical manufacturing organizations (CMOs), to carry out our preclinical and clinical development and manufacture and supply of our preclinical and clinical materials to be used during the development of our product candidates. We do not have any products approved for sale and have not generated any revenue since inception. Prior to the completion of our initial public offering (IPO) in September 2019, we had funded our operations primarily with an aggregate of approximately $162.0 million in gross cash proceeds from the sale of convertible preferred stock and issuance of unsecured promissory notes. In September 2019, we completed our IPO and sold and issued an aggregate of 12,578,125 shares of common stock, including 1,640,625 shares issues in connection with the full exercise by the underwriters of their option to purchase additional shares of common stock, at $16.00 per share for gross proceeds of $201.3 million. The aggregated net proceeds from our IPO, inclusive of the full exercise by the underwriters of their option to purchase additional shares of common stock, were approximately $183.0 million after deducting underwriting discounts and commissions and other offering costs. Immediately prior to the closing of our IPO, all shares of convertible preferred stock then outstanding automatically converted into 10,787,861 shares of common stock and 6,431,205 shares of non-voting common stock. We were incorporated in Delaware in 1993 under the name Palingen, Inc. From 1993 to 2010, we were principally engaged in research related to naturally occurring IgM antibodies. In 2010, we received an initial equity investment from Haldor Topsøe Holding A/S, changed our name to IGM Biosciences, Inc. and refocused our research and development efforts toward developing our IgM platform and engineering new IgM antibodies. In December 2017, we established a Danish holding company-IGM Biosciences A/S (Holdco); in April 2019, we dissolved Holdco. The capitalization information included in this Annual Report on Form 10-K is consistently presented as that of IGM Biosciences, Inc. even during the interim period when we had a holding company structure and our investors held their equity interests in Holdco. Revenue To date, we have not generated any revenue and do not expect to generate any revenue from the sale of products in the near future. Operating Expenses Research and Development Research and development expenses consist primarily of costs incurred for the discovery and development of product candidates, which include: Direct expenses consisting of: ▪ Fees paid to third parties such as consultants, contractors and CROs, for animal studies and other costs related to preclinical studies and clinical trials; ▪ Costs related to acquiring and manufacturing research and clinical trial materials, including under agreements with third parties such as CMOs and other vendors; ▪ Costs related to the preparation of regulatory submissions; and ▪ Expenses related to laboratory supplies and services; Indirect expenses consisting of: ▪ Personnel-related expenses, including salaries, benefits and stock-based compensation expense, for personnel in our research and development functions; and ▪ Depreciation of equipment and facilities expenses. We expense research and development costs in the periods in which they are 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. All direct research and development expenses are tracked by stage of development. We do not track our indirect research and development costs by product candidate or program. We expect our research and development expenses to increase substantially for the foreseeable future as we continue to invest in research and development activities to advance our product candidates and our clinical programs, expand our product candidate pipeline and continue to build out and expand our in-house manufacturing capabilities. The process of conducting the necessary preclinical and clinical research to obtain regulatory approval is costly and time-consuming. To the extent that our product candidates continue to advance into clinical trials, as well as advance into larger and later stage clinical trials, our expenses will increase substantially and may become more variable. 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, investment in our clinical programs, manufacturing capability and competition with other products. As a result of these variables, 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. We may never succeed in achieving regulatory approval for any of our product candidates. General and Administrative Our general and administrative expenses consist primarily of personnel-related expenses for personnel in our executive, finance, corporate and other administrative functions, intellectual property, facilities and other allocated expenses, other expenses for outside professional services, including legal, human resources, audit and accounting services, and insurance costs. Personnel-related expenses consist of salaries, benefits and stock-based compensation. We expect our general and administrative expenses to increase for the foreseeable future as we increase our headcount to support our continued research activities and development of product candidates and as a result of operating as a public company, including compliance with the rules and regulations of the Securities and Exchange Commission (SEC) and those of any national securities exchange on which our securities are traded, legal, auditing, additional insurance expenses, investor relations activities and other administrative and professional services. We also expect our intellectual property expenses to increase as we expand our intellectual property portfolio. Other Income, Net Other income, net includes sublease income, interest income earned on our cash, cash equivalents, investments, and restricted cash balances and interest expense incurred on unsecured promissory notes. Results of Operations Comparison of the Years Ended December 31, 2019 and 2018 Research and Development Expenses The following table summarizes our research and development expenses incurred during the periods indicated: (1) Includes direct expenses related to our lead product candidate, IGM-2323, for which we announced the dosing of the first patient in our Phase 1 clinical trial in October 2019. Research and development expenses were $35.3 million in 2019 compared to $19.0 million in 2018. The increase of $16.3 million was driven by advancement of our product candidates, including $3.2 million of expenses related to our clinical stage program, which consisted of preclinical, clinical and manufacturing expense incurred in the development of our lead product candidate, IGM-2323, for which we announced the dosing of the first patient in our Phase 1 clinical trial in October 2019, and $6.7 million related to our preclinical stage programs which consisted of preclinical and manufacturing expenses incurred in the development of our second product candidate, IGM-8444, and expenses related to our discovery programs. Personnel-related expenses, including stock-based compensation, increased by $4.8 million due to an increase in headcount. Depreciation and facilities increased by $1.6 million primarily due to new lease agreements for additional office, laboratory and manufacturing space in Mountain View which commenced in 2019. General and Administrative Expenses General and administrative expenses were $9.2 million in 2019 compared to $3.8 million in 2018. The increase of $5.4 million was primarily due to a $2.3 million increase in personnel-related expenses, including stock-based compensation, due to an increase in headcount. Professional services increased by $1.8 million due to legal, accounting, consulting and other services in preparation for our public company status. Administrative expenses increased by $0.9 million primarily due to an increase in directors’ and officers’ liability insurance. Depreciation and facilities increased by $0.3 million primarily due to new lease agreements for additional office, laboratory and manufacturing space in Mountain View which commenced in 2019. Other Income, Net Other income, net was $1.4 million compared to $80,000 in 2018. The increase of $1.3 million was primarily due to higher cash and investment balances. Comparison of the Years Ended December 31, 2018 and 2017 Research and Development Expenses The following table summarizes our research and development expenses incurred during the periods indicated: (1) Includes direct expenses related to our lead product candidate, IGM-2323, for which we announced the dosing of the first patient in our Phase 1 clinical trial in October 2019. Research and development expenses were $19.0 in 2018 compared to $8.6 million in 2017. The increase of $10.3 million was driven by an increase in expenses to advance our product candidates, including $6.2 million of expenses related to our clinical stage program, which consisted of preclinical and clinical expenses and expenses incurred in the development of our lead product candidate, IGM-2323 and the preparation for its Phase 1 clinical trial, and $2.2 million related to our preclinical stage programs. Personnel-related expenses, including stock-based compensation, increased by $1.9 million due to an increase in headcount. General and Administrative Expenses General and administrative expenses were $3.8 million in 2018 compared to $2.5 million in 2017. The increase of $1.3 million was primarily due to a $0.7 million increase in legal and advisory fees, a $0.3 million increase in recruitment expenses and a $0.2 million increase in personnel-related expenses. Other Income, Net Other income, net was $80,000 in 2018 compared to $93,000 in 2017. The decrease of $13,000 was primarily due to an increase in interest expense resulting from an interest-bearing unsecured promissory note. Liquidity and Capital Resources Liquidity Due to our significant research and development expenditures, we have generated operating losses since our inception. We have funded our operations primarily through the sale of convertible preferred stock and common stock and the issuance of unsecured promissory notes. As of December 31, 2019, we had cash and investments of $236.6 million. As of December 31, 2019, we had an accumulated deficit of $107.2 million. We believe that our cash and investments will be sufficient to fund our planned operations into early 2022. Future Funding Requirements Our primary uses of cash are to fund operating expenses, which consist primarily of research and development expenditures related to our programs and related personnel costs. The timing and amount of our future funding requirements depends on many factors, including the following: ▪ the initiation, scope, rate of progress, results and cost of our preclinical studies, clinical trials and other related activities for our product candidates; ▪ the costs associated with manufacturing our product candidates, including building out and expanding our own manufacturing facilities, and establishing commercial supplies and sales, marketing and distribution capabilities; ▪ the timing and cost of capital expenditures to support our research, development and manufacturing efforts; ▪ the number and characteristics of other product candidates that we pursue; ▪ the costs, timing and outcome of seeking and obtaining U.S. Food and Drug Administration (FDA) and non-U.S. regulatory approvals; ▪ our ability to maintain, expand and defend the scope of our intellectual property portfolio, including the amount and timing of any payments we may be required to make in connection with the licensing, filing, defense and enforcement of any patents or other intellectual property rights; ▪ the timing, receipt and amount of sales from our potential products; ▪ our need and ability to hire additional management, scientific and medical personnel; ▪ the effect of competing products that may limit market penetration of our product candidates; ▪ our need to implement additional internal systems and infrastructure, including financial and reporting systems; ▪ the economic and other terms, timing and success of any collaboration, licensing, or other arrangements into which we may enter in the future, including the timing of receipt of any milestone or royalty payments under these agreements; ▪ the compliance and administrative costs associated with being a public company; and ▪ the extent to which we acquire or invest in businesses, products or technologies, although we currently have no commitments or agreements relating to any of these types of transactions. In addition, we will continue to require additional funding in order to complete development of our product candidates and commercialize our products, if approved. 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 and other marketing and distribution arrangements. There can be no assurance that, in the event we require additional financing, such financing will be available at terms acceptable to us, if at all. Failure to generate sufficient cash flows from operations, raise additional capital and reduce discretionary spending should additional capital not become available could have a material adverse effect on our ability to achieve our intended business objectives. 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 preclinical studies and clinical trials. To the extent that we raise additional capital through collaborations, strategic alliances or licensing arrangements with third parties, we may have to relinquish valuable rights to our product candidates, future revenue streams or research programs at an earlier stage of development or on less favorable terms than we would otherwise choose 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. If we are unable to obtain additional funding from these or other sources, it may be necessary to significantly reduce our rate of spending through reductions in staff and delaying, scaling back, or stopping certain research and development programs. Summary Statement of Cash Flows The following table sets forth the primary sources and uses of cash for each of the periods presented below: Net Cash Used in Operating Activities In 2019, net cash used in operating activities was $45.1 million, which consisted of a net loss of $43.1 million and a net change of $5.0 million in our net operating assets and liabilities, partially offset by $3.0 million in non-cash charges. The net change in our operating assets and liabilities was primarily due to an increase in prepaid expenses of $5.4 million, an increase in other assets of $0.3 million and a decrease in lease liabilities of $1.3 million, partially offset by an increase in accounts payable of $2.0 million. The non-cash charges primarily consisted of non-cash lease expense of $1.7 million, stock-based compensation of $1.0 million and depreciation expense of $0.6 million, partially offset by net amortization of premiums and accretion of discounts on investments of $0.3 million. In 2018, net cash used in operating activities was $20.0 million, which consisted of a net loss of $22.7 million, partially offset by a net change of $2.2 million in our net operating assets and liabilities and $0.5 million in non-cash charges. The net change in our operating assets and liabilities was primarily due to an increase in accrued liabilities of $2.8 million resulting from an increase in research and development activities. This was partially offset by an increase in prepaid expenses of $0.3 million primarily associated with prepayments made for ongoing research and development activities conducted by third-party service providers. The non-cash charges primarily consisted of depreciation of $0.3 million and stock-based compensation of $0.2 million. In 2017, net cash used in operating activities was $10.4 million, which consisted of a net loss of $11.1 million, partially offset by a net change of $0.4 million in our net operating assets and liabilities and $0.3 million in non-cash charges. The net change in our operating assets and liabilities was primarily due to an increase in accrued liabilities of $0.3 million resulting from an increase in research and development activities. The non-cash charges primarily consisted of depreciation of $0.2 million and stock-based compensation of $0.1 million. Net Cash Used in Investing Activities In 2019, net cash used in investing activities was $203.2 million, which consisted of $208.9 million in purchases of investments and $2.3 million in purchases of lab equipment for research and development activities, partially offset by $8.0 million in maturities of investments. Net cash used in investing activities was $0.8 million and $0.4 million in 2018 and 2017, respectively, related to the purchase of property and equipment. Net Cash Provided by Financing Activities In 2019, net cash provided by financing activities was $282.3 million, which consisted primarily of $182.8 million of net proceeds from our IPO, $81.7 million of net proceeds from the issuance of shares of our Series C convertible preferred stock, $15.0 million of proceeds from the issuance of an unsecured promissory note to a related party which was subsequently settled as Series C convertible preferred stock in June 2019, the receipt of a $2.6 million receivable that was due from a related party, and $0.2 million from the issuance of common stock and exercise of stock options. In 2018, net cash provided by financing activities was $22.3 million, which consisted primarily of $17.3 million in proceeds from the issuance of shares of our Series B convertible preferred stock and $5.0 million from the issuance of an unsecured promissory note. In 2017, net cash provided by financing activities was $8.1 million, which consisted of proceeds from the issuance of shares of our Series B convertible preferred stock. Contractual Obligations and Commitments The following table summarizes our contractual obligations and other commitments as of December 31, 2019: (1) Payments due for our lease of office, laboratory and manufacturing spaces in Mountain View, California. The payments represent gross operating lease obligations. In addition, we enter into agreements in the normal course of business with CROs, CMOs, and other vendors for the research and development services for operating purposes, which are generally cancelable upon written notice. These payments are not included in this table of contractual obligations. We have not included milestone or royalty payments or other contractual payment obligations in the table above as the timing and amount of such obligations are unknown or uncertain. See Note 5 to our financial statements included in this Form 10-K. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements, as defined in the rules and regulations of the SEC. Critical Accounting Policies and Use of Estimates Our financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP). The preparation of these 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 financial statements and 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. While our significant accounting policies are described in the notes to our financial statements included elsewhere in this Annual Report on Form 10-K, we believe that the following critical accounting policies are most important to understanding and evaluating our reported financial results. Accrued Research and Development Expenses The Company records accruals for estimated costs of research, preclinical studies, clinical trials, and manufacturing, which are significant components of research and development expenses. A substantial portion of the Company’s ongoing research and development activities is conducted by third-party service providers, CROs and CMOs. The Company’s contracts with the CMOs generally include fees such as initiation fees, reservation fees, costs related to animal studies and safety tests, verification run costs, materials and reagents expenses, taxes, etc. The Company’s contracts with CROs generally include pass-through fees such as regulatory expenses, investigator fees, travel costs and other miscellaneous costs, including shipping and printing fees. 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 to the Company under such contracts. The Company accrues the costs incurred under agreements with these third parties based on estimates of actual work completed in accordance with the respective agreements. The Company determines the estimated costs through discussions with internal personnel and external service providers as to the progress, or stage of completion or actual timeline (start-date and end-date) of the services and the agreed-upon fees to be paid for such services. In the event the Company makes advance payments, the payments are recorded as a prepaid expense and recognized as the services are performed. As actual costs become known, the Company adjusts its accruals. Although the Company does not expect its estimates to be materially different from amounts actually incurred, such estimates for the status and timing of services performed relative to the actual status and timing of services performed may vary and could result in us reporting amounts that are too high or too low in any particular period. The Company’s accrual is dependent, in part, upon the receipt of timely and accurate reporting from CROs and other third-party vendors. Variations in the assumptions used to estimate accruals including, but not limited to, the number of patients enrolled, the rate of patient enrollment and the actual services performed, may vary from our estimates, resulting in adjustments to clinical trial expenses in future periods. Changes in these estimates that result in material changes to the Company’s accruals could materially affect its financial condition and results of operations. Through December 31, 2019, there have been no material differences from the Company’s estimated accrued research and development expenses to actual expenses. Stock-Based Compensation We account for stock-based compensation by measuring and recognizing compensation expense for all share-based awards made to employees and directors based on estimated grant-date fair values. We use the straight-line method to allocate compensation cost to reporting periods over the requisite service period, which is generally the vesting period, and estimate the fair value of share-based awards to employees and directors using the Black-Scholes option-pricing valuation model. The Black-Scholes model requires the input of subjective assumptions, including fair value of common stock, expected term, expected volatility, risk-free interest rate and expected dividends, which are described in greater detail below. Fair Value of Common Stock-Prior to the IPO, there was no public market for our common stock, the fair value of our common stock was determined by our board of directors based in part on valuations of our common stock prepared by a third-party valuation firm. Since the completion of our IPO, the fair value of each share of common stock underlying stock option grants is based on the closing price of our common stock on the Nasdaq Global Select Market as reported on the date of grant. Expected Term-The expected term of the options represents the average period the stock options are expected to remain outstanding. As we do not have sufficient historical information to develop reasonable expectations about future exercise patterns and post-vesting employment termination behavior, the expected term of options granted is derived from the average midpoint between the weighted average vesting and the contractual term, also known as the simplified method. Expected Volatility- Since we have only recently become a public company and have only a limited trading history for our common stock, the expected volatility was 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 selected companies with comparable characteristics, including enterprise value, risk profiles, position within the industry, and, where applicable, with historical share price information sufficient to meet the expected life of our stock-based awards. We will continue to apply this process until enough 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 yield of zero-coupon U.S. Treasury notes as of the grant date with maturities commensurate with the expected term of the awards. Expected Dividends-The expected dividends assumption is based on our expectation of not paying dividends in the foreseeable future; therefore, we used an expected dividend yield of zero. We account for forfeitures as they occur. Disclosures related to stock-based compensation have been included for employee stock-based compensation only. As a result of the adoption of ASU No. 2018-07, Improvements to Nonemployee Share-Based Payment Accounting, effective January 1, 2019, there is no change in the measurement and recognition of the compensation expense between employee and non-employee during the year ended December 31, 2019. Stock-based compensation awarded to non-employees for the years ended December 31, 2019, 2018, and 2017 was not material. The fair value of each purchase under the employee stock purchase plan (ESPP) is estimated at the beginning of the offering period using the Black-Scholes option pricing model. Assumptions we used in applying the Black-Scholes option-pricing model to determine the estimated fair value of our stock options granted 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 equity-based compensation could be materially different. Fair Value of Common Stock Historically, for all periods prior to our IPO, the fair value of the shares of common stock underlying our share-based awards were estimated on each grant date by our board of directors. In order to determine the fair value of our common stock underlying option grants, our board of directors considered, among other things, timely valuations of our common stock prepared by an unrelated third-party valuation firm in accordance with the guidance provide by the American Institute of Certified Public Accountants Practice Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. Given the absence of a public trading market for our common stock prior to our IPO, 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 our stage of development; progress of our research and development efforts; the rights, preferences and privileges of our convertible preferred stock relative to those of our common stock; equity market conditions affecting comparable public companies and the lack of marketability of our common stock. Since the completion of our IPO, the fair value of each share of common stock underlying stock option grants is based on the closing price of our common stock on the Nasdaq Global Select Market as reported on the date of grant. Leases During 2019, we elected to early adopt Accounting Standard Update (ASU) No. 2016-02, Leases (ASC 842) and its associated amendments as of January 1, 2019 using the modified retrospective transition approach. There was no cumulative-effect adjustment recorded to accumulated deficit upon adoption. Under ASC 842, we determine if an arrangement is a lease at inception. In addition, we determine whether leases meet the classification criteria of a finance or operating lease at the lease commencement date considering: (1) whether the lease transfers ownership of the underlying asset to the lessee at the end of the lease term, (2) whether the lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise, (3) whether the lease term is for a major part of the remaining economic life of the underlying asset, (4) whether the present value of the sum of the lease payments and residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the underlying asset, and (5) whether the underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term. As of December 31, 2019, our lease population consisted of real estate. As of the date of adoption of ASC 842 and December 31, 2019, we did not have finance leases. Operating leases are included in operating lease right-of-use (ROU) assets, lease liabilities, current, and lease liabilities, non-current in our balance sheet. ROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at the lease commencement date based on the present value of lease payments over the lease term. In determining the present value of lease payments, we use our incremental borrowing rate based on the information available at the lease commencement date if the rate implicit in the lease is not readily determinable. We determine the incremental borrowing rate base on an analysis of corporate bond yields with a credit rating similar ours. The determination of our incremental borrowing rate requires management judgment including the development of a synthetic credit rating and cost of debt as we currently do not carry any debt. We believe that the estimates used in determining the incremental borrowing rate are reasonable based upon current facts and circumstances. Applying different judgments to the same facts and circumstances could result in the estimated amounts to vary. The operating lease ROU assets also include adjustments for prepayments and accrued lease payments and exclude lease incentives. Our lease terms may include options to extend or terminate the lease when it is reasonably certain that we will exercise such options. Operating lease cost is recognized on a straight-line basis over the expected lease term. Lease agreements entered into after the adoption of ASC 842 that include lease and non-lease components are accounted for as a single lease component. Lease agreements with a noncancelable term of less than 12 months are not recorded on our balance sheet. For more information about the impact of adoption and disclosures on our leases, refer to “Note 10 - Commitments and Contingencies.”

<s>[INST] Overview We are a biotechnology company pioneering the development of engineered IgM antibodies for the treatment of cancer patients. IgM antibodies have inherent properties that we believe may enable them to bind more strongly to cancer cells than comparable IgG antibodies. We have created a proprietary IgM antibody technology platform that we believe is particularly well suited for developing T cell engagers, receptor crosslinking agonists and targeted cytokines. Our lead product candidate, IGM2323, is a bispecific T cell engaging IgM antibody targeting CD20 and CD3 proteins, and in October 2019 we announced the dosing of the first patient in our Phase 1 clinical trial for the treatment of relapsed/refractory B cell NonHodgkin’s lymphoma (NHL) patients. Our second product candidate, IGM8444 is an IgM antibody targeting Death Receptor 5 (DR5) proteins, and we plan to file an investigational new drug application (IND) for the treatment of patients with solid and hematologic malignancies in 2020. Our third product candidate, IGM7354, is a bispecific IgM antibody delivering interleukin15 (IL15) cytokines to PDL1 expressing cells, and we plan to file an IND for the treatment of patients with solid and hematologic malignancies in 2021. We believe that we have the most advanced research and development program focused on engineered therapeutic IgM antibodies. We have created a portfolio of patents and patent applications, knowhow and trade secrets directed to our platform technology, product candidates and manufacturing capabilities, and we retain worldwide commercial rights to all of our product candidates and the intellectual property related thereto. Since the commencement of our operations, we have focused substantially all of our resources on conducting research and development activities, including drug discovery, preclinical studies and clinical trials, establishing and maintaining our intellectual property portfolio, the manufacturing of clinical and research material, developing our inhouse manufacturing capabilities, hiring personnel, raising capital and providing general and administrative support for these operations. Since 2010, such activities have exclusively related to the research, development and manufacture of IgM antibodies and to building our proprietary IgM antibody technology platform. We do not have any products approved for sale, and we have not generated any revenue from product sales. We have incurred significant net losses to date. Our ability to generate product revenue sufficient to achieve profitability will depend on the successful development and eventual commercialization of one or more of our current or future product candidates. Our net losses were $43.1 million, $22.7 million, and $11.1 million for the years ended December 31, 2019, 2018 and 2017, respectively. As of December 31, 2019, we had an accumulated deficit of $107.2 million. These losses have resulted primarily from costs incurred in connection with research and development activities and general and administrative costs associated with our operations. We expect to continue to incur significant expenses and increasing operating losses for the foreseeable future, and our net losses may fluctuate significantly from period to period, depending on the timing of and expenditures on our planned research and development activities. In addition, we expect to incur additional costs associated with operating as a public company. We expect our expenses and capital requirements will increase substantially in connection with our ongoing activities as we: ▪ advance the development of IGM2323, IGM8444 and IGM7354; ▪ expand our pipeline of IgM antibody product candidates; ▪ continue to invest in our IgM antibody technology platform; ▪ build out and expand our inhouse manufacturing capabilities; ▪ maintain, protect and expand our intellectual property portfolio, including patents, trade secrets and knowhow; ▪ seek marketing approvals for any product candidates that successfully complete clinical trials; ▪ establish a sales, marketing, and distribution infrastructure to commercialize any product candidate for which we may obtain marketing approval and related commercial manufacturing buildout; [/INST] Negative. </s>

Mayville Engineering Company, Inc.

2020-03-02

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 is intended to assist in the understanding and assessing the trends and significant changes in our results of operations and financial condition. Historical results may not be indicative of future performance. This discussion includes forward-looking statements that reflect our plans, estimates and beliefs. Such statements involve risks and uncertainties. Our actual results may differ materially from those contemplated by these forward-looking statements as a result of various factors, including those set forth in “Risk Factors” in Part I, Item 1A and “Cautionary Statement Regarding Forward-Looking Statements” of this Annual Report on Form 10-K. This discussion should be read in conjunction with our audited consolidated financial statements and the notes thereto included in Part II, Item 8 of this Annual Report on Form 10-K. In this discussion, we use certain non-GAAP financial measures. Explanation of these non-GAAP financial measures and reconciliation to the most directly comparable GAAP financial measures are included in this Management’s Discussion and Analysis of Financial Condition and Results of Operations. Investors should not consider non-GAAP financial measures in isolation or as substitutes for financial information presented in compliance with GAAP. Critical Accounting Policies and Estimates Critical accounting policies are those policies that, in management’s view, are most important in the portrayal of our financial condition and results of operations. The notes to the consolidated financial statements include full disclosure of significant accounting policies. The methods, estimates and judgments that we use in applying our accounting policies have a significant impact on the results that we report in our financial statements. These critical accounting policies require us to make difficult and subjective judgments, often as a result of the need to make estimates regarding matters that are inherently uncertain. Those critical accounting policies and estimates that require the most significant judgment are discussed further below. See Note 1 - Nature of business and summary of significant accounting policies, in the Notes to the Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K for more specifics. Goodwill, Other Intangibles and Other Long-Lived Assets Our long-lived assets consist primarily of property, equipment, purchased intangible assets and goodwill. The valuation and the impairment testing of these long-lived assets involve significant judgments and assumptions, particularly as they relate to the identification of reporting units, asset groups and the determination of fair market value. We test our tangible and intangible long-lived assets subject to amortization for impairment whenever facts and circumstances indicate that the carrying amount of an asset may not be recoverable. We test goodwill and indefinite lived intangible assets for impairment annually, or more frequently if triggering events occur indicating that there may be impairment. We have recorded goodwill and perform testing for potential goodwill impairment at a reporting unit level. A reporting unit is an operating segment, or a business unit one level below an operating segment for which discrete financial information is available, and for which management regularly reviews the operating results. Additionally, components within an operating segment can be aggregated as a single reporting unit if they have similar economic characteristics. We have performed testing on each of our reporting units which contain goodwill. We determine the fair value of our reporting units using multiple valuation methodologies, relying largely on an income approach but also incorporating value indicators from a 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. The income approach is dependent on several key management assumptions, including estimates of future sales, gross margins, operating costs, interest expense, income tax rates, capital expenditures, changes in working capital requirements and the weighted average cost of capital or the discount rate. Discount rate assumptions include an assessment of the risk inherent in the future cash flows of the reporting unit. Expected cash flows used under the income approach are developed in conjunction with our budgeting and forecasting process. Under the market approach, we estimate fair value of the reporting units using EBITDA multiples. The multiples are derived from comparable publicly traded companies with similar operating and investment characteristics as the respective reporting units. During the fourth fiscal quarters of 2019 and 2018, we performed our annual impairment assessments of goodwill, which did not indicate an impairment existed. For the twelve months ended December 31, 2018 we had two reporting units, DMP and MEC. The DMP reporting unit was acquired on December 14, 2018 and had preliminarily estimated goodwill of $29.2 million as of December 31, 2018. For the 18-day period from December 14 through December 31, 2018, DMP’s actual results of operations were above estimates utilized to determine the preliminary purchase price allocation. As a result, the fair value of the DMP reporting unit at December 31, 2018 is nominally above its carrying value. At December 31, 2018, the MEC reporting unit had goodwill with a carrying amount of approximately $40.2 million. The fair value of the MEC reporting unit substantially exceeded carrying value for 2018. For the twelve months ended December 31, 2019, we concluded that the DMP and MEC reporting units were integrated into one reporting unit. At December 31, 2019, the reporting unit had goodwill with a carrying amount of approximately $71.5 million. The fair value of this reporting unit substantially exceeded the carrying value for 2019. Changes to management assumptions and estimates utilized in the income and market approaches could negatively impact the fair value conclusions for our reporting units resulting in goodwill impairment. All key assumptions and valuations are determined by and are the responsibility of management. The factors used in the impairment analysis are inherently subject to uncertainty. We believe that the estimates and assumptions are reasonable to determine the fair value of our reporting units, however, if actual results are not consistent with these estimates and assumptions, goodwill and other intangible assets may be overstated which could trigger an impairment charge. For impairment testing of long-lived assets, we identify asset groups at the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flow expected to be generated by the assets. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the estimated fair value of the asset. For the years ended December 31, 2019 and 2018, there were no events or changes in circumstances that would indicate a material impairment of our long-lived assets. Determining the useful life of an intangible asset also requires judgment. Certain intangible assets are expected to have indefinite lives based on their history and our plans to continue to support and build the acquired brands. Other acquired intangible assets such as customer relationships, trade names, and non-compete agreements are expected to have determinable useful lives. The costs of determinable-lived intangibles are amortized to expense over their estimated lives. Income Taxes The provision for, or benefit from, income taxes includes deferred taxes resulting from temporary differences in income for financial and tax purposes using the liability method. Such temporary differences result primarily from differences in the carrying value of assets and liabilities. Future realization of deferred income tax assets requires sufficient taxable income within the carryback and/or carryforward period available under tax law. The Company evaluates on a quarterly basis whether, based on all available evidence, it is probable that the deferred income tax assets are realizable. Valuation allowances are established when it is estimated that it is more likely than not that the tax benefit of the deferred tax asset will not be realized. The evaluation includes the consideration of all available evidence, both positive and negative, regarding the estimated future reversals of existing taxable temporary differences, estimated future taxable income exclusive of reversing temporary differences and carryforwards, historical taxable income in prior carryback periods if carryback is permitted, and potential tax planning strategies which may be employed to prevent an operating loss or tax credit carryforward from expiring unused. The verifiable evidence such as future reversals of existing temporary differences and the ability to carryback are considered before the subjective sources such as estimate future taxable income exclusive of temporary differences and tax planning strategies. Additionally, we record uncertain tax positions at their net recognizable amount, based on the amount that management deems is more likely than not to be sustained upon ultimate settlement with the tax authorities in jurisdictions in which we operate. Revenue recognition The Company adopted ASC 606 January 1, 2019, where the Company recognizes revenue for the transfer of goods or services to a customer in an amount that reflects the consideration it expects to receive in exchange for those goods or services. When goods are shipped, the customer takes ownership at shipment, and this is when control transfers. Sales are supported by documentation such as supply agreements and purchase order, which specify certain terms and conditions including product specifications, quantities, fixed prices, delivery dates and payments terms. Revenue related to services is recognized in the period services are performed, thus the Company recognizes revenue at a point in time. There are many customers where the Company designs, engineers and builds production tooling, which is purchased by the customer. Revenue is recognized when the tooling is completed, the customer signs off the product through the Product Part Approval Process (PPAP) and the tool is placed into service. Revenue related to production tooling is recognized as a point in time when it meets the PPAP criteria. The Company offers certain customers discounts for early payments. These discounts are recorded against net sales in the consolidated statement of comprehensive income and accounts receivable in the consolidated balance sheet. The Company does not offer any other customer incentives, rebates or allowances. ESOP Prior to completion of this offering, shares of our common stock held by the ESOP are presented as temporary equity as they include a cash redemption feature that is not solely within our control. Throughout the year, as employee services are rendered, we record compensation expense based on a percentage of salaries or wages for eligible employees. The stock in the ESOP is held in trust for the sole benefit of the participants. Shares allocated to a participant’s account are fully vested. Upon retirement, death, termination of employment or exercise of diversification rights, the eligible portion of a participant’s ESOP account is redeemable annually at the current price per share of the stock. Such per share price is established annually by an independent valuation firm as of the end of the plan year preceding the redemption. Under the current terms of the ESOP, we are obligated to redeem eligible participant account balances for cash (in accordance with the redemption schedule and subject to the limitations set forth in the ESOP). Prior to this offering, we present all shares held by the ESOP as temporary equity on the consolidated balance sheet at their maximum redemption value. Following this offering, (i) we no longer redeem participants’ ESOP interests, as distributions from the ESOP made to a participant following retirement, death or termination of employment, or the exercise of diversification rights under the Traditional ESOP, will be made in our common stock, and upon receiving a distribution of our common stock from the ESOP a participant will be able to sell such shares of common stock in the market, subject to any requirements of federal securities law; and (ii) with respect to any participant who exercises statutory diversification rights under the 401(k) ESOP, the ESOP Trustee will sell, on behalf of the participant, the shares that the participant has elected to diversify and reinvest the sale proceeds in an alternate investment option as directed by the participant. Emerging Growth Company The JOBS Act permits an “emerging growth company” like us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies. We are choosing to use this provision and, as a result, we will comply with new or revised accounting standards as required for private companies. Internal Controls and Procedures Our management is responsible for establishing and maintaining adequate internal control over financial reporting for our company. Internal control over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. Internal control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of our financial statements; providing reasonable assurance that receipts and expenditures of our assets are made in accordance with management’s authorization; and providing reasonable assurance that unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a misstatement of our financial statements would be prevented or detected. Furthermore, our controls and procedures can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the control, and misstatements due to error or fraud may occur and not be detected on a timely basis. During the course of the quarterly and year-end close processes in 2019, we identified a material weakness in the design and operation of our internal control over financial reporting. The material weakness relates to a lack of consistently documented accounting policies and procedures and a lack of formalized controls over the accounting and recording of complex and significant unusual transactions which, in the aggregate, constitute a material weakness. We have taken numerous steps to enhance our internal control environment during 2019. While preparing for our initial public offering, as of December 31, 2018, we had identified two material weaknesses in the design and operation of our internal control over financial reporting. As of December 31, 2019, we have concluded that one of the previously identified material weaknesses has been remediated and the other has been partially remediated. The previously identified deficiencies, that represented the two material weaknesses, included the preparation and review of journal entries, a limited number of personnel with a level of GAAP accounting knowledge commensurate with our financial reporting requirements and certain information technology general controls specific to segregation of duties, systems access and change management processes. However, deficiencies in our control environment, specifically deficiencies related to a lack of consistently documented accounting policies and procedures and a lack of formalized controls over the accounting and recording of complex and significant unusual transactions, which we have collectively determined aggregate to a material weakness, remained as of December 31, 2019. We are currently evaluating a number of steps to enhance our control over financial reporting and address this material weakness, including: enhancing our internal review procedures during the financial statement close process, and designing and implementing consistent policies throughout the Company; however, our current efforts to design and implement effective controls may not be sufficient to remediate the material weakness described above or prevent future material weaknesses or other deficiencies from occurring. Despite these actions, we may identify additional material weaknesses in our internal control over financial reporting in the future. If we fail to effectively remediate this material weakness in our internal control over financial reporting, if we identify future material weaknesses in our internal control over financial reporting or if we are unable to comply with the demands that will be placed upon us as a public company, including the requirements of Section 404 of the Sarbanes-Oxley Act, in a timely manner, we may be unable to accurately report our financial results, or report them within the timeframes required by the SEC. In addition, if we are unable to assert that our internal control over financial reporting is effective, or if our independent registered public accounting firm is unable to express an opinion as to the effectiveness of our internal control over financial reporting, when required, investors may lose confidence in the accuracy and completeness of our financial reports, we may face restricted access to the capital markets and our stock price may be adversely affected. Overview MEC is a leading U.S.-based value-added manufacturing partner that provides a broad range of prototyping and tooling, production fabrication, coating, assembly and aftermarket components. Our customers operate in diverse end markets, including heavy- and medium-duty commercial vehicles, construction, powersports, agriculture, military and other end markets. We have developed long-standing relationships with our blue-chip customers based upon a high level of experience, trust and confidence. Our one operating segment focuses on producing metal components that are used in a broad range of heavy- and medium-duty commercial vehicles, construction, powersports, agricultural, military and other products. On December 14, 2018 we acquired DMP, a leading U.S. based manufacturer of component parts for the heavy- and medium-duty commercial vehicles, construction, agriculture and military markets. See Note 3 - Acquisition, in the Notes to the Consolidated Financial Statements for more specifics. In May 2019, we completed our IPO. In conjunction with the IPO, the Company’s legacy business converted from an S Corporation to a C Corporation. As a result, the consolidated business is subject to paying federal and state corporate income taxes on its taxable income from May 9, 2019 forward. How We Assess Performance Net Sales. Net sales reflect sales of our components and products net of allowances for returns and discounts. Several factors affect our net sales in any given period, including general economic conditions, weather, timing of acquisitions and the production schedules of our customers. Net sales are recognized at the time of shipment to the customer. Manufacturing Margins. Manufacturing margins represents net sales less cost of sales. Cost of sales consists of all direct and indirect costs used in the manufacturing process, including raw materials, labor, equipment costs, depreciation, lease expenses, subcontract costs and other directly related overhead costs. Our cost of sales is directly affected by the fluctuations in commodity prices, primarily sheet steel and aluminum, but these changes are largely mitigated by contractual agreements with our customers that allow us to pass through these price changes based upon certain market indexes. Depreciation and Amortization. We carry property, plant and equipment on our balance sheet at cost, net of accumulated depreciation and amortization. Depreciation on property, plant and equipment is computed on a straight-line basis over the estimated useful life of the asset. Amortization expense is the periodic expense related to leasehold improvements and intangible assets. Leasehold improvements are amortized over the lesser of the life of the underlying asset or the remaining lease term. Our intangible assets were recognized as a result of certain acquisitions and are generally amortized on a straight-line basis over the estimated useful lives of the assets. Other Selling, General, and Administrative Expenses. Other selling, general and administrative expenses consist primarily of salaries and personnel costs for our sales and marketing, finance, human resources, information systems, administration and certain other managerial employees and certain corporate level administrative expenses such as incentive compensation, audit, accounting, legal and other consulting and professional services, travel, and insurance. Other Key Performance Indicators EBITDA, EBITDA Margin, Adjusted EBITDA and Adjusted EBITDA Margin EBITDA represents net income before interest expense, provision (benefit) for income taxes, depreciation and amortization. EBITDA Margin represents EBITDA as a percentage of net sales for each period. Adjusted EBITDA represents EBITDA before transaction fees incurred in connection with the DMP acquisition and the IPO, the loss on debt extinguishment relating to our December 2018 credit agreement, non-cash purchase accounting charges including costs recognized on the step-up of acquired inventory and contingent consideration fair value adjustments, and one-time increases in deferred compensation and long term incentive plan expenses related to the IPO. Adjusted EBITDA Margin represents Adjusted EBITDA as a percentage of net sales for each period. These metrics are supplemental measures of our operating performance that are neither required by, nor presented in accordance with, GAAP. These measures should not be considered as an alternative to net income or any other performance measure derived in accordance with GAAP as an indicator of our operating performance. We present Adjusted EBITDA and Adjusted EBITDA Margin as management uses these measures as key performance indicators, and we believe they are measures frequently used by securities analysts, investors and other parties to evaluate companies in our industry. These measures have limitations as analytical tools and should not be considered in isolation or as substitutes for analysis of our results as reported under GAAP. Our calculation of EBITDA, EBITDA Margin, Adjusted EBITDA and Adjusted EBITDA Margin may not be comparable to the similarly named measures reported by other companies. Potential differences between our measures of EBITDA and Adjusted EBITDA compared to other similar companies’ measures of EBITDA and Adjusted EBITDA may include differences in capital structure and tax positions. The following table presents a reconciliation of net income, the most directly comparable measure calculated in accordance with GAAP, to EBITDA and Adjusted EBITDA, and the calculation of EBITDA Margin and Adjusted EBITDA Margin for each of the periods presented. Consolidated Results of Operations Twelve Months Ended December 31, 2019 Compared to Twelve Months Ended December 31, 2018 Net Sales. Net sales were $519,704 for the twelve months ended December 31, 2019 as compared to $354,526 for the twelve months ended December 31, 2018 for an increase of $165,178, or 46.6%, which was driven by approximately $189,000 of net contributions from the former DMP locations slightly offset by modest declines within our legacy business. Both the legacy MEC and former DMP businesses were adversely impacted by sudden declines in market demand that began late in the third quarter and continued through the fourth quarter, particularly in the Commercial Vehicle (CV), Agricultural and Construction end markets served. These market demand changes drove destocking activities which had a more pronounced impact on the legacy MEC business, especially in the fourth quarter. Destocking stems from lower retail sales resulting in customer decisions to reduce dealer inventory levels by reducing and curtailing near-term production schedules. In addition, several key customers in the CV market experienced labor union issues in the third and fourth quarters of 2019, which negatively impacted production schedules for both the legacy MEC and former DMP businesses. Manufacturing Margins. Manufacturing margins were $58,718 for the twelve months ended December 31, 2019 as compared to $50,578 for the twelve months ended December 31, 2018, an increase of $8,141, or 16.1%. The increase was driven by approximately $21,000 of contributions from the former DMP locations slightly offset by modest declines at the legacy MEC locations. The declines in market demand, destocking, and impact of customer labor issues adversely impacted volumes and the labor absorption associated with it. These circumstances, along with the costs associated with working through the consolidation of the Company’s Virginia facilities, shift consolidations across multiple facilities and increased healthcare costs, coupled with fewer working days in the fourth quarter, negatively impacted our costs. These conditions collectively produced an unusual amount of under-absorbed manufacturing expenses and lower manufacturing margins in the third quarter and especially in the fourth quarter of 2019. Amortization of Intangibles Expense. Amortization of intangibles expense was $10,706 for the twelve months ended December 31, 2019 as compared to $4,096 for the twelve months ended December 31, 2018. The increase of $6,610, or 161.4%, was solely due to the amortization expense associated with the identifiable intangible assets from the DMP acquisition. Please see Note 3 - Acquisition of the Consolidated Financial Statements for more information related to these identifiable intangible assets. Profit Sharing, Bonuses and Deferred Compensation Expenses. Profit sharing, bonuses, and deferred compensation expenses were $25,105 for the twelve months ended December 31, 2019 as compared to $8,058 for the twelve months ended December 31, 2018. The increase of $17,047 was primarily driven by a one-time increase of approximately $10,200 in deferred compensation plan expense and a one-time increase of approximately $9,900 in long term incentive plan (“LTIP”) expense, both related to the IPO, offset by approximately a $2,600 reduction in annual incentive-based bonus expense. Employee Stock Ownership Plan Expense. Employee stock ownership plan expense was $5,453 for the twelve months ended December 31, 2019 as compared to $4,000 for the twelve months ended December 31, 2018. The increase of $1,453, or 36.3%, was primarily due to the addition of plan participants as a result of the DMP acquisition. Other Selling, General and Administrative Expenses. Other selling, general and administrative expenses were $25,466 for the twelve months ended December 31, 2019 as compared to $12,276 for the twelve months ended December 31, 2018. The increase of $13,190, or 107.5%, was driven by approximately $5,700 of one-time IPO and DMP acquisition expenses, approximately $5,300 from the former DMP acquired entities, and additional costs associated with being a publicly traded company. Contingent Consideration Revaluation. The DMP purchase agreement provided for a payout to the previous shareholders of DMP of $7,500, but not more than $10,000 if a certain level of EBITDA was generated during the twelve-month period ended September 30, 2019. We estimated the fair value of the contingent consideration payable balance of $6,076 as of the acquisition date. We then remeasured the fair value each quarter with the change recorded as income or expense. Based on our calculations in accordance with the purchase agreement, and as agreed to by DMP’s former shareholders, DMP’s EBITDA fell short of the payout threshold and as a result, the contingent consideration payable balance was adjusted to zero in the third quarter of 2019, resulting in a revaluation gain of $6,054 for the twelve months ended December 31, 2019. Interest Expense. Interest expense was $6,728 for the twelve months ended December 31, 2019 as compared to $3,879 for the twelve months ended December 31, 2018. The increase of $2,849, or 73.5%, was due to additional debt used to fund the DMP acquisition, slightly offset by the partial paydown of our debt with the IPO proceeds in May and net positive cash flows generated by the business. Benefit for Income Taxes. Income tax benefits were $4,088 for the twelve months ended December 31, 2019 as compared to $459 for the twelve months ended December 31, 2018. The current period benefit is the result of the Company’s legacy business converting to a C Corporation in May 2019 and the one-time IPO expenses incurred which are deductible, causing the benefit. Prior to the IPO, the Company’s legacy business was a S Corporation, where substantially all taxes were passed to the shareholders and the Company did not pay federal or state corporate income taxes on its taxable income. The DMP entities have been taxable under the provisions of the Internal Revenue Code and certain state statutes since being acquired. The consolidated business has been subject to paying federal and state corporate income taxes on its taxable income since May 9, 2019. Net Income (Loss) and Comprehensive Income (Loss). Net loss and comprehensive loss was $4,753 for the twelve months ended December 31, 2019 as compared to net income and comprehensive income of $17,935 for the twelve months ended December 31, 2018. The decrease of $22,688 was due to the previously discussed expense increases, most notably the one-time LTIP and deferred compensation plan expenses related to the IPO, and other one-time IPO and DMP acquisition related expenses, slightly offset by the contingent consideration fair value revaluation adjustment and net income generated by DMP. EBITDA and EBITDA Margin. EBITDA and EBITDA Margin percent were $30,890 and 5.9%, respectively, for the twelve months ended December 31, 2019, as compared to $41,823 and 11.8%, respectively, for the twelve months ended December 31, 2018. The $10,933 decline in EBITDA was due to the previously mentioned increase in LTIP and deferred compensation plan expenses related to the IPO, and other one-time IPO and DMP acquisition related expenses. These one-time expenses and charges were slightly offset by the gain recorded for the DMP contingent consideration fair value revaluation adjustment and the addition of DMP. Adjusted EBITDA and Adjusted EBITDA Margin. Adjusted EBITDA and Adjusted EBITDA Margin percent were $53,080 and 10.2%, respectively, for the twelve months ended December 31, 2019, as compared to $43,694 and 12.3%, respectively, for the twelve months ended December 31, 2018. The increase in Adjusted EBITDA of $9,386 was primarily driven by our recent acquisition of DMP. Twelve Months Ended December 31, 2018 Compared to Twelve Months Ended December 31, 2017 Net Sales. Net sales were $354,526 for the twelve months ended December 31, 2018 compared to $313,331 for the twelve months ended December 31, 2017. The increase of $41,195, or 13.1%, was due in part to our acquisition of DMP, which accounted for $4,841, or 1.5%, of the increase, general market demand increases, which accounted for approximately $27,500 of the increase, and sales price increases passed along to our customers for increased material cost and other labor related inflationary reasons, which accounted for approximately $8,900 of the increase. Manufacturing Margins. Manufacturing margins were $50,578 for the twelve months ended December 31, 2018 compared to $34,737 for the twelve months ended December 31, 2017. Of the increase of $15,841, or 45.6%, approximately $7,500 was related to the increased market demand noted above, approximately $6,000 was related to sales price realization, and approximately $2,400 was related to realized operational efficiencies and cost improvements. Amortization of Intangibles. Amortization of intangibles were $4,096 for the twelve months ended December 31, 2018 compared to $3,756 for the twelve months ended December 31, 2017. The increase of $340, or 9.1%, related to the amortization expense associated with the identifiable intangible assets from the DMP acquisition. Profit Sharing, Bonuses and Deferred Compensation. Profit sharing, bonuses and deferred compensation expense was $8,058 for the twelve months ended December 31, 2018 compared to $5,397 for the twelve months ended December 31, 2017. The increase of $2,661, or 49.3%, related to the financial performance and increased valuation of the Company. Employee Stock Ownership Plan Expense. Employee stock ownership plan expense was $4,000 for both the twelve months ended December 31, 2018 and the twelve months ended December 31, 2017. This expense relates to stock that was repurchased during the year from our employees. Other Selling, General and Administrative Expenses. Other selling, general and administrative expenses were $12,276 for the twelve months ended December 31, 2018 compared to $12,158 for the twelve months ended December 31, 2017. The increase of $118, or 1.0%, related to salary increases. Interest Expense. Interest expense was $3,879 for the twelve months ended December 31, 2018 compared to $4,180 for the twelve months ended December 31, 2017. The decrease of $301, or 7.2%, related to debt reduction that occurred prior to the acquisition of DMP. Net Income and Comprehensive Income. Net income and comprehensive income was $17,935 for the twelve months ended December 31, 2018 compared to $5,246 for the twelve months ended December 31, 2017. The increase of $12,689, or 241.9%, was due to the factors described above. EBITDA and EBITDA Margin. EBITDA and EBITDA Margin were $41,823 and 11.8%, respectively, for the twelve months ended December 31, 2018, as compared to $30,190 and 9.6%, respectively, for the twelve months ended December 31, 2017. The increase in EBITDA and EBITDA Margin was primarily due to the factors described above. Liquidity and Capital Resources Cash Flows Analysis Twelve Months Ended December 31, 2019 Compared to Twelve Months Ended December 31, 2018 Operating Activities. Cash provided by operating activities was $33,402 for the twelve months ended December 31, 2019 as compared to $36,715 for the twelve months ended December 31, 2018. The $3,313, or 9.0% decline in operating cash flows was primarily driven by the LTIP payout of approximately $10,600 in the second quarter of 2019 and approximately $5,000 of payments made in 2019 specific to the IPO, offset by additional cash flow generated by the consolidated business during 2019. Changes to pricing, payment terms and credit terms did not have a significant impact on changes to working capital items, or any other element of the operating cash flow activities, for the periods presented. Investing Activities. Cash used in investing activities was $28,090 for the twelve months ended December 31, 2019, as compared to $132,569 for the twelve months ended December 31, 2018. The $104,479, or 78.8%, decrease in cash used in investing activities was predominantly driven by cash utilized to acquire DMP in 2018, slightly offset by greater capital expenditures in 2019. Financing Activities. Cash used by financing activities was $8,400 for the twelve months ended December 31, 2019, as compared to cash provided in financing activities of $98,867 for the twelve months ended December 31, 2018. The $107,267 change was primarily due to $101,763 of net IPO proceeds received in May 2019, net of debt repayments. Cash Flows Analysis Twelve Months Ended December 31, 2018 Compared to Twelve Months Ended December 31, 2017 Operating Activities. Cash provided by operating activities was $36,715 for the twelve months ended December 31, 2018, as compared to $30,801 for the twelve months ended December 31, 2017. The $5,914, or 19.2%, increase in cash provided by operating activities was primarily due to the increase in net income of $12,689, partially offset by changes in working capital items including $4,393 of additional inventory primarily driven by higher forecasted volumes year over year and increases in prepaid and other assets primarily due to the timing of payments. Changes to pricing, payment terms and credit terms did not have a significant impact to working capital items, or any other element of operating cash flow activities, for the periods presented. Investing Activities. Cash used in investing activities was $132,569 for the twelve months ended December 31, 2018, as compared to $11,235 for the twelve months ended December 31, 2017. The $121,334 increase in cash used in investing activities was primarily due to the $114,700 net payment to acquire DMP in addition to a $6,620 increase in capital expenditures. Financing Activities. Cash provided by financing activities was $98,867 for the twelve months ended December 31, 2018, as compared to $19,633 used in the twelve months ended December 31, 2017. The increase of $118,500 in cash provided by financing activities was primarily due to the DMP acquisition facilitated by the restructuring of our debt facilities. Amended and Restated Credit Agreement On September 26, 2019, and as last amended as of December 31, 2019, we entered into the A&R Credit Agreement with certain lenders and Wells Fargo Bank, National Association, as administrative agent (the Agent). The A&R Credit Agreement provides for a $200.0 million Revolving Loan, with a letter of credit sub-facility in an aggregate amount not to exceed $5.0 million, and a swingline facility in an aggregate amount of $20.0 million. The A&R Credit Agreement also provides for an additional $100.0 million of capacity through an accordion feature. All amounts borrowed under the A&R Credit Agreement mature on September 26, 2024. Our obligations under the A&R Credit Agreement are secured by first priority security interests in substantially all of our personal property and guaranteed by, and secured by first priority security interests in, substantially all of the personal property of, our direct and indirect subsidiaries: Center Manufacturing, Inc., Center Manufacturing Holdings, Inc., Center-Moeller Products LLC, Defiance Metal Products Co., Defiance Metal Products of Arkansas, Inc., Defiance Metal Products of PA., Inc. and Defiance Metal Products of WI, Inc. Borrowings under the A&R Credit Agreement bear interest at a fluctuating London Interbank Offered Rate (LIBOR) (which may be adjusted for certain reserve requirements), plus 1.00-2.00% depending on the current Consolidated Total Leverage Ratio (as defined in the A&R Credit Agreement). Under certain circumstances, we may not be able to pay interest based on LIBOR. If that happens, we will be required to pay interest at the Base Rate, which is the sum of (a) the higher of (i) the Prime Rate (as publicly announced by the Agent from time to time) and (ii) the Federal Funds Rate plus 0.50%, plus (b) 0.00% to 1.00%, depending on the current Total Consolidated Leverage Ratio. The A&R Credit Agreement also includes provisions for determining a replacement rate when LIBOR is no longer available. At December 31, 2019, the interest rate on outstanding borrowings under the Revolving Loan was 3.25%. At December 31, 2019, we had availability of $127.4 million under the Revolving Loan. We must pay a commitment fee at a rate of 0.20% per annum on the average daily unused portion of the aggregate unused revolving commitments under the A&R Credit Agreement. We must also pay fees as specified in the Fee Letter (as defined in the A&R Credit Agreement) and with respect to any letters of credit issued under the A&R Credit Agreement. The A&R Credit Agreement contains usual and customary negative covenants for agreements of this type, including, but not limited to, restrictions on our ability to, subject to certain exceptions, create, incur or assume indebtedness, create or incur liens, make certain investments, merge or consolidate with another entity, make certain asset dispositions, pay dividends or other distributions to shareholders, enter into transactions with affiliates, enter into sale leaseback transactions or make capital expenditures. The A&R Credit Agreement also requires us to satisfy certain financial covenants, including a minimum interest coverage ratio of 3.00 to 1.00. At December 31, 2019, our interest coverage ratio was 7.42 to 1.00. The A&R Credit Agreement also requires us to maintain a consolidated total leverage ratio not to exceed 3.25 to 1.00, although such leverage ratio can be increased in connection with certain acquisitions. At December 31, 2019, our consolidated total leverage ratio was 1.39 to 1.00. The A&R Credit Agreement includes customary events of default, including, among other things, payment default, covenant default, breach of representation or warranty, bankruptcy, cross-default, material ERISA events, material money judgments, failure to maintain subsidiary guarantees and a change in control, which will be deemed to occur if any person or group other than the ESOP or the 401(k) Plan owns or controls more than 35% of our equity interests, or our board of directors is not composed of a majority of our continuing directors (i.e., our directors as of September 26, 2019, and any additional or replacement directors that have been approved by at least 51% of the directors then in office). If an event of default occurs, the Agent will be entitled to take various actions, including the acceleration of amounts due under the A&R Credit Agreement, termination of the credit facility, and all other actions permitted to be taken by a secured creditor. At December 31, 2019, we were in compliance with all covenants under the A&R Credit Agreement. Capital Requirements and Sources of Liquidity During the twelve months ended December 31, 2019 and 2018, our capital expenditures were approximately $25.8 million and $17.9 million, respectively. The increase of $7.9 million was primarily driven by our continued investment in automation and new technology, the addition of DMP, and the timing of purchases in 2019 as compared to the prior year. Historically, we have had significant cash requirements in order to organically expand our business to meet the market related needs of our customers, continue our investment in new technologies and automation, as well as fund new projects. Additionally, prior to the IPO, we were required to use cash to repurchase shares of our common stock from the ESOP in connection with legally required diversification and other distributions to eligible ESOP participants. Following the consummation of the IPO, this requirement terminated, which allows us to direct this previously allocated cash to operating- and growth-related purposes. Our cash requirements include costs related to capital expenditures, purchase of materials and production of materials and cash to fund these needs. Our working capital needs are driven by the growth of our business, with our cash requirements greater in periods of growth. Additional cash requirements resulting from our growth include the costs of additional personnel, production and distribution facilities, enhancing our information systems and, our integration of DMP and any future acquisitions and, our compliance with laws and rules applicable to being a public company. Following the completion of the IPO, our primary uses of cash are investing in flexible, re-deployable automation used to provide our components and products and funding organic and acquisitive growth initiatives. We have historically relied upon cash available through credit facilities, in addition to cash from operations, to finance our working capital requirements and to support our growth. At December 31, 2019, we had availability of $127.4 million under our A&R Credit Agreement. We regularly monitor potential capital sources, including equity and debt financings, in an effort to meet our planned capital expenditures and liquidity requirements. Our future success will be highly dependent on our ability to access outside sources of capital. We believe that our operating cash flow and available borrowings under the A&R Credit Agreement are sufficient to fund our operations for 2020. However, future cash flows are subject to a number of variables, and additional capital expenditures will be required to conduct our operations. There can be no assurance that operations and other capital resources will provide cash in sufficient amounts to maintain planned or future levels of capital expenditures. In the event we make one or more acquisitions and the amount of capital required is greater than the amount we have available for acquisitions at that time, we could be required to reduce the expected level of capital expenditures and/or seek additional capital. If we seek additional capital, we may do so through borrowings under the A&R Credit Agreement, joint ventures, asset sales, offerings of debt or equity securities or other means. We cannot guarantee that this additional capital will be available on acceptable terms or at all. If we are unable to obtain the funds we need, we may not be able to complete acquisitions that may be favorable to us or finance the capital expenditures necessary to conduct our operations. Contractual Obligations The following table presents our obligations and commitments to make future payments under contracts and contingent commitments at December 31, 2019: (1) The long-term amounts in the table include principal payments under the Company’s A&R Credit Agreement, which expires in 2024. (2) Forecasted interest on debt payment obligations based on interest rates as of December 31, 2019

<s>[INST] Critical Accounting Policies and Estimates Critical accounting policies are those policies that, in management’s view, are most important in the portrayal of our financial condition and results of operations. The notes to the consolidated financial statements include full disclosure of significant accounting policies. The methods, estimates and judgments that we use in applying our accounting policies have a significant impact on the results that we report in our financial statements. These critical accounting policies require us to make difficult and subjective judgments, often as a result of the need to make estimates regarding matters that are inherently uncertain. Those critical accounting policies and estimates that require the most significant judgment are discussed further below. See Note 1 Nature of business and summary of significant accounting policies, in the Notes to the Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10K for more specifics. Goodwill, Other Intangibles and Other LongLived Assets Our longlived assets consist primarily of property, equipment, purchased intangible assets and goodwill. The valuation and the impairment testing of these longlived assets involve significant judgments and assumptions, particularly as they relate to the identification of reporting units, asset groups and the determination of fair market value. We test our tangible and intangible longlived assets subject to amortization for impairment whenever facts and circumstances indicate that the carrying amount of an asset may not be recoverable. We test goodwill and indefinite lived intangible assets for impairment annually, or more frequently if triggering events occur indicating that there may be impairment. We have recorded goodwill and perform testing for potential goodwill impairment at a reporting unit level. A reporting unit is an operating segment, or a business unit one level below an operating segment for which discrete financial information is available, and for which management regularly reviews the operating results. Additionally, components within an operating segment can be aggregated as a single reporting unit if they have similar economic characteristics. We have performed testing on each of our reporting units which contain goodwill. We determine the fair value of our reporting units using multiple valuation methodologies, relying largely on an income approach but also incorporating value indicators from a 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. The income approach is dependent on several key management assumptions, including estimates of future sales, gross margins, operating costs, interest expense, income tax rates, capital expenditures, changes in working capital requirements and the weighted average cost of capital or the discount rate. Discount rate assumptions include an assessment of the risk inherent in the future cash flows of the reporting unit. Expected cash flows used under the income approach are developed in conjunction with our budgeting and forecasting process. Under the market approach, we estimate fair value of the reporting units using EBITDA multiples. The multiples are derived from comparable publicly traded companies with similar operating and investment characteristics as the respective reporting units. During the fourth fiscal quarters of 2019 and 2018, we performed our annual impairment assessments of goodwill, which did not indicate an impairment existed. For the twelve months ended December 31, 2018 we had two reporting units, DMP and MEC. The DMP reporting unit was acquired on December 14, 2018 and had preliminarily estimated goodwill of $29.2 million as of December 31, 2018. For the 18day period from December 14 through December 31, 2018, DMP’s actual results of operations were above estimates utilized to determine the preliminary purchase price allocation. As a result, the fair value of the DMP reporting unit at December 31, 2018 is nominally above its carrying value. At December 31, 2018, the MEC reporting unit had goodwill with a carrying amount of approximately $40.2 million. The fair value of the MEC reporting unit substantially exceeded carrying value for 2018. For the twelve months ended December 31, 2019, we concluded that the DMP and MEC reporting units were integrated into one reporting unit. At December 31, 2019, the reporting unit had goodwill with a carrying amount of approximately $71.5 million. The fair value of this reporting unit substantially exceeded the carrying value for [/INST] Negative. </s>

ALTA EQUIPMENT GROUP INC.

2020-03-25

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 Alta Equipment Group Inc. The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements reflecting our current expectations, estimates and assumptions concerning events and financial trends that may affect our future operating results or financial position. Actual results and the timing of events may differ materially from those contained in these forward-looking statements due to a number of factors, including those discussed in the sections entitled “Risk Factors” and “Forward-Looking Statements” appearing elsewhere in this Annual Report on Form 10-K. Overview BRPM was formed as a blank check company incorporated on October 30, 2018 as a Delaware corporation formed 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”). On November 14, 2018, GA International Services Corp. (“GA International”), a California corporation, owned by Great American Group, LLC (“Great American”), a wholly owned subsidiary of B. Riley Financial, Inc. (“B. Riley Financial”) merged into BRPM. GA International operated as GA International Services, LLC, a former California limited liability company, from the date of its incorporation on October 9, 2012 through November 5, 2018, the date it was converted from a limited liability company to a California corporation. All of the membership interests in GA International Services, LLC were issued to Great American in 2012. Based on its business activities, BRPM was a “shell company” as defined under the Exchange Act because it had no operations and nominal assets consisting almost entirely of cash. Until the consummation of the business combination, the Company did not engage in any operations nor generated any revenue. On April 11, 2019, the Company consummated its initial public offering (the “initial public offering”) of 14,375,000 units (the “units”), including the issuance of 1,875,000 units as a result of the underwriters’ exercise of their over-allotment option. Each unit consisted of one Class A common stock and one-half of one redeemable warrant. Each whole warrant entitled the holder thereof to purchase one Class A common stock at a price of $11.50 per share. The units were sold at an offering price of $10.00 per unit, generating gross proceeds, before expenses, of $143,750,000. In connection with our initial formation in 2012, a wholly-owned subsidiary of B. Riley Financial which is the parent of our Sponsor was issued all of our outstanding equity. Prior to the consummation of the initial public offering, in November, 2018, we conducted a 1:3,593,750 stock split and reclassification of our common stock, resulting in our sole stockholder owning 3,593,750 founder shares. On March 12, 2019, 20,000 founder shares were transferred to each of Patrick J. Bartels, Jr., James L. Kempner, Timothy M. Presutti and Robert Suss, then our independent directors, at their par value, and on April 4, 2019, the remaining 3,513,750 founder shares were contributed to our Sponsor. The number of founder shares outstanding was determined based on the expectation that the founder shares would represent 20% of the outstanding shares after the IPO. As such, our initial stockholders collectively own founder shares representing 20% of our issued and outstanding shares, excluding the private placement shares underlying the private placement units. Up to 468,750 founder shares were subject to forfeiture by our sponsor depending on the extent to which the underwriters’ over-allotment option was exercised so that our initial stockholders would maintain ownership of founder shares representing 20% of our common stock after the IPO excluding the private placement shares underlying the private placement units. As the underwriters exercised their over-allotment option in full, such shares are no longer subject to forfeiture. Simultaneously with the closing of the initial public offering, we consummated the private placement (“private placement”) of 462,500 private placement units (“private placement units”), including the issuance of 37,500 private placement units as a result of the underwriter’s exercise of their over-allotment option, each exercisable to purchase one share of Class A common stock and one-half of one redeemable warrant at $11.50 per share, to the Sponsor at a price of $10.00 per unit, generating gross proceeds of approximately $4.625 million. Upon the closing of the initial public offering (including the over-allotment) and the private placement on April 11, 2019, approximately $143,750,000 from the net proceeds of the sale of the units in the initial public offering and the private placement was placed in a U.S.-based trust account maintained by Continental Stock Transfer & Trust Company, acting as trustee (the “Trust Account”). The funds in the Trust Account were invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act, with maturities of 180 days or less or in any open-ended investment company that holds itself out as a money market fund 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 an initial business combination and (ii) the distribution of the funds in the Trust Account. Business Combination On December 12, 2019, BRPM entered into the Agreement and Plan of Merger (the “Merger Agreement”) with BR Canyon Merger Sub Corp., a Delaware corporation and wholly owned subsidiary of BRPM (“Merger Sub”), Alta Equipment Holdings Inc., a Michigan corporation (“Alta”) and Ryan Greenawalt. On February 11, 2020, the business combination was approved by the stockholders of BRPM at the special meeting of stockholders. In connection with the business combination, 1,049,036 shares of the Company’s common stock were redeemed at a per share price of approximately $10.14. On February 14, 2020 (the “Closing Date”), we consummated the business combination, pursuant to which the Company acquired Alta. In connection with the closing of the business combination (the “Closing”), pursuant to the Merger Agreement, Merger Sub merged with and into Alta, with Alta surviving the merger in accordance with the Delaware General Corporation Law as a wholly owned subsidiary of the Company (the “Merger”). Immediately after the Closing, we had 29,511,359 shares of common stock outstanding, 16,884,213 of which were held by non-affiliates of the Company. At the time of our IPO, we entered into the forward purchase agreement which provided for the purchase, immediately prior to the closing of the business combination, by BRPI, an affiliate of the Sponsor, or its designees of $25,000,000 of our units at a price of $10.00 per unit, or an aggregate of 2,500,000 units, each comprised of one share of Class A common stock and one-half of one warrant. On February 14, 2020, in connection with the forward purchase agreement, BRPI purchased 2,500,000 units at a price of $10.00 per unit for an aggregate purchase price of $25,000,000 in a private placement that took place concurrently with the close of the initial business combination.

<s>[INST] Overview BRPM was formed as a blank check company incorporated on October 30, 2018 as a Delaware corporation formed 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”). On November 14, 2018, GA International Services Corp. (“GA International”), a California corporation, owned by Great American Group, LLC (“Great American”), a wholly owned subsidiary of B. Riley Financial, Inc. (“B. Riley Financial”) merged into BRPM. GA International operated as GA International Services, LLC, a former California limited liability company, from the date of its incorporation on October 9, 2012 through November 5, 2018, the date it was converted from a limited liability company to a California corporation. All of the membership interests in GA International Services, LLC were issued to Great American in 2012. Based on its business activities, BRPM was a “shell company” as defined under the Exchange Act because it had no operations and nominal assets consisting almost entirely of cash. Until the consummation of the business combination, the Company did not engage in any operations nor generated any revenue. On April 11, 2019, the Company consummated its initial public offering (the “initial public offering”) of 14,375,000 units (the “units”), including the issuance of 1,875,000 units as a result of the underwriters’ exercise of their overallotment option. Each unit consisted of one Class A common stock and onehalf of one redeemable warrant. Each whole warrant entitled the holder thereof to purchase one Class A common stock at a price of $11.50 per share. The units were sold at an offering price of $10.00 per unit, generating gross proceeds, before expenses, of $143,750,000. In connection with our initial formation in 2012, a whollyowned subsidiary of B. Riley Financial which is the parent of our Sponsor was issued all of our outstanding equity. Prior to the consummation of the initial public offering, in November, 2018, we conducted a 1:3,593,750 stock split and reclassification of our common stock, resulting in our sole stockholder owning 3,593,750 founder shares. On March 12, 2019, 20,000 founder shares were transferred to each of Patrick J. Bartels, Jr., James L. Kempner, Timothy M. Presutti and Robert Suss, then our independent directors, at their par value, and on April 4, 2019, the remaining 3,513,750 founder shares were contributed to our Sponsor. The number of founder shares outstanding was determined based on the expectation that the founder shares would represent 20% of the outstanding shares after the IPO. As such, our initial stockholders collectively own founder shares representing 20% of our issued and outstanding shares, excluding the private placement shares underlying the private placement units. Up to 468,750 founder shares were subject to forfeiture by our sponsor depending on the extent to which the underwriters’ overallotment option was exercised so that our initial stockholders would maintain ownership of founder shares representing 20% of our common stock after the IPO excluding the private placement shares underlying the private placement units. As the underwriters exercised their overallotment option in full, such shares are no longer subject to forfeiture. Simultaneously with the closing of the initial public offering, we consummated the private placement (“private placement”) of 462,500 private placement units (“private placement units”), including the issuance of 37,500 private placement units as a result of the underwriter’s exercise of their overallotment option, each exercisable to purchase one share of Class A common stock and onehalf of one redeemable warrant at $11.50 per share, to the Sponsor at a price of $10.00 per unit, generating gross proceeds [/INST] Negative. </s>

Sunnova Energy International 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 contain forward-looking statements that are subject to risks, uncertainties and assumptions. Our actual results and timing of selected events may differ materially from those anticipated in these forward-looking statements as a result of many factors, including but not limited to those discussed under "Special Note Regarding Forward-Looking Statements", "Risk Factors" and elsewhere in this Annual Report on Form 10-K. Moreover, we operate in a very competitive and rapidly changing environment and new risks emerge from time to time. It is not possible for our management to predict all risks, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements we may make. In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this Annual Report on Form 10-K may not occur and actual results could differ materially and adversely from those anticipated or implied in the forward-looking statements. Unless the context otherwise requires, the terms "Sunnova," "the Company," "we," "us" and "our" refer to Sunnova Energy International Inc. ("SEI") and its consolidated subsidiaries. Company Overview We are a leading residential solar and energy storage service provider, serving more than 80,000 customers in more than 20 U.S. states and territories. Our goal is to be the leading provider of clean, affordable and reliable energy for consumers, and we operate with a simple mission: to power energy independence. We were founded to deliver customers a better energy service at a better price; and, through our solar and solar plus energy storage service offerings, we are disrupting the traditional energy landscape and the way the 21st century customer generates and consumes electricity. We have a differentiated residential solar dealer model in which we partner with local dealers who originate, design and install our customers' solar energy systems and energy storage systems on our behalf. Our focus on our dealer model enables us to leverage our dealers' specialized knowledge, connections and experience in local markets to drive customer origination while providing our dealers with access to high quality products at competitive prices and technical oversight and expertise. We believe this structure provides operational flexibility, reduced exposure to labor shortages and lower fixed costs relative to our peers, furthering our competitive advantage. We offer customers products to power their homes with affordable solar energy. We are able to offer savings and storage opportunities to most customers compared to utility-based retail rates with little to no up-front expense to the customer, and we are able to provide energy resiliency and reliability to our solar plus energy storage customers. Our solar service agreements take the form of a lease, PPA or loan. The initial term of our solar service agreements is typically either 10 or 25 years. Service is an integral part of our agreements and includes operations and maintenance, monitoring, repairs and replacements, equipment upgrades, on-site power optimization for the customer (for both supply and demand), the ability to efficiently switch power sources among the solar panel, grid and energy storage system, as appropriate, and diagnostics. During the life of the contract we have the opportunity to integrate related and evolving home servicing and monitoring technologies to upgrade the flexibility and reduce the cost of our customers' energy supply. In the case of leases and PPAs, we also currently receive tax benefits and other incentives from federal, state and local governments, a portion of which we finance through tax equity, non-recourse debt structures and hedging arrangements in order to fund our upfront costs, overhead and growth investments. We have an established track record of attracting capital from diverse sources. From our inception through December 31, 2019, we have raised more than $4.7 billion in total capital commitments from equity, debt and tax equity investors. In addition to providing ongoing service as a standard component of our solar service agreements, we also offer ongoing energy services to customers who purchased their solar energy system through unaffiliated third parties. Under these arrangements, we agree to provide such monitoring, maintenance and repair services to these customers for the life of the service contract they sign with us. We believe the quality and scope of our comprehensive energy service offerings, whether to customers that obtained their solar energy system through us or through another party, is a key differentiator between us and our competitors. We commenced operations in January 2013 and began providing solar energy services under our first solar energy system in April 2013. Since then, we have experienced rapid growth in our market share and in the number of customers on our platform. We operate one of the largest fleets of residential solar energy systems in the U.S., comprising more than 572 megawatts of generation capacity and serving more than 80,000 customers. Recent Developments In December 2019, we issued and sold an aggregate principal amount of $55.0 million of our 7.75% convertible senior notes (the "convertible senior notes") in a private placement to a total of seven institutional accredited investors at an issue price of 95%, for an aggregate purchase price of $52.3 million. See "-Liquidity and Capital Resources-Financing Arrangements-Convertible Notes" below. In December 2019, one of our subsidiaries entered into a credit facility with Credit Suisse AG, New York Branch, as administrative agent, and the lenders party thereto. Under the credit facility, the subsidiary may borrow up to an aggregate principal amount of $95.2 million in revolving loans subject to compliance with a borrowing base. The aggregate commitments may be increased up to $137.6 million, subject to lender consent and certain other conditions. See "-Liquidity and Capital Resources-Financing Arrangements-TEPINV Financing" below. In February 2020, one of our subsidiaries issued $337.1 million in aggregate principal amount of Series 2020-1 Class A solar asset-backed notes and $75.4 million in aggregate principal amount of Series 2020-1 Class B solar asset-backed notes with a maturity date of January 2055. The notes bear interest at an annual rate of 3.35% and 5.54% for the Class A and Class B notes, respectively. See "-Liquidity and Capital Resources-Financing Arrangements-Rule 144A Securitization Financing" below and Note 18, Subsequent Events, to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. Initial Public Offering and Recapitalization Transactions On July 29, 2019, we completed our IPO in which we sold 14,000,000 shares of our common stock at a public offering price of $12.00 per share. On August 19, 2019, we issued and sold an additional 865,267 shares of our common stock at a public offering price of $12.00 per share pursuant to the underwriters' exercise of their option to purchase additional shares. We received aggregate net proceeds from our IPO of approximately $162.3 million, after deducting underwriting discounts and commissions of approximately $10.7 million and offering expenses of approximately $5.4 million. In connection with our IPO, we completed a series of recapitalization transactions as follows: • we decreased the total number of outstanding shares with a 1 for 2.333 reverse stock split effective July 29, 2019 (the "Reverse Stock Split"). All current and past period amounts stated herein have given effect to the Reverse Stock Split; • we converted 108,138,971 shares (or 46,351,877 shares as adjusted for the Reverse Stock Split) of our Series A convertible preferred stock and 32,958,645 shares (or 14,127,140 shares as adjusted for the Reverse Stock Split) of our Series C convertible preferred stock, which represented all the outstanding shares of our Series A convertible preferred stock and Series C convertible preferred stock, into 60,479,017 shares of our common stock; • we converted 23,870 shares of our non-voting Series B common stock, which represented all the outstanding shares of our Series B common stock, into 23,870 shares of our voting Series A common stock. • our Series A common stock was redesignated as common stock; • we exercised our right to redeem all the senior secured notes for an aggregate principal plus unpaid cash and paid-in-kind interest amount of $57.1 million for cash; • holders of the convertible note issued in March 2018 for $15.0 million (the "2018 Note") converted the principal amount plus any accrued and unpaid interest as of the date of conversion into 3,319,312 shares (or 1,422,767 shares as adjusted for the Reverse Stock Split) of Series A convertible preferred stock, which in turn converted into 1,422,767 shares of common stock. In addition, holders of the convertible note issued in June 2019 for $15.0 million (the "2019 Note") converted the principal amount plus any accrued and unpaid interest as of the date of conversion into 2,613,818 shares (or 1,120,360 shares as adjusted for the Reverse Stock Split) of Series C convertible preferred stock, which in turn converted into 1,120,360 shares of common stock; • we implemented an internal reorganization that resulted in SEI owning all the outstanding capital stock of Sunnova Energy Corporation (the "Reorganization"). In connection with the Reorganization, a direct, wholly-owned subsidiary of SEI merged with and into Sunnova Energy Corporation, with Sunnova Energy Corporation surviving as a direct, wholly owned subsidiary of SEI. Each share of each class of Sunnova Energy Corporation stock issued and outstanding immediately prior to the Reorganization, by virtue of the Reorganization and without any action on the part of the holders thereof, automatically converted into an equivalent corresponding share of stock of SEI, having the same designations, rights, powers and preferences and the qualifications, limitations and restrictions with respect to SEI as each such corresponding share of Sunnova Energy Corporation stock being converted with respect to Sunnova Energy Corporation. Accordingly, upon consummation of the Reorganization, each of Sunnova Energy Corporation's stockholders immediately prior to the consummation of the Reorganization became a stockholder of SEI; • approximately 50% of the non-vested stock options outstanding at that time, or 995,517 stock options, became exercisable and the vesting terms for all remaining stock options were amended so all stock options will be fully vested on the first anniversary of the closing date of our IPO. We recorded an additional $3.2 million of expense in July 2019 related to the accelerated vesting periods; and • our Board adopted the 2019 Long-Term Incentive Plan (the "LTIP") to incentivize employees, officers, directors and other service providers of SEI and its affiliates. The LTIP provides for the grant, from time to time, at the discretion of our Board or a committee thereof, of stock options, stock appreciation rights, stock awards, including restricted stock and restricted stock units, performance awards and cash awards. The LTIP provides the aggregate number of shares of common stock that may be issued pursuant to awards shall not exceed 5,229,318 shares. The awards vest over a period of either one year, three years or seven years. Securitizations As a source of long-term financing, we securitize qualifying solar energy systems and related solar service agreements into special purpose entities who issue solar asset-backed and solar loan-backed notes to institutional investors. We also securitize the cash flows generated by the membership interests in certain of our indirect, wholly-owned subsidiaries that are the managing member of a tax equity fund that owns a pool of solar energy systems and related solar service agreements that were originated by one of our wholly-owned subsidiaries. We do not securitize the Section 48(a) ITC incentives associated with the solar energy systems as part of these arrangements. We use the cash flows these solar energy systems generate to service the quarterly or semi-annual principal and interest payments on the notes and satisfy the expenses and reserve requirements of the special purpose entities, with any remaining cash distributed to their sole members, who are typically our indirect wholly-owned subsidiaries. In connection with these securitizations, certain of our affiliates receive a fee for managing and servicing the solar energy systems pursuant to management, servicing, facility administration and asset management agreements. The special purpose entities are also typically required to maintain a liquidity reserve account and a reserve account for inverter replacements and, in certain cases, reserve accounts for financing fund purchase option/withdrawal right exercises or storage system replacement for the benefit of the lenders under the applicable series of notes, each of which are funded from initial deposits or cash flows to the levels specified therein. The creditors of these special purpose entities have no recourse to our other assets except as expressly set forth in the terms of the notes. From our inception through December 31, 2019, we have issued $824.6 million in solar asset-backed and solar loan-backed notes. Tax Equity Funds Our ability to offer long-term solar service agreements depends in part on our ability to finance the installation of the solar energy systems by co-investing with tax equity investors such as large banks who value the resulting customer receivables and Section 48(a) ITCs, accelerated tax depreciation and other incentives related to the solar energy systems primarily through structured investments known as "tax equity". Tax equity investments are generally structured as non-recourse project financings known as "tax equity funds". In the context of distributed generation solar energy, tax equity investors make contributions upfront or in stages based on milestones in exchange for a share of the tax attributes and cash flows emanating from an underlying portfolio of solar energy systems. In these tax equity funds, the U.S. federal tax attributes offset taxes that otherwise would have been payable on the investors' other operations. The terms and conditions of each tax equity fund vary significantly by investor and by fund. We continue to negotiate with potential investors to create additional tax equity funds. In general, our tax equity funds are structured using the "partnership flip" structure. Under partnership flip structures, we and our tax equity investors contribute cash into a partnership. The partnership uses this cash to acquire long-term solar service agreements and solar energy systems developed by us and sells energy from such solar energy systems to customers or directly leases the solar energy systems to customers. We assign these solar service agreements, solar energy systems and related incentives to our tax equity funds in accordance with the criteria of the specific funds. Upon such assignment and the satisfaction of certain conditions precedent, we are able to draw down on the tax equity fund commitments. The conditions precedent to funding vary across our tax equity funds but generally require that we have entered into a solar service agreement with the customer, the customer meets certain credit criteria, the solar energy system is expected to be eligible for the Section 48(a) ITC, we have a recent appraisal from an independent appraiser establishing the fair market value of the solar energy system and the property is in an approved state or territory. All the capital contributed by our tax equity investors into the tax equity funds is, depending on the tax equity fund structure, either paid to us to acquire solar energy systems or distributed to us following our contribution of solar energy systems to the tax equity fund. Some tax equity investors have additional criteria that are specific to those tax equity funds. Once received by us, these proceeds are generally used for working capital or capital expenditures to develop and deliver solar energy systems. Each tax equity investor agrees to receive a minimum target rate of return, typically on an after-tax basis, which varies by tax equity fund. Prior to receiving a contractual rate of return or a date specified in the contractual arrangements, the tax equity investor receives substantially all of the non-cash value attributable to the solar energy systems, which includes accelerated depreciation and Section 48(a) ITCs, and a significant portion of the value attributable to customer payments; however, we receive a majority of the cash distributions, which are typically paid quarterly. After the tax equity investor receives its contractual rate of return or after the specified date, we receive substantially all of the cash. Under the partnership flip structure, in part owing to the allocation of depreciation benefits to the investor, the investor's pre-tax return is much lower than the investor's after-tax return. We have determined we are the primary beneficiary in these partnership flip structures for accounting purposes. Accordingly, we consolidate the assets and liabilities and operating results of these partnerships in our consolidated financial statements. We recognize the tax equity investors' share of the net assets of the tax equity funds as redeemable noncontrolling interests in our consolidated balance sheets. These income or loss allocations, reflected in our consolidated statements of operations, may create significant volatility in our reported results of operations, including potentially changing net loss attributable to stockholders to net income attributable to stockholders, or vice versa, from quarter to quarter. We typically have an option to acquire, and our tax equity investors may have an option to withdraw and require us to purchase, all the equity interests our tax equity investor holds in the tax equity funds approximately six years after the last solar energy system in each tax equity fund is operational. If we or our tax equity investors exercise this option, we are typically required to pay at least the fair market value of the tax equity investor's equity interest. Following such exercise, we would receive 100% of the customer payments for the remainder of the term of the solar service agreements. From our inception through December 31, 2019, we have received commitments of $374.5 million through the use of tax equity funds, of which an aggregate of $308.4 million has been funded. Key Financial and Operational Metrics We regularly review a number of metrics, including the following key operational and financial metrics, to evaluate our business, measure our performance and liquidity, identify trends affecting our business, formulate our financial projections and make strategic decisions. Number of Customers. We define number of customers to include each customer that is party to an in-service solar service agreement. For our leases, PPAs and loan agreements, in-service means the related solar energy system and, if applicable, energy storage system, must have met all the requirements to begin operation and be interconnected to the electrical grid. For our Sunnova Protect services, in-service means the customer's solar energy system must have met the requirements to have the service activated. We do not include in our number of customers any customer under a lease, PPA or loan agreement that has reached mechanical completion but has not received permission to operate from the local utility or for whom we have terminated the contract and removed the solar energy system. We also do not include in our number of customers any customer of our Sunnova Protect services that has been in default under his or her solar service agreement in excess of six months. We track the total number of customers as an indicator of our historical growth and our rate of growth from period to period. Weighted Average Number of Customers. We calculate the weighted average number of customers based on the number of months a given customer is in-service during a given measurement period. The weighted average customer count reflects the number of customers at the beginning of a period, plus the total number of new customers added in the period adjusted by a factor that accounts for the partial period nature of those new customers. For purposes of this calculation, we assume all new customers added during a month were added in the middle of that month. We track the weighted average customer count in order to accurately reflect the contribution of the appropriate number of customers to key financial metrics over the measurement period. Adjusted EBITDA. We define Adjusted EBITDA as net income (loss) plus net interest expense, depreciation and amortization expense, income tax expense, financing deal costs, natural disaster losses and related charges, net, amortization of payments to dealers for exclusivity and other bonus arrangements, legal settlements and excluding the effect of certain non-recurring items we do not consider to be indicative of our ongoing operating performance such as, but not limited to, costs of our IPO, losses on unenforceable contracts, losses on extinguishment of long-term debt, realized and unrealized gains and losses on fair value option instruments and other non-cash items such as non-cash compensation expense and asset retirement obligation ("ARO") accretion expense. Adjusted EBITDA is a non-GAAP financial measure we use as a performance measure. We believe investors and securities analysts also use Adjusted EBITDA in evaluating our operating performance. This measurement is not recognized in accordance with accounting principles generally accepted in the United States of America ("GAAP") and should not be viewed as an alternative to GAAP measures of performance. The GAAP measure most directly comparable to Adjusted EBITDA is net income (loss). The presentation of Adjusted EBITDA should not be construed to suggest our future results will be unaffected by non-cash or non-recurring items. In addition, our calculation of Adjusted EBITDA is not necessarily comparable to Adjusted EBITDA as calculated by other companies. We believe Adjusted EBITDA is useful to management, investors and analysts in providing a measure of core financial performance adjusted to allow for comparisons of results of operations across reporting periods on a consistent basis. These adjustments are intended to exclude items that are not indicative of the ongoing operating performance of the business. Adjusted EBITDA is also used by our management for internal planning purposes, including our consolidated operating budget, and by our Board in setting performance-based compensation targets. Adjusted EBITDA should not be considered an alternative to but viewed in conjunction with GAAP results, as we believe it provides a more complete understanding of ongoing business performance and trends than GAAP measures alone. Adjusted EBITDA has limitations as an analytical tool, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. We use per customer metrics, including Adjusted Operating Expense per weighted average customer (as described below), as an additional way to evaluate our performance. Specifically, we consider the change in these metrics from period to period as a way to evaluate our performance in the context of changes we experience in the overall customer base. While the Adjusted Operating Expense figure provides a valuable indicator of our overall performance, evaluating this metric on a per unit basis allows for further nuanced understanding by management, investors and analysts of the financial impact of each additional customer. (1) Amount includes non-cash effect of equity-based compensation plans of $9.2 million, $3.0 million and $1.5 million for the years ended December 31, 2019, 2018 and 2017, respectively, and partial forgiveness of a loan to an executive officer used to purchase our capital stock of $1.3 million and $0.4 million for the years ended December 31, 2019 and 2018, respectively. Interest Income and Principal Payments from Customer Notes Receivable. Under our loan agreements, the customer obtains financing for the purchase of a solar energy system from us and we agree to operate and maintain the solar energy system throughout the duration of the agreement. Pursuant to the terms of the loan agreement, the customer makes scheduled principal and interest payments to us and has the option to prepay principal at any time in part or in full. Whereas we typically recognize payments from customers under our leases and PPAs as revenue, we recognize payments received from customers under our loan agreements (a) as interest income, to the extent attributable to earned interest on the contract that financed the customer's purchase of the solar energy system; (b) as a reduction of a note receivable on the balance sheet, to the extent attributable to a return of principal (whether scheduled or prepaid) on the contract that financed the customer's purchase of the solar energy system; and (c) as revenue, to the extent attributable to payments for operations and maintenance services provided by us. While Adjusted EBITDA effectively captures the operating performance of our leases and PPAs, it only reflects the service portion of the operating performance under our loan agreements. We do not consider our types of solar service agreements differently when evaluating our operating performance. In order to present a measure of operating performance that provides comparability without regard to the different accounting treatment among our three types of solar service agreements, we consider interest income from customer notes receivable and principal proceeds from customer notes receivable, net of related revenue, as key performance metrics. We believe these two metrics provide a more meaningful and uniform method of analyzing our operating performance when viewed in light of our other key performance metrics across the three primary types of solar service agreements. Adjusted Operating Cash Flow. We define Adjusted Operating Cash Flow as net cash used in operating activities plus principal proceeds from customer notes receivable and distributions to redeemable noncontrolling interests less payments to dealers for exclusivity and other bonus arrangements, inventory and prepaid inventory purchases and payments of non-capitalized costs related to our IPO. Adjusted Operating Cash Flow is a non-GAAP financial measure we use as a liquidity measure. This measurement is not recognized in accordance with GAAP and should not be viewed as an alternative to GAAP measures of liquidity. The GAAP measure most directly comparable to Adjusted Operating Cash Flow is net cash used in operating activities. We believe Adjusted Operating Cash Flow is a supplemental financial measure useful to management, analysts, investors, lenders and rating agencies as an indicator of our ability to internally fund origination activities, service or incur additional debt and service our contractual obligations. We believe investors and analysts will use Adjusted Operating Cash Flow to evaluate our liquidity and ability to service our contractual obligations. However, Adjusted Operating Cash Flow has limitations as an analytical tool because it does not account for all future expenditures and financial obligations of the business or reflect unforeseen circumstances that may impact our future cash flows, all of which could have a material effect on our financial condition and results from operations. In addition, our calculations of Adjusted Operating Cash Flow are not necessarily comparable to liquidity measures presented by other companies. Investors should not rely on these measures as a substitute for any GAAP measure, including net cash used in operating activities. Adjusted Operating Expense. We define Adjusted Operating Expense as total operating expense less depreciation and amortization expense, financing deal costs, natural disaster losses and related charges, net, amortization of payments to dealers for exclusivity and other bonus arrangements, legal settlements and excluding the effect of certain non-recurring items we do not consider to be indicative of our ongoing operating performance such as, but not limited to, costs of our IPO, losses on unenforceable contracts and other non-cash items such as non-cash compensation expense and ARO accretion expense. Adjusted Operating Expense is a non-GAAP financial measure we use as a performance measure. We believe investors and securities analysts will also use Adjusted Operating Expense in evaluating our performance. This measurement is not recognized in accordance with GAAP and should not be viewed as an alternative to GAAP measures of performance. The GAAP measure most directly comparable to Adjusted Operating Expense is total operating expense. We believe Adjusted Operating Expense is a supplemental financial measure useful to management, analysts, investors, lenders and rating agencies as an indicator of the efficiency of our operations between reporting periods. Adjusted Operating Expense should not be considered an alternative to but viewed in conjunction with GAAP total operating expense, as we believe it provides a more complete understanding of our performance than GAAP measures alone. Adjusted Operating Expense has limitations as an analytical tool and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP, including total operating expense. We use Adjusted Operating Expense per weighted average customer as an additional way to evaluate our performance. Specifically, we consider the change in this metric from period to period as a way to evaluate our performance in the context of changes we experience in the overall customer base. While the Adjusted Operating Expense figure provides a valuable indicator of our overall performance, evaluating this metric on a per customer basis provides a more contextualized understanding of our performance to us, investors and analysts of the financial impact of each additional customer. Estimated Gross Contracted Customer Value. We calculate estimated gross contracted customer value as defined below. We believe estimated gross contracted customer value can serve as a useful tool for investors and analysts in comparing the remaining value of our customer contracts to that of our peers. Estimated gross contracted customer value as of a specific measurement date represents the sum of the present value of the remaining estimated future net cash flows we expect to receive from existing customers during the initial contract term of our leases and PPAs, which are typically 25 years in length, plus the present value of future net cash flows we expect to receive from the sale of related SRECs, either under existing contracts or in future sales, plus the carrying value of outstanding customer loans on our balance sheet. From these aggregate estimated initial cash flows, we subtract the present value of estimated net cash distributions to redeemable noncontrolling interests and estimated operating, maintenance and administrative expenses associated with the solar service agreements. These estimated future cash flows reflect the projected monthly customer payments over the life of our solar service agreements and depend on various factors including but not limited to solar service agreement type, contracted rates, expected sun hours and the projected production capacity of the solar equipment installed. For the purpose of calculating this metric, we discount all future cash flows at 6%. The anticipated operating, maintenance and administrative expenses included in the calculation of estimated gross contracted customer value include, among other things, expenses related to accounting, reporting, audit, insurance, maintenance and repairs. In the aggregate, we estimate these expenses are $20 per kilowatt per year initially, with 2% annual increases for inflation. We do not include maintenance and repair costs for inverters and similar equipment as those are largely covered by the applicable product and dealer warranties for the life of the product, but we do include additional cost for energy storage systems, which are only covered by a 10-year warranty. Expected distributions to tax equity investors vary among the different tax equity funds and are based on individual tax equity fund contract provisions. Estimated gross contracted customer value is forecasted as of a specific date. It is forward-looking and we use judgment in developing the assumptions used to calculate it. Factors that could impact estimated gross contracted customer value include, but are not limited to, customer payment defaults, or declines in utility rates or early termination of a contract in certain circumstances, including prior to installation. The following table presents the calculation of estimated gross contracted customer value as of December 31, 2019 and 2018, calculated using a 6% discount rate. Sensitivity Analysis. The calculation of estimated gross contracted customer value and associated operational metrics requires us to make a number of assumptions regarding future revenues and costs which may not prove accurate. Accordingly, we present below a sensitivity analysis with a range of assumptions. We consider a discount rate of 6% to be appropriate based on industry practice and recent transactions that demonstrate a portfolio of residential solar service agreements is an asset class that can be securitized successfully on a long-term basis, with a coupon of less than 6%. The appropriate discount rate for these estimates may change in the future due to the level of inflation, rising interest rates, our cost of capital and consumer demand for solar energy systems. In addition, the table below provides a range of estimated gross contracted customer value amounts if different cumulative customer loss rate assumptions were used. We are presenting this information for illustrative purposes only and as a comparison to information published by our peers. Significant Factors and Trends Affecting Our Business Our results of operations and our ability to grow our business over time could be impacted by a number of factors and trends that affect our industry generally, as well as new offerings of services and products we may acquire or seek to acquire in the future. Additionally, our business is concentrated in certain markets, putting us at risk of region-specific disruptions such as adverse economic, regulatory, political, weather and other conditions. See "Item 1A. Risk Factors" for further discussion of risks affecting our business. Financing Availability. Our future growth depends, in significant part, on our ability to raise capital from third-party investors on competitive terms to help finance the origination of our solar energy systems under our solar service agreements. We have historically used debt, such as asset-backed and loan-backed securitizations and warehouse facilities, tax equity, preferred equity and other financing strategies to help fund our operations. From our inception through December 31, 2019, we have raised more than $4.7 billion in total capital commitments from equity, debt and tax equity investors. With respect to tax equity, there are a limited number of potential tax equity investors and the competition for this investment capital is intense. The principal tax credit on which tax equity investors in our industry rely is the Section 48(a) ITC. The amount for the Section 48(a) ITC is equal to 30% of the basis of eligible solar property that began construction before 2020. By statute, the Section 48(a) ITC percentage decreases to 26% for eligible solar property that begins construction during 2020, 22% for 2021 and 10% if construction begins after 2021 or if the property is placed into service after 2023. This reduction in the Section 48(a) ITC will likely reduce our use of tax equity financing in the future unless the Section 48(a) ITC is increased or replaced. IRS guidance includes a 5% ITC Safe Harbor that may apply when a taxpayer (or in certain cases, a contractor) pays or incurs 5% or more of the costs of a solar energy system before the end of the applicable year, even though the solar energy system is not placed in service until after the end of that year. For 2020, we have purchased substantially all the inverters that will be deployed under our lease and PPA agreements that we expect will allow the related solar energy systems to qualify for the 30% Section 48(a) ITC by satisfying the 5% ITC Safe Harbor. We may make further inventory purchases in future periods to extend the availability of each period's Section 48(a) ITC. Our ability to raise capital from third-party investors is affected by general economic conditions, the state of the capital markets, inflation levels and concerns about our industry or business. Cost of Solar Energy Systems. Although the solar panel market has seen an increase in supply, upward pressure on prices may occur due to growth in the solar industry, regulatory policy changes, tariffs and duties and an increase in demand. As a result of these developments, we may pay higher prices on imported solar modules, which may make it less economical for us to serve certain markets. Attachment rates for energy storage systems have trended higher while the price to acquire has trended downward making the addition of energy storage systems a potential area of growth for us. Energy Storage Systems. Our energy storage systems increase our customers' independence from the centralized utility and provide on-site backup power when there is a grid outage due to storms, wildfires, other natural disasters and general power failures caused by supply or transmission issues. In addition, at times it can be more economic to consume less energy from the grid or, alternatively, to export solar energy back to the grid. Recent technological advancements for energy storage systems allow the energy storage system to adapt to pricing and utility rate shifts by controlling the inflows and outflows of power, allowing customers to increase the value of their solar energy system plus energy storage system. The energy storage system charges during the day, making the energy it stores available to the home when needed. It also features software that can customize power usage for the individual customer, providing backup power, optimizing solar energy consumption versus grid consumption or preventing export to the grid as appropriate. The software is tailored based on utility regulation, economic indicators and grid conditions. The combination of energy control, increased energy resilience and independence from the grid is strong incentive for customers to adopt solar and energy storage. As energy storage systems and their related software features become more advanced, we expect to see increased adoption of energy storage systems. Government Regulations, Policies and Incentives. Our growth strategy depends in significant part on government policies and incentives that promote and support solar energy and enhance the economic viability of distributed residential solar. These incentives come in various forms, including net metering, eligibility for accelerated depreciation such as MACRS, SRECs, tax abatements, rebates, renewable targets, incentive programs and tax credits, particularly the Section 48(a) ITC and the Section 25D Credit. Policies requiring solar on new homes or new roofs, such as those enacted in California and New York City, also support the growth of distributed solar. The sale of SRECs has constituted a significant portion of our revenue historically. A change in the value of SRECs or changes in other policies or a loss or reduction in such incentives could decrease the attractiveness of distributed residential solar to us, our dealers and our customers in applicable markets, which could reduce our customer acquisition opportunities. Such a loss or reduction could also reduce our willingness to pursue certain customer acquisitions due to decreased revenue or income under our solar service agreements. Additionally, such a loss or reduction may also impact the terms of and availability of third-party financing. If any of these government regulations, policies or incentives are adversely amended, delayed, eliminated, reduced, retroactively changed or not extended beyond their current expiration dates or there is a negative impact from the recent federal law changes or proposals, our operating results and the demand for, and the economics of, distributed residential solar energy may decline, which could harm our business. Components of Results of Operations Revenue. We recognize revenue from contracts with customers as we satisfy our performance obligations at a transaction price reflecting an amount of consideration based upon an estimated rate of return. We express this rate of return as the solar rate per kWh in the customer contract. The amount of revenue we recognize does not equal customer cash payments because we satisfy performance obligations ahead of cash receipt or evenly as we provide continuous access on a stand-ready basis to the solar energy system. We reflect the differences between revenue recognition and cash payments received in accounts receivable, other assets or deferred revenue, as appropriate. PPAs. We have determined solar service agreements under which customers purchase electricity from us should be accounted for as revenue from contracts with customers. We recognize revenue based upon the amount of electricity delivered as determined by remote monitoring equipment at solar rates specified under the contracts. The PPAs generally have a term of 25 years with an opportunity for customers to renew for up to an additional 10 years, via two five-year renewal options. Lease Agreements. We are the lessor under lease agreements for solar energy systems and energy storage systems, which we account for as revenue from contracts with customers. We recognize revenue on a straight-line basis over the contract term as we satisfy our obligation to provide continuous access to the solar energy system. The lease agreements generally have a term of 25 years with an opportunity for customers to renew for up to an additional 10 years, via two five-year renewal options. We provide customers under our lease agreements a performance guarantee that each solar energy system will achieve a certain specified minimum solar energy production output. The specified minimum solar energy production output may not be achieved due to natural fluctuations in the weather or equipment failures from exposure and wear and tear outside of our control, among other factors. We determine the amount of guaranteed output based on a number of different factors, including (a) the specific site information relating to the tilt of the panels, azimuth (a horizontal angle measured clockwise in degrees from a reference direction) of the panels, size of the solar energy system and shading on site; (b) the calculated amount of available irradiance (amount of energy for a given flat surface facing a specific direction) based on historical average weather data and (c) the calculated amount of energy output of the solar energy system. If the solar energy system does not produce the guaranteed production amount, we are required to provide a bill credit or refund a portion of the previously remitted customer payments, where the bill credit or repayment is calculated as the product of (a) the shortfall production amount and (b) the dollar amount (guaranteed rate) per kWh that is fixed throughout the term of the contract. These bill credits or remittances of a customer's payments, if needed, are payable in January following the end of the first three years of the solar energy system's placed in service date and then every annual period thereafter. See Note 17, Commitments and Contingencies, to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. Loan Agreements. We recognize payments received from customers under loan agreements (a) as interest income, to the extent attributable to earned interest on the contract that financed the customer's purchase of the solar energy system; (b) as a reduction of a note receivable on the balance sheet, to the extent attributable to a return of principal (whether scheduled or prepaid) on the contract that financed the customer's purchase of the solar energy system; and (c) as revenue, to the extent attributable to payments for operations and maintenance services provided by us. Similar to our lease agreements, we provide customers under our loan agreements a performance guarantee that each solar energy system will achieve a certain specified minimum solar energy production output, which is a significant proportion of its expected output. Solar Renewable Energy Certificates. Each SREC represents one megawatt hour (1,000 kWh) generated by a solar energy system. We measure and issue SRECs to the owner of the solar energy system based on meter readings of actual production. We sell SRECs to utilities and other third parties who use the SRECs to meet renewable portfolio standards and can do so with or without the actual electricity associated with the renewable-based generation source. We account for SRECs generated from solar energy systems owned by us, as opposed to those owned by our customers, as governmental incentives with no costs incurred to obtain them and do not consider those SRECs output of the underlying solar energy systems. We classify SRECs as inventory held until sold and delivered to third parties. We enter into economic hedges with major financial institutions related to expected production of SRECs through forward contracts to partially mitigate the risk of decreases in SREC market rates. The contracts require us to physically deliver the SRECs upon settlement. We recognize the related revenue upon the transfer of the SRECs to the counterparty. The costs related to the sales of SRECs are limited to fees for brokered transactions. Accordingly, the sale of SRECs in a period favorably impacts our operating results for that period. Other Revenue. Other revenue includes certain state incentives, revenue from the direct sale of energy storage systems to customers and sales of service plans. We recognize revenue from state incentives in the periods in which they are incurred. We recognize revenue from the direct sale of energy storage systems in the period in which the storage components are placed in service. Service plans are available to customers whose solar energy system was not originally sold by Sunnova. We recognize revenue from service plan contracts over the life of the contract, which is typically five years. Cost of Revenue-Depreciation. Cost of revenue-depreciation represents depreciation on solar energy systems under lease agreements and PPAs that have been placed in service. Cost of Revenue-Other. Cost of revenue-other represents other items deemed to be a cost of providing the service of selling power to customers or potential customers, such as certain costs to service loan agreements, and costs for filing under the Uniform Commercial Code to maintain title, title searches, credit checks on potential customers at the time of initial contract and other similar costs, typically directly related to the volume of customers and potential customers. Operations and Maintenance Expense. Operations and maintenance expense represents costs paid to third parties for maintaining and servicing the solar energy systems, property insurance and property taxes. In addition, operations and maintenance expense includes impairments due to natural disaster losses, losses on disposals and other impairments net of insurance proceeds recovered under our business interruption and property damage insurance coverage for natural disasters, such as Hurricane Maria, which occurred in Puerto Rico in September 2017 and for which we incurred charges through the fourth quarter of 2018. General and Administrative Expense. General and administrative expense represents costs for our employees, such as salaries, bonuses, benefits and all other employee-related costs, including stock-based compensation, professional fees related to legal, accounting, human resources, finance and training, information technology and software services, marketing and communications, travel and rent and other office-related expenses. General and administrative expense also includes depreciation on assets not classified as solar energy systems, including vehicles, furniture, fixtures, computer equipment and leasehold improvements and accretion expense on AROs. We capitalize a portion of general and administrative expense, such as payroll-related costs, that is related to employees who are directly involved in the design, construction, installation and testing of the solar energy systems but not directly associated with a particular asset. We also capitalize a portion of general and administrative expense, such as payroll-related costs, that is related to employees who are directly associated with and devote time to internal information technology software projects, to the extent of the time spent directly on the application and development stage of such software project. Interest Expense, Net. Interest expense, net represents interest, net of capitalized interest, on our borrowings under our various debt facilities and amortization of debt discounts and deferred financing costs. Interest Expense, Net-Affiliates. Interest expense, net-affiliates represents interest expense on our debt facilities, including the amortization of the debt discounts, held by our affiliates. Interest Income. Interest income represents interest income from the notes receivable under our loan program and income on short term investments with financial institutions. Loss on Extinguishment of Long-Term Debt, Net-Affiliates. Loss on extinguishment of long-term debt, net-affiliates resulted from the GAAP treatment of the amendment to the senior secured notes in April 2019 and represents the difference between the net carrying value of the senior secured notes prior to the amendment and the fair value of the notes after the amendment as discussed in Note 8, Long-Term Debt, to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. Other (Income) Expense. Other (income) expense primarily represents changes in the fair value of certain financial instruments, including the senior secured notes that were redeemed in July 2019. Income Tax. We account for income taxes under Accounting Standards Codification 740, Income Taxes. As such, we determine deferred tax assets and liabilities based on temporary differences resulting from the different treatment of items for tax and financial reporting purposes. We measure deferred tax assets and liabilities using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to reverse. Additionally, we must assess the likelihood that deferred tax assets will be recovered as deductions from future taxable income. We have a full valuation allowance on our deferred tax assets because we believe it is more likely than not that our deferred tax assets will not be realized. We evaluate the recoverability of our deferred tax assets on a quarterly basis. Currently, there is no provision or benefit for income taxes as we have incurred losses to date. Net Income Attributable to Redeemable Noncontrolling Interests. Net income attributable to redeemable noncontrolling interests represents third-party interests in the net assets of certain consolidated subsidiaries. Results of Operations-Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 The following table sets forth our consolidated statements of operations data for the periods indicated. Revenue Revenue increased by $27.2 million in the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily as a result of an increased number of solar energy systems in service. The weighted average number of customers (excluding customers with loan agreements) increased from approximately 49,200 for the year ended December 31, 2018 to approximately 60,100 for the year ended December 31, 2019. Excluding SREC revenue and revenue under our loan agreements, on a weighted average number of customers basis, revenue increased from $1,480 per customer for the year ended December 31, 2018 to $1,522 per customer for the same period in 2019 (3% increase). The year over year difference in revenue per customer was affected by (a) the market mix of portfolio and relative yields in those markets, (b) weather variability and (c) the impact of Hurricane Maria on Puerto Rico revenues (for which billing was largely curtailed for approximately two months beginning in September 2017 and then gradually increased over time until billing was materially resumed by August 2018). SREC revenue increased by $7.8 million in the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily as a result of an increase in the number of solar energy systems in service, which resulted in additional SREC production, and $3.0 million related to certain forward sales of SRECs. The fluctuations in SREC revenue from period to period are affected by the total number of solar energy systems, weather seasonality and hedge and spot prices associated with the timing of the sale of SRECs. On a weighted average number of customers basis, revenues under our loan agreements decreased from $222 per customer for the year ended December 31, 2018 to $196 per customer for the same period in 2019 (12% decrease) primarily due to market changes. Cost of Revenue-Depreciation Cost of revenue-depreciation increased by $8.8 million in the year ended December 31, 2019 compared to the year ended December 31, 2018. This increase was primarily driven by an increase in the weighted average number of customers (excluding customers with loan agreements) from approximately 49,200 for the year ended December 31, 2018 to approximately 60,100 for the year ended December 31, 2019. On a weighted average number of customers basis, cost of revenue-depreciation remained relatively flat at $705 per customer for the year ended December 31, 2018 compared to $724 per customer for the same period in 2019. Cost of Revenue-Other Cost of revenue-other increased by $1.9 million in the year ended December 31, 2019 compared to the year ended December 31, 2018. This increase was primarily driven by increases in costs related to energy storage systems of $1.2 million as a result of the introduction of energy storage systems as a new product offering in late 2018. Operations and Maintenance Expense Operations and maintenance expense decreased by $5.4 million for the year ended December 31, 2019 compared to the year ended December 31, 2018. The decrease was primarily due to a decrease in impairments and other related charges due to natural disaster losses of $4.7 million related primarily to Hurricane Maria, which occurred in September 2017 and for which $2.7 million of business interruptions proceeds were received in October 2018. A significant portion of Hurricane Maria charges occurred during the fourth quarter of 2018 as the completion of the repairs for solar energy systems damaged by the hurricane and the completion of the analysis regarding whether a solar energy system damaged by the hurricane was recoverable took an extensive amount of time for many of the assets and customers. Operations and maintenance expense per customer, excluding net natural disaster losses, decreased to $142 per customer for the year ended December 31, 2019 compared to $188 per customer for the year ended December 31, 2018 as a result of operational efficiencies. General and Administrative Expense General and administrative expense increased by $30.6 million in the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to increases in payroll and employee related expenses of $14.0 million due to the hiring of personnel to support growth and additional non-cash compensation expense in connection with our IPO, consultants, contractors and professional fees of $4.0 million, insurance expenses of $3.2 million, IPO costs of $3.2 million, loss on unenforceable contracts of $2.4 million relating to certain loans originated in 2019 that did not meet certain applicable regulatory requirements, marketing and communications expenses of $1.6 million, depreciation expense not related to solar energy systems of $1.2 million, travel and related business expenses of $0.9 million and bad debt expense of $0.7 million. Interest Expense, Net Interest expense, net increased by $56.4 million in the year ended December 31, 2019 compared to the year ended December 31, 2018. This increase was primarily driven by increases in realized loss on interest rate swaps of $30.2 million, unrealized loss on interest rate swaps of $13.1 million and interest expense of $10.8 million due to an increase in the principal debt balance after entering into new financing arrangements. Interest Expense, Net-Affiliates Interest expense, net-affiliates decreased by $5.5 million in the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to a decrease in interest expense due to a decrease in the principal debt balance between the periods and due to the redemption of the senior secured notes and conversion of the convertible notes in July 2019. Interest Income Interest income increased by $6.0 million in the year ended December 31, 2019 compared to the year ended December 31, 2018. This increase was primarily driven by the increase in the weighted average number of customers with loan agreements from approximately 4,200 for the year ended December 31, 2018 to approximately 8,400 for the year ended December 31, 2019. On a weighted average number of customers basis, loan interest income decreased from $1,464 per customer for the year ended December 31, 2018 to $1,380 per customer for the year ended December 31, 2019 (6% decrease) due to the fact that interest for the first 18 months on solar energy systems placed in service starting in July 2017 are based on 70% of the total amount financed under the loan, as the other 30% is interest free prior to the due date of the 30% prepayment typically due on the 18th month; while interest on solar energy systems placed in service in prior periods was based on the entire financed amount. Loss on Extinguishment of Long-Term Debt, Net-Affiliates Loss on extinguishment of long-term debt, net-affiliates increased by $10.6 million in the year ended December 31, 2019 compared to the year ended December 31, 2018 due to the amendment of the senior secured notes in April 2019 that met the criteria for extinguishment accounting under GAAP. Income Tax We do not have income tax expense or benefit due to pre-tax losses and a full valuation allowance recorded for the years ended December 31, 2019 and 2018. See "-Components of Results of Operations-Income Tax". Net Income Attributable to Redeemable Noncontrolling Interests Net income attributable to redeemable noncontrolling interests increased by $5.1 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to an increase in income attributable to redeemable noncontrolling interests due to tax equity funds added in 2018 and 2019. Results of Operations-Year Ended December 31, 2018 Compared to Year Ended December 31, 2017 The following table sets forth our consolidated statements of operations data for the periods indicated. Revenue Revenue increased by $27.5 million in the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily as a result of an increased number of solar energy systems in service. The weighted average number of customers (excluding customers with loan agreements) increased from approximately 37,000 for the year ended December 31, 2017 to approximately 49,200 for the year ended December 31, 2018. Excluding SREC revenue and revenue under our loan agreements, on a weighted average number of customers basis, revenue increased from $1,393 per customer for the year ended December 31, 2017 to $1,480 per customer for the same period in 2018 (6% increase). The year over year difference in revenue per customer was affected by (a) the market mix of portfolio and relative yields in those markets, (b) weather variability and (c) the impact of Hurricane Maria on Puerto Rico revenues (for which billing was largely curtailed for approximately two months beginning in September 2017 and then gradually increased over time until billing was materially resumed by August 2018). SREC revenue increased by $5.8 million in the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily as a result of an increase in the number of solar energy systems in service, which resulted in additional SREC production. The fluctuations in SREC revenue from period to period are affected by the total number of solar energy systems, weather seasonality and hedge and spot prices associated with the timing of the sale of SRECs. On a weighted average number of customers basis, revenues under our loan agreements decreased from $266 per customer for the year ended December 31, 2017 to $222 per customer for the same period in 2018 (17% decrease) primarily due to market changes. Cost of Revenue-Depreciation Cost of revenue-depreciation increased by $8.8 million in the year ended December 31, 2018 compared to the year ended December 31, 2017. This increase was primarily driven by an increase in the weighted average number of customers (excluding customers with loan agreements) from approximately 37,000 for the year ended December 31, 2017 to approximately 49,200 for the year ended December 31, 2018. On a weighted average number of customers basis, cost of revenue-depreciation remained relatively flat at $700 per customer for the year ended December 31, 2017 compared to $705 per customer for the same period in 2018. Cost of Revenue-Other Cost of revenue-other increased by $0.6 million in the year ended December 31, 2018 compared to the year ended December 31, 2017. This increase was primarily driven by an increase in costs related to repairs and maintenance, production guarantees and parts and supplies as a result of the increase in the weighted average number of customers with loan agreements from approximately 1,800 for the year ended December 31, 2017 to approximately 4,200 for the year ended December 31, 2018. Operations and Maintenance Expense Operations and maintenance expense increased by $9.0 million for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase was primarily driven by an increase in the monthly average cost per customer for operations and maintenance expense, excluding net natural disaster losses, from $146 per customer for the year ended December 31, 2017 to $188 per customer for the same period in 2018 (29% increase). The increase in operations and maintenance expense was also due to an increase in the weighted average number of customers (excluding customers with loan agreements) from approximately 37,000 for the year ended December 31, 2017 to approximately 49,200 for the year ended December 31, 2018, resulting in more service orders in 2018. The operations and maintenance expense per customer increased primarily due to higher repairs and maintenance expense, impairments and loss on disposals, meter replacement costs, higher equipment costs and higher percentage of cases completed with third-party labor in 2018 (thus increasing the average cost per closed case). In addition, operations and maintenance expense includes impairments of $5.8 million and $0.8 million for the years ended December 31, 2018 and 2017, respectively, due to natural disaster losses related primarily to Hurricane Maria, which occurred in September 2017, and other natural disasters, such as California wildfires in October 2017 and November 2018 and a typhoon in Saipan in October 2018. Operations and maintenance expense is net of both the insurance proceeds related to property damage, as estimated or completed in the periods, and the insurance proceeds related to business interruption. A significant portion of Hurricane Maria charges occurred during the fourth quarter of 2018 as the completion of the repairs for solar energy systems damaged by the hurricane and the completion of the analysis regarding whether a solar energy system damaged by the hurricane was recoverable and not recoverable took an extensive amount of time for many of the assets and customers. For further discussion of operations and maintenance expense related to natural disasters, see Note 4, Natural Disaster Losses, to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. General and Administrative Expense General and administrative expense increased by $12.6 million in the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to increases in payroll and employee related expenses of $3.5 million due to the hiring of personnel to support growth, legal and settlements expense of $1.3 million due to dealer litigation and various other general legal matters, financing deal costs of $1.6 million primarily related to $1.5 million of costs written off in March 2018 for a financing facility as it did not materialize, depreciation expense not related to solar energy systems of $1.0 million, IPO costs of $0.6 million and natural disaster losses and related charges of $0.6 million due to Hurricane Maria in Puerto Rico in September 2017. Interest Expense, Net Interest expense, net decreased by $8.3 million in the year ended December 31, 2018 compared to the year ended December 31, 2017. This decrease was primarily driven by an increase in realized gain on interest rate swaps of $20.3 million primarily due to the settlement of interest rate swaps related to repayments on subsidiary debt in November 2018 and a decrease in amortization of deferred financing costs of $5.5 million due to accelerated amortization from early pay-offs and retirement of debt in April 2017. This decrease was offset by an increase in interest expense of $17.5 million due to higher levels of outstanding debt in 2018. Interest Expense, Net-Affiliates Interest expense, net-affiliates decreased by $13.6 million in the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to a decrease of $9.0 million in amortization of debt discounts as Sunnova Asset Portfolio 5 Holdings, LLC's debt was paid down in April 2017 and a decrease in interest expense of $4.8 million due to a decrease in the principal debt balance between the periods. Interest Income Interest income increased by $3.3 million in the year ended December 31, 2018 compared to the year ended December 31, 2017. This increase was primarily driven by the increase in the weighted average number of customers with loan agreements from approximately 1,800 for the year ended December 31, 2017 to approximately 4,200 for the year ended December 31, 2018. On a weighted average number of customers basis, loan interest income decreased from $1,668 per customer for the year ended December 31, 2017 to $1,464 per customer for the year ended December 31, 2018 (12% decrease) due to the fact that interest for the first 18 months on solar energy systems placed in service starting in July 2017 are based on 70% of the total amount financed under the loan, as the other 30% is interest free prior to the due date of the 30% prepayment typically due on the 18th month; while interest on solar energy systems placed in service in prior periods was based on the entire financed amount. Income Tax We do not have income tax expense or benefit due to pre-tax losses and a full valuation allowance recorded for the years ended December 31, 2018 and 2017. See "-Components of Results of Operations-Income Tax". Net Income Attributable to Redeemable Noncontrolling Interests Net income attributable to redeemable noncontrolling interests increased by $4.9 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to the addition of two tax equity funds in December 2017 and a full year of income on assets placed in service in 2017. Liquidity and Capital Resources As of December 31, 2019, we had total cash of $150.3 million, of which $83.5 million was unrestricted, and $88.3 million of available borrowing capacity under our various financing arrangements. On July 29, 2019, we completed our IPO in which we sold 14,000,000 shares of our common stock at a public offering price of $12.00 per share. On August 19, 2019, we issued and sold an additional 865,267 shares of our common stock at a public offering price of $12.00 per share pursuant to the underwriters' exercise of their option to purchase additional shares. We received aggregate net proceeds from our IPO of approximately $162.3 million, after deducting underwriting discounts and commissions of approximately $10.7 million and offering expenses of approximately $5.4 million. We used a portion of the net proceeds from our IPO to redeem our senior secured notes due March 2021, of which $56.2 million aggregate principal amount was outstanding. The aggregate redemption price for all our senior secured notes was approximately $57.1 million, which included accrued and unpaid cash interest and pay-in-kind interest to the date of redemption. We used the remaining net proceeds from our IPO for general corporate purposes, including working capital, operating expenses, capital expenditures and repayment of indebtedness. We seek to maintain diversified and cost-effective funding sources to finance and maintain our operations, fund capital expenditures, including customer acquisitions, and satisfy obligations arising from our indebtedness. Historically, our primary sources of liquidity included non-recourse and recourse debt, investor asset-backed and loan-backed securitizations and cash generated from operations. Our business model requires substantial outside financing arrangements to grow the business and facilitate the deployment of additional solar energy systems. We will seek to raise additional required capital, including from new and existing tax equity investors, additional borrowings, securitizations and other potential debt and equity financing sources. As of December 31, 2019, we were in compliance with all debt covenants under our financing arrangements. Additionally, from time-to-time we evaluate the potential acquisition of solar energy systems, energy storage systems and related businesses and joint ventures. As a part of these efforts, we may engage in discussions with potential sellers or other parties regarding the possible purchase of or investment in assets and operations that are strategic and complementary to our existing operations. In addition, we have in the past evaluated and pursued, and may in the future evaluate and pursue, the acquisition of or investment in other energy-related assets that have characteristics and opportunities similar to our existing business lines and enable us to leverage our assets, knowledge and skill sets. Such efforts may involve participation by us in processes that have been made public and involve a number of potential buyers or investors, commonly referred to as "auction" processes, as well as situations in which we believe we are the only party or one of a limited number of parties who are in negotiations with the potential seller or other party. These acquisition and investment efforts may involve assets which, if acquired or constructed, could have a material effect on our financial condition and results of operations. We expect our solar energy systems in service to generate a positive return rate over the customer agreement, typically 25 years. Typically, once residential solar energy systems commence operations, they do not require significant additional capital expenditures to maintain operating performance. However, in order to grow, we are currently dependent on financing from outside parties. We believe we will have sufficient cash, investment fund commitments and securitization commitments described below and cash flows from operations to meet our working capital, debt service obligations, contingencies and anticipated required capital expenditures, including customer acquisitions, for at least the next 12 months. However, we are subject to business and operational risks that could adversely affect our ability to raise additional financing. If financing is not available to us on acceptable terms if and when needed, we may be unable to finance installation of our new customers' solar energy systems in a manner consistent with our past performance, our cost of capital could increase, or we may be required to significantly reduce the scope of our operations, any of which would have a material adverse effect on our business, financial condition, results of operations and prospects. In addition, our tax equity funds and debt instruments impose restrictions on our ability to draw on financing commitments. If we are unable to satisfy such conditions, we may incur penalties for non-performance under certain tax equity funds, experience installation delays, or be unable to make installations in accordance with our plans or at all. Any of these factors could also impact customer satisfaction, our business, operating results, prospects and financial condition. Financing Arrangements The following is a description of our various financing arrangements. For a complete description of the facilities in place as of December 31, 2019 see Note 8, Long-Term Debt, to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. Tax Equity Fund Commitments As of December 31, 2019, we had undrawn committed capital of approximately $50.7 million under our tax equity funds, which may only be used to purchase and install solar energy systems. We intend to establish new tax equity funds in the future depending on their attractiveness, including the availability and size of Section 48(a) ITCs and related safe harbors, and on the investor demand for such funding. The terms of the tax equity funds' operating agreements contain allocations of income (loss) and Section 48(a) ITCs that vary over time and adjust between the members after either the tax equity investor receives its contractual rate of return or after a specified date. For additional information regarding our tax equity fund commitments see Note 13, Redeemable Noncontrolling Interests, to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. Warehouse and Other Debt Financings We from time to time enter into warehouse credit facilities as a source of funding. Under the warehouse credit facilities, revolving or term financing is provided to special purpose entities, which are typically our wholly-owned subsidiaries, and secured by qualifying solar energy systems and related solar service agreements. The cash flows generated by these solar energy systems are used to cover required debt service payments under the related credit facility and satisfy the expenses and reserve requirements of the special purpose entities. The warehouse credit facilities allow for the pooling and transfer of eligible solar energy systems and related solar service agreements on a non-recourse basis to the subsidiary or us, subject to certain limited exceptions. In connection with these warehouse credit facilities, certain of our affiliates receive a fee for managing and servicing the solar energy systems pursuant to management and servicing agreements. The special purpose entities are also typically required to maintain reserve accounts, including a liquidity reserve account and a reserve account for equipment replacements, each of which are funded from initial deposits or cash flows to the levels specified therein. The warehouse credit facility structures include certain features designed to protect lenders. One of the common primary features relates to certain events, such as the insufficiency of cash flows in the collateral pool of assets to meet contractual requirements, the occurrence of which triggers an early repayment of the loans and limits the relevant borrower's ability to obtain additional advances or distribute funds to us. We refer to this as an "amortization event", which may be based on, among other things, a debt service coverage ratio falling or remaining below certain levels, default levels of solar assets exceeding certain thresholds or excess spread falling below certain levels over a multiple month period. In the event of an amortization event, the availability period under a revolving warehouse credit facility may terminate and the borrower may be required to repay the affected outstanding borrowings using available collections received from the asset pool. However, the period of ultimate repayment would be determined by the amount and timing of collections received. An amortization event would impair our liquidity and may require us to utilize our other available contingent liquidity or rely on alternative funding sources, which may or may not be available at the time. The debt agreements of our warehouse credit facilities also typically contain customary events of default for solar warehouse financings that entitle the lenders to take various actions, including the acceleration of amounts due under the related debt agreement and foreclosure on the borrower's assets. In April 2017, one of our subsidiaries entered into a secured revolving credit facility with Credit Suisse AG, New York Branch, as administrative agent, and the lenders party thereto. The credit facility was amended and restated in March 2019 and further amended in September 2019 and December 2019. Under the amended credit facility, the subsidiary may borrow up to $200.0 million, subject to a borrowing base calculated based on a specified advance rate applied to the net outstanding principal balance of the solar loans securing the credit facility. The proceeds of the loans under the credit facility are available for funding the purchase of solar loans, making deposits in the subsidiary's reserve accounts and paying fees in connection with the credit facility. The credit facility bears interest at an annual rate of adjusted LIBOR plus an applicable margin. The credit facility has a maturity date occurring in November 2022. As of December 31, 2019, we had $78.6 million of available borrowing capacity under the credit facility. Sunnova Energy Corporation guarantees the performance obligations of certain affiliates under agreements entered into in connection with the credit facility as well as certain indemnity and refund obligations. In April 2017, three of our subsidiaries entered into a secured term loan credit facility with Credit Suisse AG, New York Branch, as administrative agent, and the lenders party thereto. The credit facility was amended and restated in November 2018. Outstanding advances under the credit facility bear interest at LIBOR plus an applicable margin. The credit facility has a maturity date occurring in November 2022. As of December 31, 2019, we had no available borrowing capacity under the credit facility. Sunnova Energy Corporation guarantees the performance obligations of certain affiliates under agreements entered into in connection with the credit facility as well as certain indemnity obligations. In July 2014, one of our subsidiaries entered into a collateral-based financing agreement with Texas Capital Bank, N.A., as administrative agent, and the lenders party thereto. In April 2019, we contributed approximately $0.1 million to our subsidiary as an equity cure of an event of default under the credit facility caused by a failure of the subsidiary to comply with a debt covenant regarding the ratio of consolidated EBITDA to debt service for the four quarters ending on March 31, 2019. We were only permitted to exercise our equity cure right for the credit facility three times over the course of the credit facility and once in any rolling four-quarter period. Outstanding advances under the credit facility bore interest at LIBOR plus an applicable margin. The credit facility had a maturity date occurring in January 2021. As of December 31, 2019, there was no available borrowing capacity under the credit facility. In February 2020, we fully repaid the aggregate outstanding principal amount of $92.0 million and terminated the credit facility. In August 2018, one of our subsidiaries entered into a secured revolving credit facility with Credit Suisse AG, New York Branch, as administrative agent, and the lenders party thereto. The credit facility was amended and restated in March 2019 and further amended in September 2019. Under the credit facility, the subsidiary could borrow up to an initial $150.0 million with a maximum commitment amount of $250.0 million based on the aggregate value of solar assets owned by the borrower's subsidiaries, which are primarily tax equity funds, subject to certain concentration limitations. The proceeds of the loan after fees and expenses were available for funding certain reserve accounts required by the credit facility, making distributions to us and paying fees incurred in connection with closing the credit facility. The credit facility bore interest at an annual rate of adjusted LIBOR or, if such rate was not available, a base rate, plus an applicable margin. The credit facility had a maturity date occurring in November 2022. Sunnova Energy Corporation had guaranteed the performance obligations of certain affiliates under agreements entered into in connection with the credit facility as well as certain indemnity and repurchase obligations. As of December 31, 2019, we had no available borrowing capacity under the credit facility. In February 2020, we fully repaid the aggregate outstanding principal amount of $226.6 million and terminated the credit facility. In September 2019, one of our subsidiaries entered into a secured revolving credit facility with Credit Suisse AG, New York Branch, as administrative agent, and the lenders party thereto. The credit facility was amended in December 2019. Under the credit facility, the subsidiary may borrow up to an initial $100.0 million with a maximum commitment amount of $150.0 million based on the aggregate value of solar assets owned by the borrower's subsidiaries, which are primarily tax equity funds, subject to certain concentration limitations. The proceeds from the credit facility are available for funding certain reserve accounts required by the credit facility, making distributions to us and paying fees incurred in connection with closing the credit facility. The credit facility bears interest at an annual rate of either LIBOR divided by a percentage equal to 100% minus a reserve percentage or a base rate, plus an applicable margin. The credit facility has a maturity date occurring in November 2022. Sunnova Energy Corporation guarantees the performance obligations of certain affiliates under agreements entered into in connection with the credit facility as well as certain indemnity and repurchase obligations. As of December 31, 2019, we had $9.7 million of available borrowing capacity under the credit facility. In December 2019, one of our subsidiaries entered into a secured revolving credit facility with Credit Suisse AG, New York Branch, as administrative agent, and the lenders party thereto. Under the credit facility, the subsidiary may borrow up to an initial $95.2 million with a maximum commitment amount of $137.6 million, subject to lender consent and certain other conditions. The proceeds from the credit facility are available for purchasing certain eligible equipment the borrower intends will allow the related solar energy systems to qualify for the 30% Section 48(a) ITC by satisfying the 5% ITC Safe Harbor outlined in IRS Notice 2018-59, funding a reserve account required by the credit facility and paying fees incurred in connection with closing the credit facility. The credit facility bears interest at an annual rate of either LIBOR divided by a percentage equal to 100% minus a reserve percentage or a base rate, plus an applicable margin. The credit facility has a maturity date occurring in December 2022. Sunnova Energy Corporation guarantees the performance obligations of certain affiliates under agreements entered into in connection with the credit facility and also provides a limited payment guarantee in respect of the borrower's obligations under the credit facility that is subject to a cap of $9.5 million, which equates to 10% of the initial commitments. As of December 31, 2019, we had no available borrowing capacity under the credit facility. Rule 144A Securitization Financing We from time to time securitize some solar service agreements and related assets as a source of funding. We access the Rule 144A asset-backed securitization market using wholly-owned special purpose entities to securitize pools of assets, which historically have been solar energy systems and the related lease agreements and PPAs and ancillary rights and agreements both directly or indirectly through interests in the managing member of our tax equity funds. We also securitize our loan agreements and ancillary rights and agreements. In April 2017, one of our subsidiaries issued $191.8 million in aggregate principal amount of Series 2017-1 Class A solar asset-backed notes, $18.0 million in aggregate principal amount of Series 2017-1 Class B solar asset-backed notes, and $45.0 million in aggregate principal amount of 2017-1 Class C solar asset-backed notes with a maturity date of September 2049. The notes bear interest at an annual rate of 4.94%, 6.00% and 8.00% for the Class A, Class B and Class C notes, respectively. In November 2018, one of our subsidiaries issued $202.0 million in aggregate principal amount of Series 2018-1 Class A solar asset-backed notes and $60.7 million in aggregate principal amount of Series 2018-1 Class B solar asset-backed notes with a maturity date of July 2048. The notes bear interest at an annual rate of 4.87% and 7.71% for the Class A and Class B notes, respectively. In June 2019, one of our subsidiaries issued $139.7 million in aggregate principal amount of Series 2019-A Class A solar loan-backed notes, $14.9 million in aggregate principal amount of Series 2019-A Class B solar loan-backed notes and $13.0 million in aggregate principal amount of Series 2019-A Class C solar loan-backed notes with a maturity date of June 2046. The notes bear interest at an annual rate of 3.75%, 4.49% and 5.32% for the Class A, Class B and Class C notes, respectively. In February 2020, one of our subsidiaries issued $337.1 million in aggregate principal amount of Series 2020-1 Class A solar asset-backed notes and $75.4 million in aggregate principal amount of Series 2020-1 Class B solar asset-backed notes with a maturity date of January 2055. The notes bear interest at an annual rate of 3.35% and 5.54% for the Class A and Class B notes, respectively. The securitization structures include certain features designed to protect investors. The primary feature relates to the availability and adequacy of cash flows in the securitized pool of assets to meet contractual requirements, the insufficiency of which triggers an early repayment of the asset-backed notes. We refer to this as "early amortization", which may be based on, among other things, a debt service coverage ratio falling or remaining below certain levels. As of December 31, 2019, we have not had any early amortizations under any of our securitizations. In the event of an early amortization, the notes issuer would be required to repay the affected outstanding securitized borrowings using available collections received from the asset pool. However, the period of ultimate repayment would be determined by cause of the early amortization and the amount and timing of collections received. An early amortization event would impair our liquidity and may require us to utilize our available non-securitization related contingent liquidity or rely on alternative funding sources, which may or may not be available at the time. The indentures of our securitizations also typically contain customary events of default for solar securitizations that may entitle the noteholders to take various actions, including the acceleration of amounts due under the related indenture and foreclosure on the issuer's assets. Private Placement Securitization Financing We have access to additional debt issuance capacity through a privately-placed asset-backed securitization. In March 2019, one of our subsidiaries entered into a note purchase agreement pursuant to which certain institutional investors committed to purchase up to $358.0 million principal amount of notes ("RAYSI Notes") in one or more asset-backed private placement securitizations. In March 2019, our subsidiary, the RAYSI Notes issuer, issued an aggregate $133.1 million principal amount of RAYSI Notes pursuant to this note purchase agreement. In June 2019, the RAYSI Notes issuer issued an aggregate $6.4 million in principal amount of RAYSI Notes pursuant to a supplemental note purchase agreement. The remaining commitments to purchase RAYSI Notes expire in March 2020 and are subject to a variety of closing conditions set forth in the related purchase agreement and indenture, including a collateral test. We may elect to add assets to the securitized pool, subject to certain requirements. The RAYSI Notes issuer owns a pool of solar energy systems and related lease agreements and PPAs and ancillary rights and agreements both directly and through its interests in the managing member of one of our existing tax equity funds. The managing member of the tax equity fund guarantees the RAYSI Notes issuer's obligations under the RAYSI Notes. In addition, the RAYSI Notes issuer has pledged its interests in the managing member and the managing member has pledged its interests in the tax equity fund as security for the issuer's obligations under the RAYSI Notes and for the guarantee, respectively. We expect the engineering, procurement and construction cost related to the securitized pool of assets would be financed approximately evenly between tax equity and non-recourse debt in the form of asset-backed notes, assuming a 30% Section 48(a) ITC. Convertible Notes In April 2017, we issued and sold an aggregate principal amount of $80.0 million of our 12.00% senior secured notes in a private placement to a total of three institutional accredited investors at an issue price of 98%, for an aggregate purchase price of $78.4 million. In January 2019, the terms of these senior secured notes were amended to extend the maturity date from January 2019 to July 2019. In connection with our IPO, we redeemed all the senior secured notes for an aggregate redemption price of $57.1 million in cash, which includes accrued and unpaid cash interest and pay-in-kind interest to the date of redemption. In March 2018, we issued the 2018 Note for $15.0 million to certain of our existing investors, which was subordinated to the senior secured notes. In connection with our IPO, holders of the 2018 Note converted the principal amount plus any accrued and unpaid interest as of the date of conversion into 3,319,312 shares (or 1,422,767 shares as adjusted for the Reverse Stock Split) of Series A convertible preferred stock, which in turn converted into 1,422,767 shares of common stock. See "Preferred Stock Conversion" below. In June 2019, we issued the 2019 Note for $15.0 million to certain of our existing investors with a maturity date of September 2021. In connection with our IPO, holders of the 2019 Note converted the principal amount plus any accrued and unpaid interest as of the date of conversion into 2,613,818 shares (or 1,120,360 shares as adjusted for the Reverse Stock Split) of Series C convertible preferred stock, which in turn converted into 1,120,360 shares of common stock. See "Preferred Stock Conversion" below. In December 2019, we issued and sold an aggregate principal amount of $55.0 million of our 7.75% convertible senior notes in a private placement to a total of seven institutional accredited investors at an issue price of 95%, for an aggregate purchase price of $52.3 million. The convertible senior notes mature in January 2027 unless earlier redeemed, repurchased or converted. We granted the investors of the convertible senior notes an option, subject to our consent, to purchase up to an additional $20.0 million aggregate principal amount of convertible senior notes on the same terms and conditions, which such option will expire in March 2020. The convertible senior notes bear interest at a rate of 7.75% per annum. The convertible senior notes are convertible into our common stock at the option of the holders at any time prior to the close of business on the business day immediately preceding December 23, 2021 upon a change of control event. On or after December 23, 2021 until the close of business on the second scheduled trading day immediately preceding the maturity date, holders may, at their option, convert all or any portion of their convertible senior notes, in multiples of $1,000 principal amount. Upon conversion, we may satisfy our conversion obligation by paying and/or delivering, as the case may be, cash, shares of common stock, or a combination of cash and shares of common stock, at our option, subject to certain terms and conditions. The conversion rate for the convertible senior notes is 76.9231 shares of common stock per $1,000 principal amount of convertible senior notes, plus accrued and unpaid interest, which is equivalent to an initial conversion price (excluding interest) of approximately $13.00 per share of common stock. The conversion rate is subject to adjustment under certain circumstances in accordance with the terms of the convertible senior notes. On and after December 23, 2022, we have the right to cause the conversion of the convertible senior notes if certain specified common stock price and volume conditions are met. If we fail to use commercially reasonable efforts to prepare and file a shelf registration statement registering the offer and sale of the number of shares of common stock issuable upon conversion of the convertible senior notes and to cause such shelf registration statement to become effective on or prior to December 23, 2021, the convertible senior notes will bear additional interest at a rate of 0.25% per annum for each 90-day period such requirements are not met, up to a maximum of 2.00% per annum. We may, at our option, redeem for cash all or any portion of the convertible senior notes plus any accrued and unpaid interest to, but excluding, the redemption date at a redemption price equal to the following percentage of aggregate principal amount of convertible senior notes so redeemed: On and after September 23, 2024, the holders of the convertible senior notes have the option to require us to repurchase their convertible senior notes for cash at a purchase price of 110% of the aggregate principal amount repurchased, plus accrued and unpaid interest to the date of repurchase. The convertible senior notes include customary covenants and set forth certain events of default after which the convertible senior notes may be declared immediately due and payable. Preferred Stock Conversion In connection with our IPO, 108,138,971 shares (or 46,351,877 shares as adjusted for the Reverse Stock Split) of our Series A convertible preferred stock and 32,958,645 shares (or 14,127,140 shares as adjusted for the Reverse Stock Split) of our Series C convertible preferred stock, which represent all the outstanding shares of our Series A convertible preferred stock and Series C convertible preferred stock, were converted into 60,479,017 shares of our common stock. Contractual Obligations The following unaudited table summarizes our contractual obligations as of December 31, 2019: (1) Does not include amounts related to the contingent obligation to purchase all of a tax equity investor's units upon exercise of their right to withdraw rights. The withdrawal price for the tax equity investors' interest in the respective fund is equal to the sum of: (a) any unpaid, accrued priority return and (b) the greater of: (i) a fixed price and (ii) the fair market value of such interest at the date the option is exercised. Due to uncertainties associated with estimating the timing and amount of the withdrawal price, we cannot determine the potential future payments that we could have to make under these withdrawal rights. For additional information regarding the withdrawal rights see Note 13, Redeemable Noncontrolling Interests, to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. (2) Interest payments related to long-term debt and interest rate swaps are calculated and estimated for the periods presented based on the amount of debt outstanding and the interest rates as of December 31, 2019. (3) Negative amount relates to reimbursements of $2.4 million for leasehold improvements. (4) Other obligations relate to information technology services and licenses and distributions payable to redeemable noncontrolling interests. Historical Cash Flows-Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 The following table summarizes our cash flows for the periods indicated: Operating Activities Net cash used in operating activities increased by $158.7 million in the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase is primarily a result of increased payments made to dealers for exclusivity and other bonus arrangements and increased purchases of inventory and prepaid inventory with net outflows of $31.7 million and $127.8 million, respectively, in 2019 compared to an insignificant amount and $14.3 million, respectively, in 2018. The increase is also due to net outflows of $19.1 million in 2019 compared to net inflows of $8.0 million in 2018 based on: (a) our net loss of $133.4 million in 2019 excluding non-cash operating items of $114.4 million, primarily from depreciation, impairments and losses on disposals, amortization of deferred financing costs and debt discounts, unrealized net losses on derivatives, payment-in-kind interest on debt, unrealized net losses on fair value option instruments, loss on extinguishment of debt and equity-based compensation charges, results in net outflows of $19.1 million and (b) our net loss of $68.4 million in 2018 excluding non-cash operating items of $76.4 million, primarily from depreciation, impairments and losses on disposals, amortization of deferred financing costs and debt discounts, unrealized net losses on derivatives, payment-in-kind interest on debt and equity-based compensation charges, results in net inflows of $8.0 million. These net differences between the two periods result in a net change in operating cash flows of $27.1 million in 2019 compared to 2018. Investing Activities Net cash used in investing activities increased by $219.5 million in the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase is largely due to an increase in purchases of property and equipment, primarily solar energy systems, of $430.8 million in 2019 compared to $252.6 million in 2018 and payments for investments and customer notes receivable of $159.3 million in 2019 compared to $108.4 million in 2018. The increase is partially offset by proceeds from customer notes receivable of $21.6 million (of which $18.2 million was prepaid) in 2019 compared to $7.7 million (of which $6.4 million was prepaid) in 2018. Financing Activities Net cash provided by financing activities increased by $436.1 million in the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase is primarily a result of net borrowings under our debt facilities of $494.9 million in 2019 compared to $128.5 million in 2018, net proceeds related to the issuance of common stock of $164.5 million in 2019 compared to an insignificant amount in 2018, net contributions from our redeemable noncontrolling interests of $149.6 million in 2019 compared to $77.0 million in 2018 and net proceeds from the equity component of a debt instrument of $14.0 million in 2019 compared to an insignificant amount in 2018. This increase is partially offset by net payments related to the issuance of convertible preferred stock of $2.5 million in 2019 compared to net proceeds of $172.8 million in 2018 and payments of deferred financing costs and debt discounts of $13.2 million in 2019 compared to $11.1 million in 2018. Historical Cash Flows-Year Ended December 31, 2018 Compared to Year Ended December 31, 2017 The following table summarizes our cash flows for the periods indicated: Operating Activities Net cash used in operating activities decreased by $37.4 million in the year ended December 31, 2018 compared to the year ended December 31, 2017. The decrease is primarily a result of a decrease in payments to certain dealers for advances on work to be performed relating to solar energy systems in the amount of $10.4 million. The decrease is also due to net inflows of $8.0 million in 2018 compared to net outflows of $20.5 million in 2017 based on: (a) our net loss of $68.4 million in 2018 excluding non-cash operating items of $76.4 million, primarily from depreciation, impairments and losses on disposals, amortization of deferred financing costs and debt discounts, unrealized net losses on derivatives, payment-in-kind interest on debt and equity-based compensation charges, results in net inflows of $8.0 million and (b) our net loss of $90.2 million in 2017 excluding non-cash operating items of $69.7 million, primarily from depreciation, impairments and losses on disposals, amortization of deferred financing costs and debt discounts, unrealized net losses on derivatives, payment-in-kind interest on debt and equity-based compensation charges, results in net outflows of $20.5 million. These net differences between the two periods result in a net change in operating cash flows of $28.5 million in 2018 compared to 2017. Investing Activities Net cash used in investing activities increased by $59.7 million in the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase is largely due to an increase in purchases of property and equipment, primarily solar energy systems, of $252.6 million in 2018 compared to $240.6 million in 2017 and payments for investments and customer notes receivable of $108.4 million in 2018 compared to $52.4 million in 2017. The increase is partially offset by proceeds from customer notes receivable of $7.7 million (of which $6.4 million was prepaid) in 2018 compared to $2.8 million (of which $2.3 million was prepaid) in 2017. Financing Activities Net cash provided by financing activities decreased by $4.2 million in the year ended December 31, 2018 compared to the year ended December 31, 2017. The decrease is primarily a result of net borrowings under our debt facilities of $128.5 million in 2018 compared to $238.9 million in 2017. The decrease is partially offset by net proceeds related to the issuance of convertible preferred stock of $172.8 million in 2018 compared to $89.9 million in 2017, payments of deferred financing costs and debt discounts of $11.1 million in 2018 compared to $28.0 million in 2017 and net contributions from our redeemable noncontrolling interests of $77.0 million in 2018 compared to $71.9 million in 2017. Seasonality See "Business-Seasonality". Off-Balance Sheet Arrangements As of December 31, 2019 and 2018, we did not have any off-balance-sheet arrangements. We consolidate all our securitization vehicles and tax equity funds. Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations are based upon our consolidated annual financial statements, which have been prepared in accordance with GAAP which requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, cash flows and related disclosures. We base our estimates on historical experience and on various other assumptions we believe to be reasonable under the circumstances. In many instances, we could have reasonably used different accounting estimates, and in other instances, changes in the accounting estimates are reasonably likely to occur from period-to-period. Actual results may differ from these estimates. Our future consolidated financial statements will be affected to the extent our actual results materially differ from these estimates. We identify our most critical accounting policies as those that are the most pervasive and important to the portrayal of our financial position and results of operations, and that require the most difficult, subjective, and/or complex judgments by management regarding estimates about matters that are inherently uncertain. We believe the assumptions and estimates associated with the estimated useful life of our solar energy systems, the valuation of the assumptions regarding AROs and the valuation of redeemable noncontrolling interests have the greatest subjectivity and impact on our consolidated financial statements. Therefore, we consider these to be our critical accounting policies and estimates and these items are discussed below. See Note 2, Significant Accounting Policies, to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for further discussion of our accounting policies. Useful Life of Solar Energy Systems Our solar energy systems have an estimated useful life of 35 years. We considered both (a) available information related to the technology currently being employed in the solar energy systems and (b) the terms of the solar leases that have a 25 year term with two five-year renewal options to conclude a 35 year useful life is appropriate. In addition, we reviewed numerous published and online sources from academia, government institutions and private industry and held discussions with certain manufacturers of our solar energy systems to support our estimated useful life of 35 years for the crystalline silicone solar modules we use. We define the useful life of a solar module as the duration for which a solar module operates at or above 80% of its initial power output, which we understand to be the generally accepted standard used by government, academia and the solar industry. Depreciation and amortization of solar energy systems are calculated using the straight-line method over the estimated useful lives of the solar energy systems and are included in cost of revenue-depreciation. Depreciation begins when a solar energy system is placed in service. Costs associated with improvements to a solar energy system, which extend the life, increase the capacity or improve the efficiency of the solar energy systems, are capitalized and depreciated over the remaining life of the asset. AROs We have AROs arising from contractual or regulatory requirements to perform certain asset retirement activities at the time the solar energy systems are disposed. We recognize an ARO at the point an obligating event takes place, typically when the solar energy system is placed in service. An asset is considered retired when it is permanently taken out of service, such as through a sale or disposal. The liability is initially measured at fair value based on the present value of estimated removal costs and subsequently adjusted for changes in the underlying assumptions and for accretion expense. We estimate approximately half of our solar energy systems will require removal at our expense in the future. The corresponding asset retirement costs are capitalized as part of the carrying amount of the solar energy system and depreciated over the solar energy system's remaining useful life. We may revise our estimated future liabilities based on recent actual experiences, changes in certain customer-specific estimates and other cost estimate changes. If there are changes in estimated future costs, those changes will be recorded as either a reduction or addition in the carrying amount of the remaining unamortized asset and the ARO and either decrease or increase depreciation and accretion expense amounts prospectively. Inherent in the calculation of the fair value of our AROs are numerous assumptions and judgments, including the ultimate settlement amounts, inflation factors, credit adjusted discount rates, timing of settlement and changes in the legal, regulatory, environmental and political environments. Due to the intrinsic uncertainties present when estimating asset retirement costs as well as asset retirement dates, our ARO estimates are subject to ongoing volatility. Redeemable Noncontrolling Interests Redeemable noncontrolling interests represent third-party interests in the net assets of certain consolidated subsidiaries, which were created to finance the cost of solar energy systems under long-term solar service agreements. The contractual provisions of the financing arrangements represent substantive profit sharing arrangements. We determined the appropriate methodology for attributing income and loss to the redeemable noncontrolling interests is a balance sheet approach referred to as the hypothetical liquidation at book value ("HLBV") method. We, therefore, determine the amount of the redeemable noncontrolling interests in the net assets of the subsidiaries at each balance sheet date using the HLBV method, which is presented in the consolidated balance sheets as redeemable noncontrolling interests. Under the HLBV method, the amounts reported as redeemable noncontrolling interests in the consolidated balance sheets represent the amounts the third parties would hypothetically receive at each balance sheet date under the liquidation provisions of the financing arrangements, assuming the net assets of the subsidiaries were liquidated at the recorded amounts determined in accordance with GAAP and distributed to the third parties. The third parties' interests in the results of operations of the subsidiaries are determined as the difference in the redeemable noncontrolling interests balances in the consolidated balance sheets between the start and end of each reporting period, after taking into account any capital transactions, such as contributions and distributions, between the subsidiaries and the third parties. However, the redeemable noncontrolling interests balance is at least equal to the redemption amount. The estimated redemption value is calculated using the discounted cash flows attributable to the third parties subsequent to the reporting date. We classify redeemable noncontrolling interests with redemption features that are not solely within our control outside of permanent equity in our consolidated balance sheets. Recent Accounting Pronouncements See Note 2, Significant Accounting Policies, to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K.

<s>[INST] Company Overview We are a leading residential solar and energy storage service provider, serving more than 80,000 customers in more than 20 U.S. states and territories. Our goal is to be the leading provider of clean, affordable and reliable energy for consumers, and we operate with a simple mission: to power energy independence. We were founded to deliver customers a better energy service at a better price; and, through our solar and solar plus energy storage service offerings, we are disrupting the traditional energy landscape and the way the 21st century customer generates and consumes electricity. We have a differentiated residential solar dealer model in which we partner with local dealers who originate, design and install our customers' solar energy systems and energy storage systems on our behalf. Our focus on our dealer model enables us to leverage our dealers' specialized knowledge, connections and experience in local markets to drive customer origination while providing our dealers with access to high quality products at competitive prices and technical oversight and expertise. We believe this structure provides operational flexibility, reduced exposure to labor shortages and lower fixed costs relative to our peers, furthering our competitive advantage. We offer customers products to power their homes with affordable solar energy. We are able to offer savings and storage opportunities to most customers compared to utilitybased retail rates with little to no upfront expense to the customer, and we are able to provide energy resiliency and reliability to our solar plus energy storage customers. Our solar service agreements take the form of a lease, PPA or loan. The initial term of our solar service agreements is typically either 10 or 25 years. Service is an integral part of our agreements and includes operations and maintenance, monitoring, repairs and replacements, equipment upgrades, onsite power optimization for the customer (for both supply and demand), the ability to efficiently switch power sources among the solar panel, grid and energy storage system, as appropriate, and diagnostics. During the life of the contract we have the opportunity to integrate related and evolving home servicing and monitoring technologies to upgrade the flexibility and reduce the cost of our customers' energy supply. In the case of leases and PPAs, we also currently receive tax benefits and other incentives from federal, state and local governments, a portion of which we finance through tax equity, nonrecourse debt structures and hedging arrangements in order to fund our upfront costs, overhead and growth investments. We have an established track record of attracting capital from diverse sources. From our inception through December 31, 2019, we have raised more than $4.7 billion in total capital commitments from equity, debt and tax equity investors. In addition to providing ongoing service as a standard component of our solar service agreements, we also offer ongoing energy services to customers who purchased their solar energy system through unaffiliated third parties. Under these arrangements, we agree to provide such monitoring, maintenance and repair services to these customers for the life of the service contract they sign with us. We believe the quality and scope of our comprehensive energy service offerings, whether to customers that obtained their solar energy system through us or through another party, is a key differentiator between us and our competitors. We commenced operations in January 2013 and began providing solar energy services under our first solar energy system in April 2013. Since then, we have experienced rapid growth in our market share and in the number of customers on our platform. We operate one of the largest fleets of residential solar energy systems in the U.S., comprising more than 572 megawatts of generation capacity and serving more than 80,000 customers. Recent Developments In December 2019, we issued and sold an aggregate principal amount of $55.0 million of our 7.75% convertible senior notes (the "convertible senior notes") in a private placement to a total of seven institutional accredited investors at an issue price of 95%, for an aggregate purchase price of $52.3 million. See "Liquidity and Capital ResourcesFinancing ArrangementsConvertible Notes" below. In December 2019, one of our subsidiaries entered into a credit facility with Credit Suisse AG, New York Branch, as administrative agent, and the lenders party thereto. Under the credit facility, the subsidiary may borrow up to an aggregate principal amount of $95.2 million in revolving loans subject to compliance with [/INST] Positive. </s>

Act II Global Acquisition Corp.

2020-03-30

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. Forward-Looking Statements All statements other than statements of historical fact included in this annual report including, without limitation, statements under this “Item 7. 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, 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 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 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 in the Cayman Islands on August 16, 2018 formed for the purpose of effecting a merger, share exchange, asset acquisition, stock purchase, reorganization or similar Business Combination with one or more businesses. We intend to effectuate our Business Combination using cash derived from the proceeds of the Initial Public Offering, our shares, debt or a combination of cash, shares and debt. The issuance of additional ordinary shares 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 ordinary shares resulted in the issuance of Class A ordinary shares on a greater than one-to-one basis upon conversion of the Class B ordinary shares; ● may subordinate the rights of holders of ordinary shares if preference shares are issued with rights senior to those afforded our ordinary shares; ● could cause a change of control if a substantial number of our ordinary shares 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 share ownership or voting rights of a person seeking to obtain control of us; and ● may adversely affect prevailing market prices for our Class A ordinary shares and/or warrants. Similarly, if we issue debt securities, 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 ordinary shares; ● 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 ordinary shares 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. We cannot assure you that our plans to complete a Business Combination will be successful. Recent Developments PENDING ACQUISITION AND RELATED AGREEMENTS Purchase Agreement The Company is party to a purchase agreement dated December 19, 2019, as amended February 12, 2020 (the “Agreement”), with Flavors Holdings Inc. (“Flavors Holdings”), MW Holdings I LLC (“MW Holdings I”), MW Holdings III LLC (“MW Holdings III”) and Mafco Foreign Holdings, Inc. (together with Flavors Holdings, MW Holdings I and MW Holdings III, the “Sellers”), in connection with the proposed purchase of all of the outstanding equity interests of Merisant Company (“Merisant”), Merisant Luxembourg (“Merisant Luxembourg”), Mafco Worldwide LLC (“Mafco Worldwide”), Mafco Shanghai LLC (“Mafco Shanghai”), EVD Holdings LLC (“EVD Holdings”), and Mafco Deutschland GmbH (together with Merisant, Merisant Luxembourg, Mafco Worldwide, Mafco Shanghai, and EVD Holdings, the “Transferred Entities”). Subject to the terms and conditions of the Agreement, at the closing (the “Closing”) of the transactions contemplated thereunder (the “Transactions”), the Sellers will sell, convey, assign, transfer and deliver to the Company, and the Company will purchase, all of the issued and outstanding equity interests of the Transferred Entities and certain assets thereof, and assume certain liabilities included in the Transferred Assets and Liabilities (as defined in the Agreement), in each instance, free and clear of all liens (subject to certain exceptions set forth in the Agreement), in exchange, subject to the limitations set forth below, for the Cash Consideration and the Ordinary Shares Consideration (each as defined below). Subject to the terms and conditions set forth in the Agreement, at the Closing, the Sellers will receive (i) $450,000,000 in cash (the “Base Cash Consideration”), plus or minus the Adjustment Amount (as defined in the Agreement) (the “Cash Consideration”), and (ii) that number of Class A ordinary shares of the Company (“Class A Ordinary Shares”) equal to the quotient of (A) the sum of (x) 60,000,000 and (y) the amount, if any, by which the Base Cash Consideration is reduced by the Company in accordance with the terms of the Agreement, divided by (B) the lowest per share price at which Class A Ordinary Shares are sold by the Company to any person from and after the date of the Agreement but prior to, at or in connection with the Closing (the “Ordinary Share Consideration”). The Agreement further provides the Company with the option, immediately prior to Closing, subject to certain conditions set forth in the Agreement and after (a) giving effect to the Private Placement (described below), any additional equity financing, and the Debt Financing (described below) and (b) taking into account all amounts held by the Company in trust, to reduce the Base Cash Consideration by the amount of funds necessary (up to $55,000,000) for the Company to pay (i) the Cash Consideration, (ii) any amounts paid in connection with the Warrant Amendment (described below), and (iii) the Transaction Costs (as defined in the Agreement) in exchange for a dollar-for-dollar increase in the Ordinary Shares Consideration. In addition, the Agreement contemplates that immediately following the Closing, the Company’s sponsor, Act II Global LLC (the “Sponsor”), will place 2,000,000 Class A Ordinary Shares (which will be converted at Closing from Class B ordinary shares of the Company currently held by the Sponsor) (the “Escrowed Sponsor Shares”) into escrow, which will be held in escrow by the Company’s transfer agent. The Escrowed Sponsor Shares will be released to the Sponsor upon the earliest to occur of (i) the volume weighted-average per-share trading price of Class A Ordinary Shares being at or above $20.00 per share for twenty (20) trading days in any thirty (30)-trading day continuous trading period during the Escrow Period, (ii) a change in control of the Company, and (iii) 5-year anniversary of the Closing. Debt Financing On December 19, 2019, in connection with entering into the Agreement, the Company entered into a commitment letter (the “Commitment Letter”) with TD Securities (USA) LLC (“TDSL”), as left lead arranger and book runner, The Toronto-Dominion Bank, New York Branch (“TDNY”), and Toronto Dominion (Texas) LLC (“TDTX”) as administrative agent. Pursuant to the Commitment Letter, TDSL agreed to arrange and TDNY committed to provide the Company with (i) a senior secured term loan facility in the aggregate amount of up to $185,000,000 (the “Term Facility”) and (ii) a senior secured revolving credit facility of up to $50,000,000 (the “Revolving Facility,” and together with the Term Facility, the “Credit Facilities”). The proceeds of the Term Facility on the Closing Date (as defined in the Agreement) may be used (x) to fund the Transactions, and (y) to pay the fees, costs and expenses incurred in connection with the Transactions. Up to $5,000,000 of the proceeds of the Revolving Facility (which may be increased) may be used on the Closing Date for general corporate purposes and to backstop or replace letters of credit. The proceeds of the Revolving Facility after the Closing Date may be used for working capital and general corporate purposes, including for capital expenditures. The availability of the borrowings under the Credit Facilities is subject to the satisfaction of certain customary conditions, including the consummation of the Transactions. Private Placement Transactions In connection with the foregoing Agreement, on February 12, 2020, the Company entered into subscription agreements with certain investors (collectively, the “Private Placement Investors”) pursuant to which, among other things, such investors agreed to subscribe for and purchase, and the Company agreed to issue and sell to such investors, 7,500,000 of the Company’s Class A ordinary shares, par value $0.0001 (the “Class A Ordinary Shares”) and warrants representing the right to purchase 2,631,750 Class A Ordinary Shares (the “Warrants”) for gross proceeds of approximately $75,000,000 (the “Private Placement”). The Company granted certain customary registration rights to the Private Placement Investors. The Class A Ordinary Shares and Warrants to be offered and sold in connection with the Private Placement have not been registered under the Securities Act of 1933, as amended (the “Securities Act”), in reliance upon the exemption provided in Section 4(a)(2) of the Securities Act and/or Regulation D or Regulation S promulgated thereunder without any form of general solicitation or general advertising. The Private Placement is contingent upon, among other things, the closing of the Transactions. The proceeds from the Private Placement will be used to fund a portion of the Aggregate Cash Obligations (as defined under the Agreement) for the Transactions. In connection with the above agreements, the Company has agreed to put forth a proposal to the Company’s public warrantholders to consider and vote upon an amendment (the “Warrant Amendment”) to the existing warrant agreement that governs all of the Company’s outstanding warrants to provide that, immediately prior to the Closing, (i) each of the Company’s outstanding warrants, which currently entitle the holder thereof to purchase one Class A Ordinary Share at an exercise price of $11.50 per share, will become exercisable for one-half of one share at an exercise price of $5.75 per one-half share ($11.50 per whole share) and (ii) each holder of a warrant will receive, for each such warrant, a cash payment of $0.75 (although the holders of the Private Placement warrants have waived their rights to receive such payment). Sponsor Support Agreement In connection with the Agreement, the Company, the Sponsor, and the Sellers entered into a Sponsor Support Agreement on December 19, 2019, as amended on February 12, 2020 (the “Sponsor Support Agreement”), pursuant to which the Sponsor agreed to certain covenants and agreements related to the Transactions, particularly with respect to taking supportive actions to consummate the Transactions and to designate two of the Sellers’ directors to the board of directors of the Company, to be effective at the Closing. In addition, the Sponsor irrevocably waived its anti-dilution protections under the Company’s Amended and Restated Memorandum and Articles of Association in connection with any new issuances of Ordinary Shares. In accordance with the terms of the Sponsor Support Agreement, the Sponsor will forfeit (i) 3,000,000 Class B ordinary shares of the Company; and (ii) 6,750,000 warrants to purchase Class A Ordinary Shares at a price of $11.50 per share (the “Founder Warrants”) immediately following the Closing; and the Sponsor has waived any rights that it might otherwise have to receive any cash payment with respect to its Founder Warrants. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities from inception through December 31, 2019 were organizational activities, those necessary to prepare for the Initial Public Offering, described below, the Company’s search for a target business with which to complete a Business Combination and activities in connection with the proposed Transactions. We do not expect to generate any operating revenues until after the completion of our initial Business Combination. We generate non-operating income in the form of interest income on marketable securities. We are incurring 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 $3,932,144, which consists of interest income on marketable securities held in the Trust Account of $4,254,861 and an unrealized gain on marketable securities held in the Trust Account of $28,164, offset by operating costs of $350,881. Liquidity and Capital Resources Until the consummation of the Initial Public Offering, the Company’s only source of liquidity was an initial purchase of ordinary shares by the Sponsor and loans from our Sponsor. On April 30, 2019, we consummated the Initial Public Offering of 30,000,000 Units, inclusive of the underwriters’ election to partially exercise their option to purchase an additional 3,900,000 Units, at a price of $10.00 per Unit, generating gross proceeds of $300,000,000. Simultaneously with the closing of the Initial Public Offering, we consummated the sale of 6,750,000 Private Placement Warrants to the Sponsor at a price of $1.00 per warrant, generating gross proceeds of $6,750,000. Following the Initial Public Offering and the sale of the Private Placement Warrants, a total of $300,000,000 was placed in the Trust Account. We incurred $16,614,355 in transaction costs, including $5,220,000 of underwriting fees, $11,280,000 of deferred underwriting fees and $114,355 of other costs. For the year ended December 31, 2019, cash used in operating activities was $396,814. Net income of $3,932,144 was offset by interest earned on marketable securities held in the Trust Account of $4,254,861, an unrealized gain on marketable securities of $28,164 and changes in operating assets and liabilities, which used of $45,933 of cash. As of December 31, 2019, we had cash and marketable securities held in the Trust Account of $304,283,025. We may withdraw interest to pay our income taxes, if any. 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 excluding deferred underwriting commissions) to complete our Business Combination. To the extent that our share capital is used, in whole or in part, as consideration to complete a 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 $1,005,831. 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, 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 warrants, at a price of $1.00 per warrant unit at the option of the lender. The warrants would be identical to the Private Placement Warrants. 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 initial 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. 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, or long-term liabilities, other than: (a) an agreement to pay the Sponsor a monthly fee of $10,000 for office space, and administrative and support services, provided to the Company. We began incurring these fees on April 25, 2019 and will continue to incur these fees monthly until the earlier of the completion of a Business Combination and the Company’s liquidation; and (b) a sub-lease agreement providing the Company with office space. The sub-lease provides that the Company’s occupancy begins January 2020 with monthly rental payments $19,000 commencing May 1, 2020. The sub-lease terminates on July 13, 2021. The underwriters are entitled to a deferred fee of $11,280,000. The deferred fee will be forfeited by the underwriters solely in the event that we fail to complete a Business Combination, subject to the terms of the underwriting agreement. Critical Accounting Policies The preparation of condensed 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: Ordinary shares subject to 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 not 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, ordinary shares subject to possible redemption are presented at redemption value as temporary equity, outside of the shareholders’ equity section of our balance sheet. Net income (loss) per ordinary share We apply the two-class method in calculating earnings per share. Ordinary shares 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 income (loss) per ordinary 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 ordinary shares subject to 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 other 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 annual report including, without limitation, statements under this “Item 7. 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, 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 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 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 in the Cayman Islands on August 16, 2018 formed for the purpose of effecting a merger, share exchange, asset acquisition, stock purchase, reorganization or similar Business Combination with one or more businesses. We intend to effectuate our Business Combination using cash derived from the proceeds of the Initial Public Offering, our shares, debt or a combination of cash, shares and debt. The issuance of additional ordinary shares in a Business Combination: may significantly dilute the equity interest of investors, which dilution would increase if the antidilution provisions in the Class B ordinary shares resulted in the issuance of Class A ordinary shares on a greater than onetoone basis upon conversion of the Class B ordinary shares; may subordinate the rights of holders of ordinary shares if preference shares are issued with rights senior to those afforded our ordinary shares; could cause a change of control if a substantial number of our ordinary shares 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 share ownership or voting rights of a person seeking to obtain control of us; and may adversely affect prevailing market prices for our Class A ordinary shares and/or warrants. Similarly, if we issue debt securities, 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 ordinary shares; 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 ordinary shares 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, ac [/INST] Negative. </s>

Revolution Medicines, Inc.

2020-03-30

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 the consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K. In addition to historical financial information, this discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties. As a result of many factors, including those factors set forth in the “Risk Factors” section of this report, our actual results could differ materially from the results described or implied by the forward-looking statements contained in the following discussion and analysis. Overview We are a clinical-stage precision oncology company focused on developing novel targeted therapies to inhibit elusive, high-value frontier targets within notorious growth and survival pathways, with particular emphasis on the RAS and mTOR signaling pathways. Our understanding of genetic drivers and adaptive resistance mechanisms in cancer, coupled with robust drug discovery and medicinal chemistry capabilities, has guided us to establish a deep pipeline targeting critical signaling nodes within these pathways. This cohesive approach underpins our clinical strategy of exploring mechanism-based dosing paradigms and in-pathway combinations to optimize treatment for cancer patients. Our most advanced product candidate, RMC-4630, is a potent and selective inhibitor of SHP2, a central node in the RAS signaling pathway. In collaboration with Sanofi, we are evaluating RMC-4630 in a multi-cohort Phase 1/2 clinical program. This RMC-4630 Phase 1/2 program currently consists of two active clinical trials: RMC-4630-01, a Phase 1 study of RMC-4630 as a single agent, and RMC-4630-02, a Phase 1b/2 study of RMC-4630 in combination with the MEK inhibitor cobimetinib (Cotellic). In this Annual Report on Form 10-K, we report preliminary data from 63 patients who had enrolled in our Phase 1 study and received RMC-4630 as a monotherapy as of November 6, 2019 and from 8 patients who had enrolled in our Phase 1b/2 combination study and received RMC-4630 as of November 14, 2019. Leveraging our proprietary tri-complex technology platform, we are also developing a portfolio of mutant-selective RAS inhibitors that we believe are the first potent, selective, cell-active inhibitors of the active, GTP-bound form of RAS, or RAS(ON). Initially, we will prioritize four mutant RAS(ON) targets-KRASG12C, KRASG13C, KRASG12D and NRASG12C-and expect to nominate our first development candidate in 2020. Our pipeline also includes inhibitors of other key nodes within the RAS and mTOR signaling pathways, such as SOS1 and mTORC1. We believe our deep, differentiated pipeline and development strategies provide us with the opportunity to pioneer novel treatment regimens to maximize the depth and durability of clinical benefit and circumvent adaptive resistance mechanisms for patients with cancers dependent on these critical pathways. In addition, we have two preclinical programs targeting other key nodes in the RAS and mTOR signaling pathways. Our program targeting SOS1, a protein that plays a key role in converting RAS(OFF) to RAS(ON) in cells, is currently in lead generation stage. In addition, our preclinical development candidate, RMC-5552, is designed to selectively and deeply inhibit mTORC1, thereby preventing phosphorylation and inactivation of 4EBP1, a downstream protein in the mTOR signaling pathway that normally suppresses expression of certain oncogenes such as C-MYC. We advanced RMC-5552 into IND-enabling development in June 2019. We have incurred net losses in each year since inception in 2014. Our net losses were $47.7 million and $41.8 million and $31.1 million for the years ended December 31, 2019, 2018 and 2017, respectively. As of December 31, 2019, we had an accumulated deficit of $157.4 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 in connection with our ongoing activities, as we: • continue our platform research and drug discovery efforts to identify product candidates; • advance product candidates through preclinical programs and clinical trials; • manufacture supplies for our preclinical studies and clinical trials; • pursue regulatory approval of product candidates; • operate as a public company following the completion of our IPO in February 2020; • maintain, protect and expand our portfolio of intellectual property rights, including patents, trade secrets and know-how; and • hire additional personnel to support our development programs and secure additional facilities to support our operations. Collaboration agreement with Sanofi In June 2018, we entered into a collaborative research, development and commercialization agreement with Aventis, Inc. (an affiliate of Sanofi), or the Sanofi Agreement, to research and develop SHP2 inhibitors, including RMC-4630, for any indications. The Sanofi Agreement was assigned to Genzyme Corporation, a Sanofi affiliate, in December 2018. For the purposes of this discussion, we refer to Genzyme Corporation as Sanofi. Pursuant to the Sanofi Agreement, we granted Sanofi a worldwide, exclusive, sublicensable (subject to our consent in certain circumstances) license under certain of our patents and know-how to research, develop, manufacture, use, sell, offer for sale, import and otherwise commercialize SHP2 inhibitors, including RMC-4630, for any and all uses, subject to our exercise of rights and performance of obligations under the Sanofi Agreement. Such intellectual property exclusively licensed to Sanofi includes our interest under any of our solely-owned or jointly-owned inventions arising out of activities undertaken pursuant to the development of SHP2 inhibitor product candidates under the Sanofi Agreement. Under the Sanofi Agreement, we have primary responsibility for performing preclinical research on SHP2 inhibitors, pursuant to an initial research plan and budget directed toward the identification, validation and optimization of SHP2 inhibitors for 2018-2020. The research plan and budget beyond 2020 will be determined by a joint research and development committee, over which Sanofi has final decision-making power subject to certain exceptions. We have primary responsibility for early clinical development of RMC-4630 pursuant to an initial development plan. The joint research and development committee is responsible for preparing development plans for other SHP2 inhibitors approved by such committee for development, if any. Sanofi is responsible for 80% of all internal and external research costs and expenses incurred under the research plan for 2019 and 2020, and for all other internal and external costs and expenses incurred to perform activities under the research and development plans. We are responsible for 20% of all internal and external research costs incurred under the research plan for 2019 and 2020, in which our share of these costs is estimated to be approximately $2 million in total, representing less than three percent of the anticipated overall budget for the SHP2 program in 2019 and 2020. Sanofi is responsible for all costs under the development plan, and since our SHP2 program is in clinical development, the costs under the development plan are expected to be significantly greater than the costs under the research plan. We are responsible for the manufacture of SHP2 inhibitors for Phase 1 and non-registrational Phase 2 clinical trials at Sanofi’s cost, while Sanofi is responsible for manufacturing SHP2 inhibitors for all other clinical trials and commercial supply. Sanofi has the sole right and responsibility to perform all regulatory activities under the Sanofi Agreement, except with respect to certain trials conducted by us or otherwise conducted under our IND, including our current clinical trials evaluating RMC-4630. Once we have completed all clinical trials for a product candidate that are assigned to us under a development plan, all regulatory approvals for such product candidate are automatically assigned to Sanofi. Unless otherwise delegated to us by the joint commercialization committee, Sanofi also has the sole right and responsibility for all aspects of the commercialization of SHP2 inhibitors in the world for any and all uses, at its expense, subject to our right to elect to co-promote SHP2 inhibitors in the United States. Sanofi is obligated to use commercially reasonable efforts to seek marketing approval for at least one SHP2 inhibitor product candidate in certain major market countries. Sanofi agrees to provide us, and we agree to provide Sanofi, with research, development and commercialization updates through the joint committees. During the term of the Sanofi Agreement, we may not, alone or with any affiliate or third party, conduct certain research activities with respect to, or develop or commercialize, any product that contains a SHP2 inhibitor outside of the Sanofi Agreement. Pursuant to the Sanofi Agreement, we received an upfront payment of $50 million from Sanofi in July 2018. Upon the achievement of specified development and regulatory milestones, Sanofi will be obligated to pay us up to $520 million in the aggregate, including up to $235 million upon the achievement of specified development milestones and up to $285 million upon achievement of certain marketing approval milestones. In the United States, we will share equally with Sanofi the profits and losses applicable to commercialization of SHP2 inhibitor products, pursuant to a profit/loss share agreement that the parties will negotiate based on key terms agreed in the Sanofi Agreement. On a product-by-product basis, Sanofi will also be required to pay us tiered royalties on annual net sales of each product outside the United States ranging from high single digit to mid-teen percentages. The royalty payments are subject to reduction under specified conditions set forth in the Sanofi Agreement. Subject to certain exceptions, the royalties are payable on a product-by-product and country-by-country basis until the latest of the expiration of all valid claims covering such product in such country contained in the patents licensed to Sanofi under the Sanofi Agreement and the expiration of regulatory exclusivity for such product in such country. Sanofi has the sole and exclusive right to file, prosecute and maintain any patents licensed to it pursuant to the Sanofi Agreement, as well as to enforce infringement of or defend claims against such patents that relate to SHP2 inhibitor products. Unless terminated earlier, the Sanofi Agreement will continue in effect until the later of the expiration of all of Sanofi’s milestone and royalty payment obligations and the expiration of the profit/loss share agreement. Upon expiration of the Sanofi Agreement, the licenses granted to Sanofi thereunder shall become fully paid-up, royalty-free, perpetual and irrevocable. Sanofi may terminate the Sanofi Agreement in its entirety or on a country-by-country or product-by-product basis for any reason or for significant safety concerns, upon prior notice to us within certain specified time periods. Sanofi may terminate the Sanofi Agreement in its entirety upon our change of control, with prior notice. Either party may terminate the Sanofi Agreement if an undisputed material breach by the other party is not cured within a defined period of time, or immediately upon notice for insolvency-related events of the other party. We may terminate the Sanofi Agreement after a certain number of years if Sanofi develops a competing program without commencing a registrational clinical trial for a SHP2 inhibitor product candidate, and subject to certain other conditions. We may also terminate the Sanofi Agreement at any time, if Sanofi ceases certain critical activities for SHP2 inhibitor product candidates for more than a specified period of time, provided that such cessations of critical activity were not a result of certain specified factors, and subject to certain other conditions. Upon any termination of the Sanofi Agreement with respect to any product or country, all licenses to Sanofi with respect to such product or country shall automatically terminate and all rights generally revert back to us. If the Sanofi Agreement is terminated, in its entirety or with respect to a product, other than by us for Sanofi’s material breach or insolvency, we may be required to pay Sanofi royalties on worldwide net sales of reverted products up to mid-single digit percentages based on the development and regulatory status of such reverted products, in each case subject to reductions in accordance with the terms of the Sanofi Agreement. Through December 31, 2019, we have received an aggregate of $92.6 million from Sanofi, including the upfront payment and research and development expense reimbursements. Acquisition of Warp Drive In October 2018, we acquired all outstanding shares of Warp Drive Bio, Inc., or Warp Drive. In connection with the acquisition, we issued 6,797,915 shares of our Series B preferred stock and $0.9 million in other consideration, for total consideration valued at $69.0 million. The operating results associated with Warp Drive programs are reflected in our consolidated financial statements beginning on the closing date of the transaction. In connection with the Warp Drive acquisition, we recorded $55.8 million of in-process research and development, or IPR&D, and $13.6 million of developed technology related to the tri-complex and genome mining platforms. Warp Drive’s RAS programs were accounted for as an IPR&D asset. The IPR&D asset is considered to be an indefinite-lived asset until the completion or abandonment of the associated research and development efforts. Warp Drive’s tri-complex development platform was accounted for as developed technology and is being amortized over seven years. Warp Drive’s genome mining platform was accounted for as held for sale developed technology and was divested in January 2019 when we sold this genome mining platform to Ginkgo Bioworks, Inc., or Ginkgo. In addition, we recorded $14.6 million in goodwill associated with the Warp Drive acquisition, which largely relates to the establishment of a deferred tax liability for the non-deductible IPR&D intangible assets acquired. Goodwill will not be amortized. Goodwill and IPR&D will be tested at least annually for impairment. No impairment has been recognized as of December 31, 2019. Financial Operations Overview Collaboration revenue Collaboration revenue, related party, consists of revenue under the Sanofi Agreement for our SHP2 program. We entered into the Sanofi Agreement in June 2018 and Sanofi subsequently became a related party in October 2018 as it was a stockholder of Warp Drive to which we issued equity in connection with the acquisition. We received a $50.0 million upfront payment from Sanofi in July 2018, receive reimbursement for research and development services, and are entitled to future potential development and regulatory milestones. Collaboration revenue, other, consists of revenue under our collaboration agreement with F. Hoffmann-La Roche Ltd and Hoffmann-La Roche Inc. that we became a party to in October 2018 as part of the Warp Drive acquisition. This collaboration agreement was divested to Ginkgo in January 2019. For further information on our revenue recognition policies, see “Note 2. Summary of significant accounting policies” Research and development expenses We substantially rely on third parties to conduct our preclinical studies, clinical trials and manufacturing. We estimate research and development expenses based on estimates of services performed, and rely on third party contractors and vendors to provide us with timely and accurate estimates of expenses of services performed to assist us in these estimates. Research and development expenses consist primarily of costs incurred for the development of our product candidates and costs associated with identifying compounds through our discovery platform, 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 discovery programs, preclinical and clinical trials; • employee-related expenses, which include salaries, benefits and stock-based compensation; and • facilities and other expenses, which include allocated expenses for rent and maintenance of facilities, depreciation and amortization expense, information technology 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. Nonrefundable advance payments for goods or services to be received in future periods for use in research and development activities are deferred and recorded as prepaid assets. The prepaid amounts are then expensed as the related goods are delivered or as services are performed. Under the Sanofi Agreement, all of our RMC-4630 research and development expenses incurred from June 2018 to December 2018 have been reimbursed by Sanofi. All RMC-4630 development expenses and 80% of RMC-4630 research expenses in 2019 are reimbursable by Sanofi. These reimbursements from Sanofi are recorded as collaboration revenue. We are responsible for early non-registrational clinical trials and Sanofi is responsible for conducting registrational clinical trials. We expect our research and development expenses to increase substantially for the foreseeable future as we continue to invest in discovering and developing product candidates and advancing product candidates into later stages of development, which may include conducting larger clinical trials. The process of conducting the necessary research and development and clinical trials to seek regulatory approval for product candidates 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 clinical trials or if 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, consultants and professional services expenses, including legal, audit, accounting and human resources services, allocated facilities and information technology costs, and other general operating expenses not otherwise classified as research and development expenses. Personnel-related costs consist of salaries, benefits and stock-based compensation. Facilities costs consist of rent, utilities and maintenance of facilities. We expect our general and administrative expenses to increase for the foreseeable future due to anticipated increases in headcount and as a result of operating as a public company, including expenses related to compliance with the rules and regulations of the Securities and Exchange Commission, the Nasdaq Global Select Market, additional insurance expenses, investor relations activities and other administrative and professional services. Interest income Interest income primarily consists of interest earned on our cash equivalents and marketable securities. Interest and other expense Interest and other expense primarily consists of interest related to our capital lease and interest on other outstanding obligations. Change in fair value of redeemable convertible preferred stock liability Our March 2018 issuance and sale of Series B redeemable convertible preferred stock was tranched into two funding dates, a first closing in March 2018, and a second closing to purchase additional shares in June 2018. We classified the obligation for the future purchase of additional shares under the second closing as a liability on our consolidated balance sheets as the obligation met the definition of a freestanding financial instrument. This redeemable convertible preferred stock tranche liability was initially recorded at fair value upon the date of issuance and was subsequently remeasured to fair value at each reporting date. Changes in the fair value of the redeemable convertible preferred stock liability were recognized in the consolidated statements of operations and comprehensive loss until the obligation for the second tranche was fulfilled upon the second closing date in June 2018. Benefit from income taxes Benefit from income taxes relates to net changes in the valuation allowance resulting from the Warp Drive acquisition. Results of Operations Comparison of the years ended December 31, 2019 and 2018 Collaboration revenue Collaboration revenue, related party consists of revenue under the Sanofi Agreement, which was entered into in June 2018. Collaboration revenue, related party increased by $30.6 million, or 158%, during the year ended December 31, 2019 compared to the same period in 2018. The increase in collaboration revenue, related party during the year ended December 31, 2019 was primarily due to increased research and development costs incurred by us for our SHP2 program under the Sanofi Agreement, which are subject to reimbursement by Sanofi to us and which advanced into a Phase 1 clinical trial in the third quarter of 2018. 2019 included a full calendar year of reimbursed expenses from Sanofi, whereas 2018 included a partial year. Cash received from Sanofi during the years ended December 31, 2019 and 2018 was $35.2 million and $57.4 million, respectively. Revenue is recognized based on actual costs incurred relative to total estimated costs expected to fulfill the performance obligation. Accordingly, the timing of revenue recognition is not directly correlated to the timing of cash receipts. We anticipate collaboration revenue, related party to increase in 2020 from 2019 due to increased development costs for our SHP2 program, which are subject to reimbursement by Sanofi to us. Research and development expenses Research and development expenses increased by $40.7 million, or 80%, during the year ended December 31, 2019 compared to the same period in 2018. The increase in research and development expenses during the year ended December 31, 2019 was primarily due to a $16.2 million increase in third party costs for our RAS programs, which was acquired as part of the Warp Drive acquisition in October 2018; a $10.4 million increase in third party expenses for our SHP2 program, which advanced into a Phase 1 monotherapy clinical trial in the third quarter of 2018, and into a Phase 1b/2 study in combination with the MEK inhibitor, cobimetinib, in the third quarter 0f 2019; a $7.4 million increase in third party costs for our SOS1 program, which commenced in 2019, a $5.1 million increase in facilities and other allocated expenses as a result of higher rent, lab supplies, utilities and information technology expenses associated with higher headcount in 2019; a $2.5 million increase in salaries and other employee-related expenses due to increased headcount to support our research and development programs; a $1.2 million increase in stock based compensation; and a $0.9 million increase related to amortization of developed technology acquired as part of the Warp Drive acquisition, offset by decreases of $2.6 million in third party expenses for our discovery programs and $1.0 million in third party expenses for our 4EBP1 program. General and administrative expenses General and administrative expenses increased by $3.0 million, or 32%, during the year ended December 31, 2019 compared to the same period in 2018. The increase was primarily due to an increase of $1.3 million in legal, accounting and consulting expenses and an increase of $1.1 million in stock-based compensation expense. Interest income Interest income increased by $1.4 million the year ended December 31, 2019 compared to the same period in 2018. The increase was primarily due to interest income earned from higher average investment balances resulting from the net proceeds from our Series C preferred stock financing in 2019. Interest and other expense Interest and other expense was $0.1 million for both years ended December 31, 2019 and 2018. Change in fair value of redeemable convertible preferred stock liability The liability associated with our Series B redeemable convertible preferred stock was remeasured to fair value at each reporting date until it was settled in June 2018, and we recognized the changes in the fair value in our consolidated statements of operations and comprehensive loss during year ended December 31, 2018. As the liability was settled in 2018, there were no amounts recorded to the consolidated statements of operations and comprehensive loss during the year ended December 31, 2019 associated with this liability. Benefit from income taxes Benefit from income taxes was $4.4 million the year ended December 31, 2019 and relates to net changes in the valuation allowance resulting from the Warp Drive acquisition. There was no benefit from income taxes for the year ended December 31, 2018. Comparison of the years ended December 31, 2018 and 2017 Collaboration revenue Collaboration revenue, related party consists of revenue under the Sanofi Agreement, which was entered into in June 2018. Collaboration revenue, related party for the years ended December 31, 2018 and 2017 was $19.4 million and zero, respectively. Cash received from Sanofi during the years ended December 31, 2018 and 2017 was $57.4 million and zero, respectively. Revenue is recognized based on actual costs incurred relative to total estimated costs expected to fulfill the performance obligation. Accordingly, the timing of revenue recognition is not directly correlated to the timing of cash receipts. Research and development expenses Research and development expenses increased by $24.5 million, or 92%, during the year ended December 31, 2018 compared to the same period in 2017. The increase in research and development expenses in 2018 was primarily due to a $6.7 million increase in salaries and other employee-related expenses due to increased headcount to support our research and development programs; a $6.3 million increase in third party expenses for our SHP2 program, which advanced into a Phase 1 clinical trial in the third quarter of 2018; a $4.2 million increase in facilities and other allocated expenses as a result of higher rent, lab supplies, utilities and information technology expenses associated with higher headcount in 2018; a $3.4 million increase in third party expenses for our 4EBP1/mTORC1 program due to advancing the program into the lead optimization phase in 2018, which included increased pharmacology, chemistry CROs, and preliminary safety assessment costs; a $3.1 million increase in third party expenses related to our discovery programs; and a $0.5 million increase in stock-based compensation expense. General and administrative expenses General and administrative expenses increased by $4.9 million, or 107%, during the year ended December 31, 2018 compared to 2017. The increase was primarily due to an increase of personnel-related expenses of $2.3 million related to higher headcount in 2018; an increase of $2.3 million in legal, accounting and consulting expenses primarily due to business development transactions and increased intellectual property activities; and an increase of $0.3 million in stock-based compensation expense. Interest income Interest income increased by $0.7 million during the year ended December 31, 2018 compared to 2017. The increase was primarily due to interest income earned from higher average investment balances resulting from the net proceeds from our Series B preferred stock financing and the upfront payment from Sanofi received in 2018. Interest and other expense Interest and other expense was $0.1 million for both years ended December 31, 2018 and December 31, 2017. Change in fair value of redeemable convertible preferred stock liability The liability associated with our Series B redeemable convertible preferred stock was remeasured to fair value at each reporting date until it was settled in June 2018, and we recognized the changes in the fair value in our consolidated statements of operations and comprehensive loss during the year ended December 31, 2018. Benefit from income taxes Benefit from income taxes was zero for both the years ended December 31, 2018 and 2017. Liquidity and capital resources Liquidity Since our inception through December 31, 2019, our operations have been financed primarily by net proceeds of $230.6 million from the issuance of our preferred stock and $92.6 million in proceeds received under the Sanofi Agreement. As of December 31, 2019, we had $122.8 million in cash, cash equivalents and marketable securities. On February 18, 2020, we closed our initial public offering, or IPO, and issued 16,100,000 shares of its common stock (including the exercise in full by the underwriters of their option to purchase an additional 2,100,000 shares of common stock) at a price to the public of $17.00 per share for net proceeds of approximately $251.0 million, after deducting underwriting discounts and commissions of $19.2 million and expenses of $3.5 million. As of December 31, 2019, we had an accumulated deficit of $157.4 million. Our primary use of cash is to fund operating expenses, which consist primarily of research and development expenditures related to our product candidates and our discovery programs, and to a lesser extent, general and administrative expenditures. We expect our expenses to continue to increase in connection with our ongoing activities, in particular as we continue to advance our product candidates and our discovery programs. In addition, upon the completion of our IPO, we expect to incur additional costs associated with operating as a public company. We believe that our existing cash, cash equivalents and marketable securities will enable us to fund our planned operations for at least 12 months following the date of this report. The timing and amount of future funding requirements will depend on many factors, including: • the scope, progress, results and costs of researching and developing our product candidates and programs, and of conducting preclinical studies and clinical trials; • the timing of, and the costs involved in, obtaining marketing approvals for product candidates we develop if clinical trials are successful; • the success of our collaboration with Sanofi, including the continued reimbursement by Sanofi of substantially all of our research costs and all of our development costs for the SHP2 program under the Sanofi Agreement; • whether we achieve certain clinical and regulatory milestones under our collaboration agreement with Sanofi, each of which would trigger additional payments to us; • the cost of commercialization activities for RMC-4630, to the extent not borne by Sanofi, and any other future product candidates we develop, whether alone or in collaboration, including marketing, sales and distribution costs if RMC-4630 or any other product candidate we develop is approved for sale; • the cost of manufacturing our current and future product candidates for clinical trials in preparation for marketing approval and in preparation for commercialization; • our ability to establish and maintain strategic licenses or other arrangements and the financial terms of such agreements; • the costs involved in preparing, filing, prosecuting, maintaining, expanding, defending and enforcing patent claims, including litigation costs and the outcome of such litigation; • the timing, receipt and amount of sales of, profit share or royalties on, our future products, if any; • the emergence of competing cancer therapies and other adverse market developments; and • any plans to acquire or in-license other programs or technologies. We expect to need to obtain substantial additional funding in the future for our research and development activities and continuing operations. Sanofi reimburses us for almost all of our research and development expenses associated with our SHP2 program, however Sanofi has the right to terminate the Sanofi Agreement for any reason, upon prior notice to us within certain specified time periods and upon any such termination by Sanofi with respect to any product or country, all licenses to Sanofi with respect to such product or country shall automatically terminate and all rights generally revert back to us. 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 may 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 consolidated cash flows for the periods indicated: Cash provided by (used in) operating activities During the year ended December 31, 2019, cash used in operating activities of $49.6 million was attributable to a net loss of $47.7 million and a net change of $8.8 million in our operating assets and liabilities, partially offset by a net change of $6.9 million in non-cash charges. The non-cash charges consisted of depreciation and amortization of $2.9 million, stock-based compensation expense of $3.2 million, a loss on disposal of held for sales assets of $0.6 million and a loss on disposal of property and equipment of $0.2 million. The change in operating assets and liabilities was primarily due to a $13.4 million decrease in deferred revenue associated with the Sanofi Agreement, a $4.4 million decrease in deferred tax liability related to the net change in valuation allowance resulting from the Warp Drive acquisition, a $1.4 million increase in receivable from a related party resulting from the Sanofi Agreement and a $0.5 million increase in prepaid expenses and other current assets primarily resulting from the timing of prepayments made for research and development activities, partially offset by a $11.3 million increase in accounts payable and accrued liabilities resulting from increases in spend for research and development activities. During the year ended December 31, 2018, cash provided by operating activities of $1.2 million was attributable to a net change of $38.1 million in our operating assets and liabilities and $4.9 million in non-cash charges, partially offset by a net loss of $41.8 million. The non-cash charges consisted of depreciation and amortization of $1.8 million, stock-based compensation expense of $0.9 million, a change in the fair value of our redeemable convertible preferred stock liability of $2.1 million, and a loss on disposal of property and equipment of $0.2 million. The change in operating assets and liabilities was primarily due to a $44.5 million increase in deferred revenue associated with the Sanofi Agreement, a $2.0 million increase in accounts payable and accrued liabilities resulting from increases in spend for research and development, offset by a $7.3 million increase in receivable from a related party resulting from the Sanofi Agreement and a $0.9 million increase in prepaid expenses and other current assets primarily resulting from the timing of prepayments made for research and development activities. During the year ended December 31, 2017, cash used in operating activities of $25.1 million was attributable to a net loss of $31.1 million, partially offset by $1.3 million in non-cash charges and a net change of $4.7 million in our operating assets and liabilities. The non-cash charges consisted of depreciation and amortization of $1.2 million and stock-based compensation expense of $0.1 million. The change in operating assets and liabilities was primarily due to a $4.0 million increase in accounts payable and accrued liabilities resulting from increases in spend for research and development, and a $0.6 million decrease in prepaid expenses and other current assets resulting from the timing of prepayments made for research and development activities. Cash used in investing activities During the year ended December 31, 2019, cash used in investing activities of $102.0 million, was primarily comprised of purchases of marketable securities of $172.3 million and purchases of property and equipment of $2.5 million, partially offset by cash provided by maturities of marketable securities of $55.5 million; sales of marketable securities of $11.2 million, proceeds from sale of held for sale assets of $6.0 million; and proceeds from sales of property and equipment of $0.2 million. During the years ended December 31, 2018 and 2017 cash used in investing activities of $1.3 million and $1.6 million, respectively, was comprised primarily of purchases of property and equipment. Cash provided by financing activities During the year ended December 31, 2019, cash provided by financing activities of $98.7 million was comprised primarily of $100.0 million in net cash proceeds received from the issuance of our Series C redeemable convertible preferred stock and $0.3 million in proceeds from the issuance of common stock upon the exercise of stock options; partially offset by $1.6 million in payments of deferred offering costs related to the IPO which closed in February 2020. During the year ended December 31, 2018, cash provided by financing activities of $60.8 million was comprised primarily of $60.6 million in net cash proceeds received from the issuances of our Series B redeemable convertible preferred stock, $0.4 million in proceeds from the issuance of common stock upon the exercise of stock options, offset by $0.1 million in repurchases of early exercised stock options. During the year ended December 31, 2017, cash provided by financing activities of $22.7 million was comprised primarily of $22.6 million in net cash proceeds received from the issuances of our Series A preferred stock, and $0.1 million in proceeds from the issuance of common stock upon the exercise of stock options. Contractual obligations and commitments The following table summarizes our commitments and contractual obligations as of December 31, 2019: Our contractual obligations reflect our minimum payments due for office and laboratory space leases in Redwood City, California and Cambridge, Massachusetts, which are our operating leases, and our equipment leases, which are our capital leases. Our primary Redwood City lease commenced in January 2015 and ends in April 2023. As part of the Warp Drive acquisition, we assumed Warp Drive’s office and laboratory space lease in Cambridge, which ends in February 2023. In March 2019, we fully subleased the Cambridge lease to Casma Therapeutics, Inc., or Casma, on financial terms substantially the same as the original lease. The amounts reflected in the table above include our lease payments for the Cambridge lease, but do not reflect any offset for the sublease payments we are entitled to receive from Casma. The sublease by Casma and related sublease payments by Casma to us are fully guaranteed by Third Rock Ventures, LLC. We enter into agreements in the normal course of business with contract research organizations for clinical trials, contract manufacturing organizations to provide clinical trial materials and with vendors for preclinical studies and other services and products for operating purposes which are generally cancelable at any time by us upon 30 to 90 days prior 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 in Item 303 of Regulation S-K. Indemnification agreements We enter into standard indemnification arrangements in the ordinary course of business. Pursuant to these arrangements, we indemnify, hold harmless and agree to reimburse the indemnified parties for losses suffered or incurred by the indemnified party, in connection with any trade secret, copyright, patent or other intellectual property infringement claim by any third party with respect to its technology. The term of these indemnification agreements is generally perpetual any time after the execution of the agreement. The maximum potential amount of future payments we could be required to make under these arrangements is not determinable. We have never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the fair value of these agreements is minimal. Critical Accounting Policies, Significant Judgments and Use of Estimate Our management’s discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with United States generally accepted accounting principles, or U.S. GAAP. The preparation of these consolidated 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 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. Revenue recognition Effective January 1, 2018, we adopted Accounting Standards Codification Topic 606, Revenue from Contracts with Customers (ASC 606) using the full retrospective transition method. We did not have any effective contracts within the scope of this guidance prior to January 1, 2018, and the adoption of ASC 606 had no impact on our consolidated financial statements. 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 such entity expects to receive in exchange for those goods or services. In determining the appropriate amount of revenue to be recognized as we fulfill our obligations under arrangements, we perform 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 the 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 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 enter into collaboration agreements under which we may obtain upfront license fees, research and development funding, and development, regulatory and commercial milestone payments and royalty payments. Our performance obligations under these arrangements may include licenses of intellectual property, sales and distribution rights, research and development services, delivery of manufactured product and/or participation on joint steering committees. Licenses of intellectual property: If the license to the our intellectual property is determined to be distinct from the other performance obligations identified in the arrangement, we recognize revenue from upfront license fees allocated to the license when the license is transferred to the customer and the customer 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 proportional performance for purposes of recognizing revenue from non-refundable, upfront fees. We evaluate the measure of proportional performance each reporting period and, if necessary, adjust the measure of performance and related revenue recognition. Research, development and regulatory milestone payments: At the inception of each arrangement that includes research, development, or regulatory milestone payments, we evaluate whether the milestones are considered probable of being reached and estimate the amount to be included in the transaction price. We use the most likely amount method for research, development and regulatory milestone payments. Under the most likely amount method, an entity considers the single most likely amount in a range of possible consideration amounts. If it is probable that a significant revenue reversal would not occur, the associated milestone value is included in the transaction price. Sales-based milestones and royalties: For arrangements that include sales-based milestone or royalty payments based on the level of sales, and in which the license is deemed to be the predominant item to which the sales-based milestone or royalties relate to, we recognize revenue in the period in which the sales-based milestone is achieved and in the period in which the sales associated with the royalty occur. To date, we have not recognized any sales-based milestone or royalty revenue resulting from our collaboration arrangements. The transaction price for each collaboration agreement is determined based on the amount of consideration we expect to be entitled for satisfying all performance obligations within the agreement. Significant judgment may be required in determining the amount of variable consideration to be included in the transaction price. We use the most likely amount method to determine variable consideration and will re-evaluate the transaction price in each reporting period and as uncertain events are resolved or other changes in circumstances occur. Revenue is recognized based on actual costs incurred as a percentage of total estimated costs to be incurred over the performance obligation as we fulfill our performance obligations. A cost-based input method of revenue recognition requires management to make estimates of costs to complete our performance obligations. In making such estimates, significant judgment is required to evaluate assumptions related to cost estimates. The cumulative effect of revisions to estimated costs to fulfill our performance obligations will be recorded in the period in which changes are identified and amounts can be reasonably estimated. Business combinations Accounting for business combinations requires us to make significant estimates and assumptions, especially at the acquisition date with respect to tangible and intangible assets acquired and liabilities assumed and pre-acquisition contingencies. We use our best estimates and assumptions to accurately assign fair value to the tangible and intangible assets acquired and liabilities assumed at the acquisition date as well as the useful lives of those acquired intangible assets. Examples of critical estimates in valuing certain of the intangible assets we have acquired include but are not limited to developed technologies and in-process research and development. Our estimates may also impact our deferred income tax assets and liabilities. Unanticipated events and circumstances may occur that may affect the accuracy or validity of such assumptions, estimates or actual results. Accrued research and development expenses 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 maintain an equity incentive plan as a long-term incentive for employees, consultants and members of our board of directors. The plan allows for the issuance of non-statutory options, or NSOs, incentive stock options to employees and NSOs to nonemployees. Stock-based compensation is measured using estimated grant date fair value and recognized as compensation expense over the service period in which the awards are expected to vest. We estimate the grant date fair value, and the resulting stock-based compensation, using the Black-Scholes option-pricing model, and we use the straight-line method for expense attribution. The fair-value-based measurements of options granted to nonemployees are remeasured at each period end until the options vest and are amortized to expense as earned. The valuation model used for calculating the estimated fair value of stock awards is the Black-Scholes option-pricing model. The Black-Scholes model requires us to make assumptions and judgments about the variables used in the calculations, including the expected term (weighted-average period of time that the options granted are expected to be outstanding), the expected volatility of our common stock, the related risk-free interest rate and the expected dividend. We have elected to recognize forfeitures of stock-based awards as they occur. 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 weighted-average period the stock options are expected to remain outstanding and is based on the options’ vesting terms, contractual terms and industry peers, as we did not have sufficient historical information to develop reasonable expectations about future exercise patterns and post-vesting employment termination behavior. • Expected Volatility-Since we have been privately held and do not have any trading history for our common stock, the expected volatility is 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 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 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. Common stock valuation Historically, for all periods prior to our IPO, the fair values of the shares of common stock underlying our stock-based awards were estimated on each grant date by our board of directors. In order to determine the fair value of our common stock underlying option grants, our board of directors considered, among other things, valuations of our common stock prepared by an unrelated 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. For our valuations performed on or prior to December 31, 2018, we used the discounted cash flow model to estimate the value of equity, and allocated the equity value to the various classes of equity using an option pricing method, or OPM. The OPM uses option theory to value the various classes of a company’s securities in light of their respective claims to the enterprise value. For our valuations performed in 2019, we utilized a multi-scenario OPM utilizing two scenarios, an IPO, scenario and a non-IPO scenario. The IPO scenario value was based on management’s estimated IPO valuation and IPO timing, discounted back to the valuation date. The non-IPO scenario per share value was based on the discounted cash flow model to estimate the value of equity, allocating the equity value to the various classes of equity using an OPM. Under a multi-scenario OPM, the per share values calculated under each scenario of the OPM are weighted based on the probability of expected outcomes and the quality of the information specific to each allocation methodology to arrive at a final estimated fair value per share of the common stock before a discount for lack of marketability is applied. Given the absence of a public trading market for our common stock, our board of directors exercised their judgment and considered a number of objective and subjective factors to determine the best estimate of the fair value of our common stock, including important developments in our operations, valuations performed by an independent third party, sales of 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, and the lack of liquidity of our common stock, among other factors. After the closing of our IPO, our board of directors determined the fair value of each share of underlying common stock based on the closing price of our common stock as reported on the date of the grant. Our board of directors intends all options granted 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 grant date. Emerging growth company status 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 an 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 early adopted ASC 606 as the JOBS Act does not preclude an EGC from early adopting a new or revised accounting standard earlier than the time that such standard applies to private companies. We have elected to use the extended transition period for any other new or revised accounting standards during the period in which we remain an emerging growth company; however, we may adopt certain new or revised accounting standards early. For a complete description of our significant accounting policies, see “Note 2. Summary of significant accounting policies” in the “Notes to Consolidated Financial Statements” contained in Part II, Item 8 of this Annual Report on Form 10-K. Recent Accounting Pronouncements For a description of the expected impact of recent accounting pronouncements, see “Note 2. Summary of significant accounting policies” in the “Notes to Consolidated Financial Statements” contained in Part II, Item 8 of this Annual Report on Form 10-K.

<s>[INST] Overview We are a clinicalstage precision oncology company focused on developing novel targeted therapies to inhibit elusive, highvalue frontier targets within notorious growth and survival pathways, with particular emphasis on the RAS and mTOR signaling pathways. Our understanding of genetic drivers and adaptive resistance mechanisms in cancer, coupled with robust drug discovery and medicinal chemistry capabilities, has guided us to establish a deep pipeline targeting critical signaling nodes within these pathways. This cohesive approach underpins our clinical strategy of exploring mechanismbased dosing paradigms and inpathway combinations to optimize treatment for cancer patients. Our most advanced product candidate, RMC4630, is a potent and selective inhibitor of SHP2, a central node in the RAS signaling pathway. In collaboration with Sanofi, we are evaluating RMC4630 in a multicohort Phase 1/2 clinical program. This RMC4630 Phase 1/2 program currently consists of two active clinical trials: RMC463001, a Phase 1 study of RMC4630 as a single agent, and RMC463002, a Phase 1b/2 study of RMC4630 in combination with the MEK inhibitor cobimetinib (Cotellic). In this Annual Report on Form 10K, we report preliminary data from 63 patients who had enrolled in our Phase 1 study and received RMC4630 as a monotherapy as of November 6, 2019 and from 8 patients who had enrolled in our Phase 1b/2 combination study and received RMC4630 as of November 14, 2019. Leveraging our proprietary tricomplex technology platform, we are also developing a portfolio of mutantselective RAS inhibitors that we believe are the first potent, selective, cellactive inhibitors of the active, GTPbound form of RAS, or RAS(ON). Initially, we will prioritize four mutant RAS(ON) targetsKRASG12C, KRASG13C, KRASG12D and NRASG12Cand expect to nominate our first development candidate in 2020. Our pipeline also includes inhibitors of other key nodes within the RAS and mTOR signaling pathways, such as SOS1 and mTORC1. We believe our deep, differentiated pipeline and development strategies provide us with the opportunity to pioneer novel treatment regimens to maximize the depth and durability of clinical benefit and circumvent adaptive resistance mechanisms for patients with cancers dependent on these critical pathways. In addition, we have two preclinical programs targeting other key nodes in the RAS and mTOR signaling pathways. Our program targeting SOS1, a protein that plays a key role in converting RAS(OFF) to RAS(ON) in cells, is currently in lead generation stage. In addition, our preclinical development candidate, RMC5552, is designed to selectively and deeply inhibit mTORC1, thereby preventing phosphorylation and inactivation of 4EBP1, a downstream protein in the mTOR signaling pathway that normally suppresses expression of certain oncogenes such as CMYC. We advanced RMC5552 into INDenabling development in June 2019. We have incurred net losses in each year since inception in 2014. Our net losses were $47.7 million and $41.8 million and $31.1 million for the years ended December 31, 2019, 2018 and 2017, respectively. As of December 31, 2019, we had an accumulated deficit of $157.4 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 in connection with our ongoing activities, as we: continue our platform research and drug discovery efforts to identify product candidates; advance product candidates [/INST] Negative. </s>

NGM BIOPHARMACEUTICALS INC

2020-03-17

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 elsewhere in this Annual Report. 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 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 We are a clinical-stage biopharmaceutical company developing novel therapeutics based on our scientific understanding of key biological pathways underlying cardio-metabolic, liver, oncologic and ophthalmic diseases. These diseases represent leading causes of morbidity and mortality and a significant burden for healthcare systems. Since the commencement of our operations in 2008, we have generated a robust portfolio of product candidates. Our most advanced product candidate, aldafermin, previously known as NGM282, is wholly-owned and entered Phase 2b development for the treatment of NASH in 2019. Five of our other product candidates are in Phase 1 clinical trials and our other programs are in preclinical testing; some of these are subject to our Merck collaboration as described below. In February 2015, we entered into a five-year research collaboration, product development and license agreement with Merck that allows us to develop multiple product candidates in parallel without bearing substantially greater costs or incurring significantly greater risk compared to developing candidates on our own. Through December 31, 2019, Merck had paid us $414.5 million, of which $20.0 million was to license NGM313 and related compounds and $394.5 million was upfront payment and reimbursement of research and development expenses. In March 2019, Merck exercised its option to extend the collaboration through March 16, 2022 and has the right to extend it again through March 16, 2024. As part of the extension through March 16, 2022, Merck agreed to continue to fund our research and development efforts at the same levels during the two-year extension period and, in lieu of a $20.0 million extension fee payable to us, Merck will make additional payments totaling up to $20.0 million in support of our research and development activities across 2021 and the first quarter of 2022. In April 2019, we completed the IPO of our common stock, in which we issued an aggregate of 7,521,394 shares of common stock, including 854,727 shares of common stock issued pursuant to the over-allotment option granted to the underwriters, at a price of $16.00 per share, before underwriting discounts and commissions. We received approximately $107.8 million in net proceeds, after deducting underwriting discounts, commissions and offering expenses of $4.1 million, of which $2.2 million was paid in 2018. The deferred offering costs were offset against the net proceeds received from the sale of common stock. At the closing of the IPO, all shares of outstanding convertible preferred stock were automatically converted to 47,283,839 shares of common stock. Concurrent with the completion of the IPO, we also issued 4,121,683 shares of common stock to Merck in a private placement at a price of $16.00 per share for proceeds of $65.9 million, which resulted in Merck owning approximately 19.9% of our outstanding shares of common stock. We have incurred net losses in each year since our inception. Our consolidated net losses were $42.8 million, $0.5 million and $14.2 million for the years ended December 31, 2019, 2018 and 2017, respectively. As of December 31, 2019, we had an accumulated deficit of $196.1 million, of which $6.1 million was a cumulative effect adjustment to accumulated deficit at January 1, 2019 for the adoption of Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606), and subsequent amendments, under the modified retrospective approach. Substantially all of our net losses have resulted from costs incurred in connection with our research and development programs and general and administrative costs associated with our operations. Our net losses may fluctuate significantly from quarter to quarter and year to year, depending on the timing of our clinical trials and our expenses on other research and development activities. Since inception, we have funded our operations primarily through the private placement of convertible preferred stock totaling $295.1 million, net proceeds from our IPO of $107.8 million, a private placement of shares of common stock to Merck for $65.9 million, research and development service fees provided by collaboration partners of $324.7 million, upfront license fees paid by collaboration partners of $123.0 million and the license of NGM313 and related compounds to Merck for $20.0 million. We do not have any products approved for sale and do not anticipate generating revenue from product sales for the foreseeable future, if ever. We plan to continue to fund our operations and capital funding needs through public or private equity or debt financings, government or other third-party funding, collaborations, strategic alliances and licensing arrangements or a combination of these. The sale of convertible debt or additional equity could result in additional dilution to our stockholders. Incurring indebtedness would result in debt service obligations and could result in operating and financing covenants that would restrict our operations. We cannot assure you that financing will be available in the amounts we need or on terms acceptable to us, if at all. 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. If we are not able to secure adequate additional funding, we may be forced to make reductions in spending, extend payment terms with suppliers, liquidate assets where possible and/or suspend or curtail planned programs. Any of these actions could materially harm our business, results of operations and future prospects. To the extent we obtain additional funding through product collaborations, these arrangements would generally require us to relinquish rights to some of our technologies, product candidates or products, and we may not be able to enter into such agreements on acceptable terms, if at all. We have no manufacturing facilities and all of our manufacturing activities are contracted out to third parties. Additionally, we utilize third-party CROs to carry out certain clinical development activities. Financial Operations Overview Collaboration Revenue Our revenue to date has been generated primarily from recognition of license fees and research and development service funding pursuant to our collaboration agreements, the most significant of which is with Merck. Merck is also a significant stockholder and, as such, collaboration revenue from Merck is referred to as related party revenue. We have not generated any revenue from commercial product sales to date. We receive research and development funding pursuant to our Collaboration Agreement and we may also be entitled to receive additional milestone and other contingent payments upon the occurrence of specific events. Due to the nature of this Collaboration Agreement and timing of related revenue recognition, our revenue has fluctuated from period to period in the past and we expect that it will continue to fluctuate in future periods. The following table summarizes the sources of our collaboration revenue for the years ended December 31, 2019, 2018 and 2017 (in thousands): (1) We adopted ASU 2014-09, Revenue from Contracts with Customers (Topic 606), and subsequent amendments, under the modified retrospective approach on January 1, 2019. Refer to Note 2 to our consolidated financial statements for more details. Research and Development Expenses Research and development efforts relating to our product candidates include manufacturing drug substance, drug product and clinical trial materials, conducting preclinical testing and clinical trials and providing support for these operations. Our research and development expenses consist of internal and external costs. Our internal costs include employee, consultant, facility and other research and development operating expenses. Our external costs include fees paid to CROs and other service providers in connection with our clinical trials and preclinical studies, third party license fees and costs related to acquiring and manufacturing drug substance, drug product and clinical trial materials. Our clinical development efforts are focused on multiple programs. Our lead product candidate, aldafermin, is the subject of our recently completed Phase 2 and ongoing and planned Phase 2b clinical trials for NASH. We anticipate the majority of our financial resources outside of the Merck collaboration will be dedicated to the development of aldafermin for the foreseeable future. We are also devoting financial resources to the development of NGM395, a product candidate in our GDF15 receptor agonist program, and may devote financial resources to other programs in the event Merck does not elect to license these programs upon completion of a proof-of-concept study or in the event Merck elects to terminate its license to a program. Additionally, if our research and development expenses exceed the funding caps provided in our Collaboration Agreement, which we are anticipating in fiscal year ended December 31, 2020 and onwards, we could be required to devote our financial resources toward the development of programs subject to the collaboration. The aldafermin clinical trials under our Phase 2 protocol include our recently completed 24-week expansion cohort of aldafermin (Cohort 4) as a double-blind, placebo-controlled study of once-daily 1 mg aldafermin for the treatment of patients with fibrosis stage or NASH. We have also initiated the ALPINE 2/3 clinical trial, which is a double-blind, placebo-controlled format testing 0.3 mg, 1 mg and 3 mg daily doses of aldafermin for 24 weeks for the treatment of patients with fibrosis stage or NASH, and plan to initiate the ALPINE 4 clinical trial of aldafermin for the treatment of NASH patients with compensated cirrhosis in the first half of 2020. Significant portions of our research and development resources are focused on these clinical trials and other work needed to prepare aldafermin for potential regulatory approval for the treatment of NASH, including manufacturing of clinical trial materials and preparation for Phase 3 testing of aldafermin in NASH. Our NGM313 product candidate has completed the SAD and MAD portions of Phase 1 testing in overweight or obese but otherwise healthy adults, as well as a Phase 1b study in obese insulin resistant subjects with NAFLD. Merck exercised its option to license the NGM313 program in 2018, and all future development expenses will be paid for by Merck unless we elect to exercise our worldwide cost and profit sharing option at the commencement of Phase 3 testing, at which point we would be responsible for a portion of the future development expense. We have initiated Phase 1 clinical trials for NGM120, NGM217 and NGM621, each of which is subject to reimbursement under our Merck collaboration up to the funding caps provided in the Collaboration Agreement. We recently completed a Phase 1 trial assessing the safety, tolerability and pharmacokinetics of NGM120. This clinical trial demonstrated that NGM120 was well tolerated at all doses studied and the pharmacokinetics supported once-monthly dosing. Earlier this year, we initiated a Phase 1a/1b clinical study with NGM120 in cancer patients to explore its potential to treat cancer anorexia-cachexia syndrome and, possibly, tumors. Merck has a one-time option to license NGM120 following completion of a proof-of-concept study in humans. We are also conducting a Phase 1 clinical trial of NGM217 to assess safety and tolerability and to inform dose-range finding for future studies. Thereafter, we plan to commence a Phase 1b/2a proof-of-concept study in diabetic patients to assess the ability of the agent to increase insulin production by the pancreas in the second half of 2020. Merck has a one-time option to license NGM217 following completion of a proof-of-concept study in humans. We initiated a Phase 1 clinical trial of NGM621 in 2019 to assess the safety and tolerability of up to two intravitreal injections of NGM621 in patients with GA, the dry form of AMD. We also plan to initiate a Phase 2 proof-of-concept clinical trial in the second half of 2020. Merck has a one-time option to license NGM621 following completion of a proof-of-concept study in humans. NGM395 and NGM386 comprise our GDF15 receptor agonist program and both were licensed to Merck at the inception of our collaboration. Substantially all of the related research and development expenses for these programs were borne directly by Merck under our Collaboration Agreement. Effective May 31, 2019, Merck terminated its license to the GDF15 receptor agonist program and we regained full rights to NGM395 and NGM386. Following our assessment of the NGM386 study results, we decided to suspend activities related to NGM386 and focus on advancing NGM395. We initiated a Phase 1 clinical trial to assess safety, tolerability and pharmacokinetics of NGM395 in obese but otherwise healthy adults in the first quarter of 2020. As a result, we will continue to incur research and development expenses with respect to NGM395 in the future. Our research and development expenses related to the development of aldafermin, NGM313, NGM120, NGM217, NGM621 and NGM395 consist primarily of: • fees paid to our CROs in connection with our clinical trials and other related clinical trial fees; • costs related to acquiring and manufacturing drug substance, drug product and clinical trial materials, including continued testing, such as process validation and stability, of drug substance and drug product; • costs related to toxicology testing and other research and preclinical related studies; • salaries and related overhead expenses, which include stock-based compensation and benefits, for personnel in research and development functions; • fees paid to consultants for research and development activities; • research and development operating expenses, including facility costs and depreciation expenses; and • costs related to compliance with regulatory requirements. The process of conducting and supplying materials for preclinical studies and clinical trials necessary to obtain regulatory approval of our product candidates is costly and time consuming. We may never succeed in achieving marketing approval for our product candidates. The success of each product candidate may be affected by numerous factors, including preclinical data, clinical data, competition, manufacturing capability, our sales capabilities, our ability to work effectively with our collaboration partners, regulatory matters, third-party payor matters and commercial viability. The following is a comparison of research and development expenses for our programs, including programs that are subject to our Collaboration Agreement with Merck, for the years ended December 31, 2019, 2018 and 2017 (in thousands): (1) Internal and unallocated research and development expenses consist primarily research supplies and consulting fees, which we deploy across multiple research and development programs. The successful development of our product candidates is highly uncertain. At this time, we cannot reasonably estimate the nature, timing or costs of the efforts that will be necessary to complete the remainder of the development of our product candidates or the period, if any, in which material net cash inflows from these product candidates may commence. This is due to the numerous risks and uncertainties associated with developing drugs, including the uncertainty of: • our ability to hire and retain key research and development personnel; • whether Merck will elect to license or terminate its license to any of our programs and the timing of such election or termination; • the scope, rate of progress, results and expense of our ongoing, as well as any additional, clinical trials and other research and development activities; and • the timing and receipt of any regulatory approvals. A change in the outcome of any of the risks and uncertainties associated with 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 currently anticipate will be required for the completion of clinical development of a product candidate, 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. General and Administrative Expenses General and administrative expenses consist primarily of salaries and other related costs, including stock-based compensation. Other significant costs include legal fees relating to patent and corporate matters, facility costs not otherwise included in research and development expenses and fees for accounting and other consulting services. We anticipate that our general and administrative expenses will increase in the future to support our continued research and development activities. 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, we anticipate increased costs associated with being a public company, including expenses related to services associated with maintaining compliance with Nasdaq listing rules and related SEC requirements and insurance and investor relations costs. In addition, we may incur expenses associated with building a commercial organization in connection with, and prior to, potential future regulatory approval of our product candidates. 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): Related Party Revenue. Related party revenue was $103.5 million and $108.7 million for the years ended December 31, 2019 and 2018, respectively. The decrease of $5.1 million in revenue was primarily due to license revenue of $20.0 million related to NGM313 in 2018, partially offset by an increase of $9.7 million in reimbursable costs related to research personnel and research and development activities and an increase $5.2 million in upfront fee revenue due to the change in revenue recognition methodology associated with the adoption of ASC 606, which requires the recognition of revenue using the cost-based input method as opposed to ratable recognition under ASC 605, which was effective January 1, 2019. Research and Development Expenses. Research and development expenses were $129.3 million and $95.7 million for the years ended December 31, 2019 and 2018, respectively. The increase in research and development expenses of $33.5 million was primarily attributable to an increase of $16.6 million in external expenses driven by ongoing clinical trials for our aldafermin program, $11.0 million for the acquisition of clinical trial materials, $7.3 million in personnel-related expenses due to increased headcount and $3.3 million in unallocated research and development expenses related to early research testing. These increases were partially offset by a decrease of $4.7 million in other program external expenses resulting from timing of clinical trial and manufacturing activities. We expect our research and development expenses to increase substantially in connection with our ongoing activities, particularly to the extent that product candidates whose costs are not borne by our collaborator, such as aldafermin and NGM395, advance in clinical development. General and Administrative Expenses. General and administrative expenses were $23.6 million and $17.3 million for the years ended December 31, 2019 and 2018, respectively. The increase in general and administrative expenses of $6.3 million was primarily attributable to an increase of $3.4 million in personnel-related expenses, including stock-based compensation due to increased headcount and the implementation of the 2019 Employee Stock Purchase Plan (“2019 ESPP”). Further increasing our general and administrative expenses were $2.0 million for consulting expenses, $1.3 million for legal and accounting expenses and $1.3 million in other miscellaneous general and administrative expenses, including supplies, travel and rent expenses. These increases were offset by $1.7 million in allocated overhead expenses from general and administrative expenses to research and development expenses. We anticipate general and administrative expenses will continue to increase year over year in connection with being a public company which may include increased expenses related to services associated with maintaining compliance with Nasdaq listing rules and related SEC requirements, insurance and investor relations costs. Interest Income. Interest income was $6.7 million and $3.6 million for the years ended December 31, 2019 and 2018, respectively. The increase in interest income was primarily attributable to an increase in our cash and investments balance subsequent to the completion of our IPO and private placement in April 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 (in thousands): Related Party Revenue. Total related party revenue was $108.7 million and $77.1 million for the years ended December 31, 2018 and 2017, respectively, of which $18.8 million in both periods was related to the partial recognition of the upfront payment from Merck in 2015. The increase of $31.5 million in total revenue was due to an additional $20.0 million of revenue in 2018 recognized from the $20.0 million received from Merck to license NGM313 and related compounds and an increase in both reimbursable personnel related expenses and higher overall external research and development expenses that we incurred in 2018. Research and Development Expenses. Research and development expenses were $95.7 million and $79.7 million for the years ended December 31, 2018 and 2017, respectively. The increase in research and development expenses of $16.0 million was primarily attributable to an increase of $9.2 million in external spend mainly driven by manufacturing costs of clinical materials related to our NGM621 program, $5.0 million in hiring- and personnel-related expenses and $3.3 million in unallocated research and development expenses related to early research testing. These increases were offset by a decrease of $1.5 million in external expense due to NGM217 program external expenses for manufacturing costs of clinical materials that occurred in 2017 and timing of clinical trial activities for our other programs. General and Administrative Expenses. General and administrative expenses were $17.3 million and $14.8 million for the years ended December 31, 2018 and 2017, respectively. The increase in general and administrative expenses of $2.4 million was primarily due to an increase of $2.8 million in personnel-related expenses, $0.7 million for increased rent expense and increases in professional fees and contract services expenses, including $0.4 million for legal expenses and $0.4 million in audit and tax expenses. These increases were partially offset by $1.9 million in allocated overhead expenses from general and administrative expenses to research and development expenses. Interest Income. Interest income was $3.6 million and $2.4 million for the years ended December 31, 2018 and 2017, respectively. The increase in interest income of $1.2 million was primarily attributable to higher yields on our available-for-sale marketable securities in 2018 compared to 2017. Benefit from Income Taxes. Benefit from income taxes was zero and $1.1 million for the years ended December 31, 2018 and 2017, respectively. The benefit from income taxes in 2017 was due to a federal alternative minimum tax credit carryforward that became refundable as a result of the 2017 Tax Cuts and Jobs Act (“2017 Tax Act”). Liquidity and Capital Resources We have incurred losses and negative cash flows from operating activities since our inception. To date, our operations have been financed primarily through the private placement of convertible preferred stock, research and development service fees provided by collaboration partners, primarily Merck, upfront license fees paid by collaboration partners and proceeds from our IPO and concurrent private placement in April 2019. As of December 31, 2019, we had cash and cash equivalents of $245.6 million, short-term marketable securities of $98.9 million, working capital (excluding deferred revenue) of $320.4 million and an accumulated deficit of $196.1 million. We anticipate that we will continue to incur net losses for the foreseeable future as we continue the development of our product candidates, expand our corporate infrastructure to support operations as a public company and conduct pre-commercialization activities. We will require substantial additional capital to achieve our development and commercialization goals for our wholly-owned programs, aldafermin and NGM395, for any future programs that Merck does not opt to license under the Collaboration Agreement and that we choose to develop, for any Merck licensed programs that we opt to co-develop, and for any programs that Merck chooses to license under the Collaboration Agreement and later elects to terminate. Additionally, if our research and development expenses exceed the funding caps provided in our Collaboration Agreement, we could be required to devote our financial resources toward the development of programs subject to the collaboration. If our Merck collaboration were to be terminated, we would require significant additional capital in order to proceed with development and commercialization of our product candidates, or we may enter into additional collaboration or license agreements in order to fund such development and commercialization. We plan to continue to fund our operations and capital funding needs through public or private equity or debt financings, government or other third-party funding, collaborations, strategic alliances and licensing arrangements or a combination of these. The sale of convertible debt or additional equity could result in additional dilution to our stockholders. Incurring indebtedness would result in debt service obligations and could result in operating and financing covenants that would restrict our operations. We cannot assure you that financing will be available in the amounts we need or on terms acceptable to us, if at all. 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. To the extent we obtain additional funding through product collaborations, these arrangements would generally require us to relinquish rights to some of our technologies, product candidates or products, and we may not be able to enter into such agreements on acceptable terms, if at all. If we are not able to secure adequate additional funding, we may be forced to make reductions in spending, extend payment terms with suppliers, liquidate assets where possible and/or suspend or curtail planned programs. Any of these actions could materially harm our business, results of operations and future prospects. We believe that our existing cash and cash equivalents, along with amounts available to us under our Collaboration Agreement with Merck, will be sufficient to meet our anticipated cash requirements for at least the next 12 months. 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. Cash Flows The following table shows a summary of our cash flows for the years ended December 31, 2019, 2018 and 2017 (in thousands): Cash Used in Operating Activities During the year ended December 31, 2019, cash used in operating activities was $41.2 million, which consisted of a net loss of $42.8 million, adjusted for non-cash charges of $19.6 million and cash used through changes in operating assets and liabilities of $17.9 million. The non-cash charges consisted primarily of stock-based compensation expense of $13.0 million and depreciation expense of $7.6 million. The change in operating assets and liabilities was mainly driven by an increase in related party receivable from collaboration of $1.5 million, increase in prepaid expenses and other current assets of $2.0 million, increase in accounts payable of $3.6 million and increase in accrued expenses and other current liabilities of $8.9 million. These increases were offset by a decrease in deferred rent of $2.7 million and deferred revenue of $24.2 million primarily attributed to both the changes in revenue recognition associated with the adoption of ASC 606 and the timing of advance payments from Merck related to the reimbursement of costs associated with research and development activities. During the year ended December 31, 2018, cash used in operating activities was $7.6 million, which consisted of a net loss of $0.5 million, adjusted for non-cash charges of $16.5 million and cash used through changes in operating assets and liabilities of $23.6 million. The non-cash charges consisted primarily of stock-based compensation expense of $10.0 million and depreciation expense of $7.2 million. The change in operating assets and liabilities was primarily due to an increase in related party receivable from collaboration of $3.7 million under our agreement with Merck, increase in prepaid expenses and other current assets of $4.4 million, increase in accounts payable of $3.5 million and increase in accrued expenses and other current liabilities of $4.1 million. These increases were offset by a decrease in deferred rent and deferred revenue of $2.0 million and $21.1 million, respectively. The decrease in deferred revenue is primarily due to the recognition of upfront fees from Merck and the timing of advance payments from Merck related to the reimbursement of costs associated with research and development activities. During the year ended December 31, 2017, cash used in operating activities was $17.4 million, which consisted of a net loss of $14.2 million, adjusted for non-cash charges of $14.5 million and cash used through changes in operating assets and liabilities of $17.7 million. The non-cash charges consisted primarily of stock-based compensation expense of $7.7 million and depreciation expense of $6.4 million. The change in operating assets and liabilities was primarily due to an increase in prepaid expenses and other current assets of $1.1 million primarily resulting from a federal tax receivable generated as a result of the 2017 Tax Act that was signed into law in December 2017 and increase in accrued expenses and other current liabilities of $2.6 million resulting from the timing of payments related to our clinical trial expenses and other research and development activities. These increases were offset by a decrease in related party receivable from collaboration of $2.8 million due to payments received from Merck under the Collaboration Agreement, decrease in accounts payable of $4.2 million, decrease in deferred rent of $1.3 million and decrease in deferred revenue of $16.5 million due to the recognition of revenue related to upfront fees from Merck and the timing of advance payments from Merck related to the reimbursement of costs associated with research and development activities. Cash Provided by Investing Activities During the year ended December 31, 2019, cash provided by investing activities was $48.7 million, which consisted of $186.5 million in proceeds from the maturities of marketable securities, partially offset by purchases of marketable securities of $134.3 million and purchases of property and equipment of $3.5 million. During the year ended December 31, 2018, cash provided by investing activities was $38.7 million, which consisted of $178.2 million in proceeds from the maturities of marketable securities, partially offset by purchases of marketable securities of $133.6 million and purchases of property and equipment of $5.8 million. During the year ended December 31, 2017, cash used in investing activities was $2.8 million, which consisted of $217.3 million in purchases of marketable securities and purchases of property and equipment of $6.4 million, partially offset by proceeds from the maturities of marketable securities of $220.9 million. Cash Provided by Financing Activities During the year ended December 31, 2019, cash provided by financing activities was $180.8 million, which consisted of net proceeds from issuance of common stock upon completion of our IPO of $110.0 million, issuance of common stock upon completion of the private placement with Merck of $65.9 million, issuance of common stock upon the exercise of previously granted stock options of $3.6 million and issuance of common stock in connection with our 2019 ESPP of $1.3 million. The net proceeds received from the completion of our IPO of $110.0 million included proceeds, after deducting underwriting discounts and commissions, of $111.9 million less offering expenses of $4.1 million, of which $2.2 million was paid in 2018. During the year ended December 31, 2018, cash provided by financing activities was $0.2 million, which consisted proceeds from the issuance of common stock upon the exercise of previously granted stock options of $2.6 million less deferred IPO costs of $2.2 million and repurchases of common stock of $0.2 million. During the year ended December 31, 2017, cash provided by financing activities was $0.3 million, which consisted of proceeds from the issuance of common stock upon the exercise of previously granted stock options. Off-Balance Sheet Arrangements We currently have not entered into and do not have any relationships with unconsolidated entities or financial collaborations, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purpose. Contractual Obligations Our principal obligations consist of the operating lease for our facilities and non-cancelable purchase commitments with contract manufacturers or service providers. The following table sets out, as of December 31, 2019, our contractual obligations due by period (in thousands): (1) Consists of our corporate headquarters lease encompassing approximately 122,000 square feet of office and laboratory space that expires in December 2023. We enter into agreements in the normal course of business with CROs, contract manufacturers and with vendors for preclinical studies and other services and products for operating purposes that are generally cancelable at any time by us, upon prior written notice, and may or may not include cancellation fees. Given that the amount and timing related to such payments are uncertain, they have not been included in the table above. We are obligated to make future payments to third parties under in-license agreements, including sublicense fees, low single-digit royalties and payments that become due and payable on the achievement of certain development and commercialization milestones. As the amount and timing of sublicense fees and the achievement and timing of these milestones are not probable and estimable, such commitments have not been included on our consolidated balance sheets or in the contractual obligations table above. Critical Accounting Policies and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which we have prepared in accordance with United States generally accepted accounting principles (“U.S. GAAP”). The preparation of our consolidated 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 our consolidated financial statements, as well as revenue and expenses during the reported periods. We evaluate these 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 may differ materially from these estimates under different assumptions or conditions. Our significant accounting policies are described in Note 2 to our consolidated financial statements appearing elsewhere in this Annual Report. We believe that the following accounting policies are the most critical for fully understanding and evaluating our financial condition and results of operations. Revenue Recognition On January 1, 2019, we adopted ASU 2014-09, Revenue from Contracts with Customers (Topic 606), and subsequent amendments, using the modified retrospective transition method applied to those contracts that were not completed as of January 1, 2019. ASC 606 supersedes all prior revenue recognition guidance. Results for operating periods beginning after January 1, 2019 are presented under ASC 606, while prior period amounts have not been adjusted and continue to be reported in accordance with previous accounting rules under ASC 605. Prior to the adoption of ASC 606, our revenue from collaboration agreements was recognized when we determined that persuasive evidence of an arrangement exists, services had been rendered, the price was fixed or determinable and collectability was reasonably assured. We would record amounts received prior to satisfying the above revenue recognition criteria as deferred revenue until all applicable revenue recognition criteria were met. Revenue allocated to research activities was generally recognized in the period the services were performed, and revenue allocated to licenses was generally recognized on a straight-line basis over the contractual term. Allocations to non-contingent elements were based on the relative selling price of each element using vendor-specific objective evidence or third-party evidence, where available. In the absence of either of these measures, we used the best estimate of selling price for that deliverable. The most significant change to our policies upon the adoption of ASC 606 is the estimation of an arrangement’s total transaction price, which includes unconstrained variable consideration, and the recognition of that transaction price based on a cost-based input method that requires estimates to determine, at each reporting period, the percentage of completion based on the estimated total effort required to complete the project and the total transaction price. Given the differences in revenue recognition policies, the revenue recognized in prior years is not strictly comparable to revenue recorded in the year ending December 31, 2019 or in future periods (see Recently Adopted Accounting Pronouncements in the consolidated financial statements). The core principle in ASC 606 requires an entity to recognize revenue upon the transfer of 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. We apply the following five-step revenue recognition model outlined in ASC 606 to adhere to this core principle: (1) identify the contract(s) with a customer; (2) identify the performance obligations in the contract; (3) determine the transaction price; (4) allocate the transaction price to the performance obligations in the contract; and (5) recognize revenue when (or as) we satisfy a performance obligation. All of our revenue to date has been generated from our collaboration agreements, primarily our Collaboration Agreement. The terms of these agreements generally require us to provide (i) license options for our compounds, (ii) research and development services and (iii) non-mandatory services in connection with participation in research or steering committees. Payments received under these arrangements may include non-refundable upfront license fees, partial or complete reimbursement of research and development costs, contingent consideration payments based on the achievement of defined collaboration objectives and royalties on sales of commercialized products. In some agreements, the collaboration partner is solely responsible for meeting defined objectives that trigger contingent or royalty payments. Often the partner only pursues such objectives subsequent to exercising an optional license on compounds identified as a result of the research and development services performed. We assess whether the promises in our arrangements, including any options provided to the customer, are considered distinct performance obligations that should be accounted for separately. Judgment is required to determine whether the license to a compound is distinct from research and development services or participation in steering committees, as well as whether options create material rights in the contract. The transaction price in each arrangement is generally comprised of a non-refundable upfront fee and unconstrained variable consideration related to the performance of research and development services. We typically submit a budget for the research and development services to the customer in advance of performing the services. The transaction price is allocated to the identified performance obligations based on the standalone selling price (“SSP”) of each distinct performance obligation. Judgment is required to determine SSP. In instances where SSP is not directly observable, such as when a license or service is not sold separately, SSP is determined using information that may include market conditions and other observable inputs. We utilize judgment to assess the nature of our performance obligations to determine whether they are satisfied over time or at a point in time and, if over time, the appropriate method of measuring progress toward completion. We evaluate the measure of progress each reporting period and, if necessary, adjust the measure of performance and related revenue recognition. Our collaboration agreements may include contingent payments related to specified development and regulatory milestones or contingent payments for royalties based on sales of a commercialized product. Milestones can be achieved for such activities in connection with progress in clinical trials, regulatory filings in various geographical markets and marketing approvals from regulatory authorities. Sales-based royalties are generally related to the volume of annual sales of a commercialized product. At the inception of each agreement that includes such payments, we evaluate whether the milestones are considered probable of being achieved and estimate the amount to be included in the transaction price by using the most likely amount method. If it is probable that a significant revenue reversal would not occur, the associated milestone value is included in the transaction price. Milestone payments that are not within our or our customer’s control, such as those related to regulatory approvals, are not considered probable of being achieved until those approvals are received. The transaction price is then allocated to each performance obligation based on a relative SSP basis. 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. Pursuant to the guidance in ASC 606, sales-based royalties are not included in the transaction price. Instead, royalties are recognized at the later of when the performance obligation is satisfied or partially satisfied, or when the sale that gives rise to the royalty occurs. Accrued Research and Development Expenses As part of the process of preparing these consolidated financial statements, we are required to estimate and accrue expenses, the largest of which are research and development expenses. This process involves: • Identifying services that have been performed on our behalf by third-party vendors 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 cost; • estimating and accruing expenses in our consolidated financial statements as of each balance sheet date based on facts and circumstances known to us at the time; and • periodically confirming the accuracy of our estimates with selected service providers and making adjustments, if necessary. Examples of estimated research and development expenses that we accrue include: • fees paid to CROs in connection with preclinical studies and clinical trials; • fees paid to investigative sites in connection with clinical trials; • fees paid to CMOs in connection with the production of clinical trial materials; and • professional service fees for consulting and other services. We base our expense accruals related to clinical trials on our estimates of the services received and efforts expended pursuant to contracts with multiple research institutions and CROs that conduct and manage clinical trials on our behalf. The financial terms of these agreements vary from contract to contract and may result in uneven payment flows. Payments under some of these contracts depend on factors such as the successful enrollment of patients and the completion of clinical study milestones. Our service providers generally invoice us monthly in arrears for services performed. 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 we do not identify costs that we have begun to incur or if we underestimate or overestimate the level of services performed or the costs of these services, our actual expenses could differ from our estimates. All of our clinical trials have been executed with support from CROs and other vendors. We accrue costs for clinical trial activities performed by CROs based upon the estimated amount of work completed on each trial. For clinical trial expenses, the significant factors used in estimating accruals include the number of patients enrolled, the activities to be performed for each patient, the number of active clinical sites and the duration for which the patients will be enrolled in the trial. We monitor patient enrollment levels and related activities to the extent possible through internal reviews, correspondence with CROs and review of contractual terms. We base our estimates on the best information available at the time. To date, we have not experienced significant changes in our estimates of accrued research and development expenses after a reporting period. However, due to the nature of estimates, we cannot assure that we will not make changes to our estimates in the future as we become aware of additional information about the status or conduct of our clinical trials and other research activities. Stock-Based Compensation Stock-based compensation expense represents the grant-date fair value of employee stock option granted under our 2008 Equity Incentive Plan (the “2008 Plan”) and 2018 Equity Incentive Plan (the “2018 Plan”) and rights to acquire stock granted under our 2019 ESPP, recognized over the requisite service period of the awards (usually the vesting period) on a straight-line basis, net of estimated forfeitures. On January 1, 2019, we adopted ASU 2018-07, Compensation - Stock Compensation (Topic 718): Improvements to Non-Employee Share-Based Payment Accounting. Subsequent to the adoption of ASU 2018-07, stock-based compensation expense for non-employee stock-based awards is also measured based on the fair value on grant date with its estimated fair value recorded over the requisite service period of the awards (usually the vesting period) on a straight-line basis, net of estimated forfeitures. We calculate the fair value of stock-based compensation awards using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model requires the use of subjective assumptions, including stock price volatility, the expected life of stock options, risk free interest rate and the fair value of the underlying common stock on the date of grant. Our key assumptions are: • Expected Stock Price Volatility: The expected volatility is based on the historical volatility of the common stock of similar entities within our industry over periods commensurate with our expected term assumption. • 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 using 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). • 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 Annual Dividends: The estimate for annual dividends is zero because we have not historically paid dividends and do not expect to pay dividends for the foreseeable future. We recorded stock-based compensation expense related to employees, directors and nonemployees of $12.9 million, $9.9 million and $7.7 million for the years ended December 31, 2019, 2018 and 2017, respectively. As of December 31, 2019, we had unrecognized stock-based compensation cost related to options granted to employees and directors of $24.1 million, net of forfeitures, which is expected to be recognized as expense over approximately 2.67 years. Prior to the closing of the Company’s IPO, the fair value of the 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, our board of directors considered, among other things, timely valuations of our common stock prepared by an unrelated third-party valuation firm in accordance with the guidance provided by the American Institute of Certified Public Accountants (“AICPA”) Practice Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. Given the absence of a public trading market for our common stock historically, 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 our stage of development; progress of our research and development efforts; the rights, preferences and privileges of our convertible preferred stock relative to those of our common stock; equity market conditions affecting comparable public companies; and the lack of marketability of our common stock. After our IPO, the fair market value of each share of underlying common stock is determined based on the closing price of our common stock as reported by the Nasdaq Global Select Market on the date of grant. JOBS Act Accounting Election We are an “emerging growth company,” as defined in the JOBS Act. Under the JOBS Act, emerging growth companies may delay the adoption of new or revised accounting standards issued subsequent to the enactment of the JOBS Act until such time as those standards would otherwise apply to private companies. The JOBS Act permits an “emerging growth company” such as us to take advantage of an extended transition time to comply with new or revised accounting standards as 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 earlier to occur of (1) (a) December 31, 2024, (b) the last day of the fiscal year in which our annual gross revenue is $1.07 billion or more, or (c) the date on which we are deemed to be a “large-accelerated filer,” under the rules of the SEC, which means the market value of our equity securities 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. Newly Issued Accounting Pronouncements Refer to Note 2 of our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for a summary of recently issued and adopted accounting pronouncements.

<s>[INST] 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. 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 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 We are a clinicalstage biopharmaceutical company developing novel therapeutics based on our scientific understanding of key biological pathways underlying cardiometabolic, liver, oncologic and ophthalmic diseases. These diseases represent leading causes of morbidity and mortality and a significant burden for healthcare systems. Since the commencement of our operations in 2008, we have generated a robust portfolio of product candidates. Our most advanced product candidate, aldafermin, previously known as NGM282, is whollyowned and entered Phase 2b development for the treatment of NASH in 2019. Five of our other product candidates are in Phase 1 clinical trials and our other programs are in preclinical testing; some of these are subject to our Merck collaboration as described below. In February 2015, we entered into a fiveyear research collaboration, product development and license agreement with Merck that allows us to develop multiple product candidates in parallel without bearing substantially greater costs or incurring significantly greater risk compared to developing candidates on our own. Through December 31, 2019, Merck had paid us $414.5 million, of which $20.0 million was to license NGM313 and related compounds and $394.5 million was upfront payment and reimbursement of research and development expenses. In March 2019, Merck exercised its option to extend the collaboration through March 16, 2022 and has the right to extend it again through March 16, 2024. As part of the extension through March 16, 2022, Merck agreed to continue to fund our research and development efforts at the same levels during the twoyear extension period and, in lieu of a $20.0 million extension fee payable to us, Merck will make additional payments totaling up to $20.0 million in support of our research and development activities across 2021 and the first quarter of 2022. In April 2019, we completed the IPO of our common stock, in which we issued an aggregate of 7,521,394 shares of common stock, including 854,727 shares of common stock issued pursuant to the overallotment option granted to the underwriters, at a price of $16.00 per share, before underwriting discounts and commissions. We received approximately $107.8 million in net proceeds, after deducting underwriting discounts, commissions and offering expenses of $4.1 million, of which $2.2 million was paid in 2018. The deferred offering costs were offset against the net proceeds received from the sale of common stock. At the closing of the IPO, all shares of outstanding convertible preferred stock were automatically converted to 47,283,839 shares of common stock. Concurrent with the completion of the IPO, we also issued 4,121,683 shares of common stock to Merck in a private placement at a price of $16.00 per share for proceeds of $65.9 million, which resulted in Merck owning approximately 19.9% of our outstanding shares of common stock. We have incurred net losses in each year since our inception. Our consolidated net losses were $42.8 million, $0.5 million and $14.2 million for the years ended December 31, 2019, 2018 and 2017, respectively. As of December 31, 2019, we had an accumulated deficit of $196.1 million, of which $6.1 million was a cumulative effect adjustment to [/INST] Negative. </s>

Olivia Ventures, Inc.

2019-07-01

2019-03-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation. Overview of our Business Olivia Ventures, Inc. was incorporated in the State of Delaware on March 20, 2018. Since inception, the Company has been engaged in organizational efforts and obtaining initial financing. The Company was formed as a vehicle to pursue a business combination through the acquisition of, or merger with, an operating business. The Company filed a registration statement on Form 10 with the SEC on May 30, 2018, and since its effectiveness, the Company has focused its efforts to identify a possible business combination. The Company is currently considered to be a “blank check” company. The SEC defines those companies as “any development stage company that is issuing a penny stock, within the meaning of Section 3(a)(51) of the Exchange Act, and that has no specific business plan or purpose, or has indicated that its business plan is to merge with an unidentified company or companies.” Many states have enacted statutes, rules and regulations limiting the sale of securities of “blank check” companies in their respective jurisdictions. The Company is also a “shell company,” defined in Rule 12b-2 under the Exchange Act as a company with no or nominal assets (other than cash) and no or nominal operations. Management does not intend to undertake any efforts to cause a market to develop in our securities, either debt or equity, until we have successfully concluded a business combination. The Company intends to comply with the periodic reporting requirements of the Exchange Act for so long as we are subject to those requirements. In addition, the Company is an “emerging growth company,” as defined in the JOBS Act, and may take advantage of certain exemptions from various reporting requirements that are 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(b) of the Sarbanes-Oxley Act, and exemptions from the requirements of Sections 14A(a) and (b) of the Exchange Act to hold a nonbinding advisory vote of shareholders on executive compensation and any golden parachute payments not previously approved. The Company has also elected to use the extended transition period for complying with new or revised accounting standards under Section 102(b)(1) of the JOBS Act. This election allows us to 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. As a result of this election, our financial statements may not be comparable to companies that comply with public company effective dates. We will remain an “emerging growth company” until the earliest of (1) the last day of the fiscal year during which our revenues equal $1.07 billion or more, (2) the date on which we issue more than $1 billion in non-convertible debt in a three year period, (3) the last day of the fiscal year following the fifth anniversary of the date of the first sale of our common equity securities pursuant to an effective registration statement filed pursuant to the Securities Act, or (4) when the market value of our common stock that is held by non-affiliates exceeds $700 million as of the last business day of our most recently completed second fiscal quarter. To the extent that we continue to qualify as a “smaller reporting company,” as such term is defined in Rule 12b-2 under the Exchange Act, after we cease to qualify as an emerging growth company, certain of the exemptions available to us as an emerging growth company may continue to be available to us as a smaller reporting company, including: (1) not being required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes Oxley Act; (2) scaled executive compensation disclosures; and (3) the requirement to provide only two years of audited financial statements, instead of three years. The Company was organized as a vehicle to investigate and, if such investigation warrants, acquire a target company or business seeking the perceived advantages of being a publicly held corporation. The Company’s principal business objective for the next 12 months and beyond such time will be to achieve long-term growth potential through a combination with an operating business. The Company will not restrict its potential candidate target companies to any specific business, industry or geographical location and, thus, may acquire any type of business. The Company currently does not engage in any business activities that provide cash flow. During the next twelve months, we anticipate incurring costs related to: (i) filing Exchange Act reports, and (ii) investigating, analyzing and consummating an acquisition. We believe we will be able to meet these costs through use of funds to be loaned by or invested in us by our stockholders, management or other investors. As of March 31, 2019, the Company had $4,866 in cash. There are no assurances that the Company will be able to secure any additional funding as needed. Currently, however, our ability to continue as a going concern is dependent upon our ability to generate future profitable operations and/or to obtain the necessary financing to meet our obligations and repay our liabilities arising from normal business operations when they come due. Our ability to continue as a going concern is also dependent on our ability to find a suitable target company and enter into a possible reverse merger with such company. Management’s plan includes obtaining additional funds by equity financing through a reverse merger transaction and/or related party advances, however, there is no assurance of additional funding being available. The Company may consider acquiring a business which has recently commenced operations, is a developing company in need of additional funds for expansion into new products or markets, is seeking to develop a new product or service, or is an established business which may be experiencing financial or operating difficulties and is in need of additional capital. In the alternative, a business combination may involve the acquisition of, or merger with, a company which does not need substantial additional capital but which desires to establish a public trading market for its shares while avoiding, among other things, the time delays, significant expense, and loss of voting control which may occur in a public offering. Any target business that is selected may be a financially unstable company or an entity in its early stages of development or growth, including entities without established records of sales or earnings. In that event, we will be subject to numerous risks inherent in the business and operations of financially unstable and early stage or potential emerging growth companies. In addition, we may effect a business combination with an entity in an industry characterized by a high level of risk, and, although our management will endeavor to evaluate the risks inherent in a particular target business, there can be no assurance that we will properly ascertain or assess all significant risks. Our management anticipates that it will likely be able to effect only one business combination, due primarily to our limited financing and the dilution of interest for present and prospective stockholders, which is likely to occur as a result of our management’s plan to offer a controlling interest to a target business in order to achieve a tax-free reorganization. This lack of diversification should be considered a substantial risk in investing in us, because it will not permit us to offset potential losses from one venture against gains from another. The Company anticipates that the selection of a business combination will be complex and extremely risky. Our management believes that there are numerous firms seeking the perceived benefits of becoming a publicly traded corporation. Such perceived benefits of becoming a publicly traded corporation include, among other things, facilitating or improving the terms on which additional equity financing may be obtained, providing liquidity for the principals of and investors in a business, creating a means for providing incentive stock options or similar benefits to key employees, and offering greater flexibility in structuring acquisitions, joint ventures and the like through the issuance of stock. Potentially available business combinations may occur in many different industries and at various stages of development, all of which will make the task of comparative investigation and analysis of such business opportunities extremely difficult and complex. As of the date of this Form 10-K, the Company has not entered into any definitive agreement with any party, nor have there been any specific discussions with any potential business combination candidate regarding business opportunities for the Company. Liquidity and Capital Resources As of March 31, 2019, the Company had total assets equal to $4,866, comprised exclusively of cash. This compares with total assets of $25, comprised exclusively of a stock subscription receivable, as of March 31, 2018. The Company’s current liabilities as of March 31, 2019 totaled $75,455, comprised of accrued expenses and amounts due to a related party. This compares to the Company’s total current liabilities of $34,577, comprised of accrued expenses and amounts due to a related party, as of March 31, 2018. The Company can provide no assurance that it can continue to satisfy its cash requirements for at least the next twelve months. The following is a summary of the Company’s cash flows provided by (used in) operating and financing activities for the year ended March 31, 2019 and for the period from March 20, 2018 (inception) to March 31, 2018: The Company has only cash assets and has generated no revenues since inception. The Company is also dependent upon the receipt of capital investment or other financing to fund its ongoing operations and to execute its business plan of seeking a combination with a private operating company. In addition, the Company is dependent upon certain related parties to provide continued funding and capital resources. If continued funding and capital resources are unavailable at reasonable terms, the Company may not be able to implement its plan of operations. Issuance of Promissory Note to a Stockholder and Director On March 22, 2018, the Company issued a promissory note to Mark Tompkins, a stockholder and director of the Company pursuant to which the Company agreed to repay Mr. Tompkins the sum of any and all amounts that Mr. Tompkins may advance to the Company on or before the date that the Company consummates a business combination with a private company or reverse takeover transaction or other transaction after which the Company would cease to be a shell company (as defined in Rule 12b-2 under the Exchange Act). Although Mr. Tompkins has no obligation to advance funds to the Company under the terms of the note, it is anticipated that he may advance funds to the Company as fees and expenses are incurred in the future. Interest shall accrue on the outstanding principal amount of the note on the basis of a 360-day year from the date of borrowing until paid in full at the rate of six percent (6%) per annum. In the event that an Event of Default (as defined in the note) has occurred, the entire note shall automatically become due and payable (the “Default Date”), and starting from five (5) days after the Default Date, the interest rate on the note shall accrue at the rate of eighteen percent (18%) per annum. As of March 31, 2019, the total amount due was $75,455 including accrued interest of $3,330. The note is attached hereto as Exhibit 4.1. Results of Operations The Company has not conducted any active operations since inception, except for its efforts to locate suitable acquisition candidates. No revenue has been generated by the Company from March 20, 2018 (Inception), through March 31, 2019. It is unlikely the Company will have any revenues unless it is able to effect an acquisition or merger with an operating company, of which there can be no assurance. It is management’s assertion that these circumstances may hinder the Company’s ability to continue as a going concern. The Company’s plan of operation for the next twelve months shall be to continue its efforts to locate suitable acquisition candidates. For the year ended March 31, 2019 and for the period from March 20, 2018 (inception) to March 31, 2018, the Company had a net loss of $36,037 and $35,052, respectively, comprised of legal, accounting, audit and other professional service fees incurred in relation to the preparation and filing of the Company’s periodic reports, general and administrative expenses, and interest expense. Off-Balance Sheet Arrangements The Company does not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. Contractual Obligations As a “smaller reporting company” as defined by Item 10 of Regulation S-K, the Company is not required to provide this information. Emerging Growth Company As an “emerging growth company” under the JOBS Act, the Company has elected to use the extended transition period for complying with new or revised accounting standards under Section 102(b)(1) of the JOBS Act. This election allows us to 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. As a result of this election, our financial statements may not be comparable to companies that comply with public company effective dates. Fiscal Year Our fiscal year ends on March 31.

<s>[INST] Olivia Ventures, Inc. was incorporated in the State of Delaware on March 20, 2018. Since inception, the Company has been engaged in organizational efforts and obtaining initial financing. The Company was formed as a vehicle to pursue a business combination through the acquisition of, or merger with, an operating business. The Company filed a registration statement on Form 10 with the SEC on May 30, 2018, and since its effectiveness, the Company has focused its efforts to identify a possible business combination. The Company is currently considered to be a “blank check” company. The SEC defines those companies as “any development stage company that is issuing a penny stock, within the meaning of Section 3(a)(51) of the Exchange Act, and that has no specific business plan or purpose, or has indicated that its business plan is to merge with an unidentified company or companies.” Many states have enacted statutes, rules and regulations limiting the sale of securities of “blank check” companies in their respective jurisdictions. The Company is also a “shell company,” defined in Rule 12b2 under the Exchange Act as a company with no or nominal assets (other than cash) and no or nominal operations. Management does not intend to undertake any efforts to cause a market to develop in our securities, either debt or equity, until we have successfully concluded a business combination. The Company intends to comply with the periodic reporting requirements of the Exchange Act for so long as we are subject to those requirements. In addition, the Company is an “emerging growth company,” as defined in the JOBS Act, and may take advantage of certain exemptions from various reporting requirements that are 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(b) of the SarbanesOxley Act, and exemptions from the requirements of Sections 14A(a) and (b) of the Exchange Act to hold a nonbinding advisory vote of shareholders on executive compensation and any golden parachute payments not previously approved. The Company has also elected to use the extended transition period for complying with new or revised accounting standards under Section 102(b)(1) of the JOBS Act. This election allows us to 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. As a result of this election, our financial statements may not be comparable to companies that comply with public company effective dates. We will remain an “emerging growth company” until the earliest of (1) the last day of the fiscal year during which our revenues equal $1.07 billion or more, (2) the date on which we issue more than $1 billion in nonconvertible debt in a three year period, (3) the last day of the fiscal year following the fifth anniversary of the date of the first sale of our common equity securities pursuant to an effective registration statement filed pursuant to the Securities Act, or (4) when the market value of our common stock that is held by nonaffiliates exceeds $700 million as of the last business day of our most recently completed second fiscal quarter. To the extent that we continue to qualify as a “smaller reporting company,” as such term is defined in Rule 12b2 under the Exchange Act, after we cease to qualify as an emerging growth company, certain of the exemptions available to us as an emerging growth company may continue to be available to us as a smaller reporting company, including: (1) not being required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes Oxley Act; (2) scaled executive compensation disclosures; and (3) the requirement to provide only two years of audited financial statements, instead of three years. The Company was organized as a vehicle to investigate and, if such investigation warrants, acquire a target company or business seeking the perceived advantages of being a publicly held corporation. The Company’s principal business objective for the next 12 months and beyond such time will be to achieve longterm growth potential through a combination with an operating business. The Company will not restrict its potential candidate target companies to any specific business, industry or geographical location and, thus, may acquire any type of business. The Company currently [/INST] Negative. </s>

Super League Gaming, Inc.

2020-03-23

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 our operations together with our financial statements and the notes thereto appearing elsewhere in this Report. This discussion contains forward-looking statements reflecting our current expectations, whose actual outcomes involve risks and uncertainties. Actual results and the timing of events may differ materially from those stated in or implied by these forward-looking statements due to a number of factors, including those discussed in the sections entitled “Risk Factors,” “Special Note Regarding Forward-Looking Statements” and elsewhere in this Report. General Super League Gaming, Inc. (“Super League,” the “Company,” “we” or “our”) is a global leader in the mission to bring live and digital esports entertainment and experiences directly to everyday competitive gamers around the world. Utilizing our proprietary technology platform, Super League operates physical and digital experiences in partnership with publishers of top-tier game titles and owners/operators of a distributed footprint of venues, a network of digital social and viewing channels, and an association/organization of city-based amateur gaming clubs and teams. In addition to providing premium experiences by operating city-vs-city amateur esports leagues and producing thousands of social gaming experiences across North America and our ever-expanding international footprint, the Super League Network features multiple forms of content celebrating the love of play via social media, live streaming and video-on-demand, along with continuous gameplay and leaderboards. Inside our network is Framerate, a large independent social video esports network powered by user-generated highlight reels, and our exclusive proprietary platform Minehut, providing a social and gameplay forum for the avid Minecraft community. Through our partnerships with high-profile venue owners such as Wanda Theatres in China, and Topgolf and Cinemark Theatres in North America, along with ggCircuit, an esports services company that provides gaming center management software solutions and access to a global network of gaming centers, Super League is committed to supporting the development of local, grassroots player communities, while providing a global, scalable infrastructure for esports competition and engagement. We address not only a wide range of gamers across game titles, ages and skill levels, but also a wide range of content-capture beyond just gameplay. This positions Super League as more than a tournament operator; we are a lifestyle and media company focused on capturing, generating, aggregating and distributing content across the genre of all things esports. Executive Summary We believe Super League is on the leading edge of the rapidly growing competitive video gaming industry, which has become an established and vital part of the entertainment landscape. According to Reuters Plus, 2018, gaming is now the world’s favorite form of entertainment, as the gaming industry generated more revenue in 2017 than television, movies and music. At the professional level, thousands of professional players on hundreds of teams compete in dozens of high stakes competitions that draw significant audiences, both in person and online. In addition, the value of brand sponsorships, media rights and prize money continue to rise, as are professional team valuations and the purchase price for securing franchises in professional leagues. With NewZoo reporting 2.6 billion gamers globally, we believe there is a larger opportunity for the world of mainstream competitive players who want their own esports experience. These amateur gamers are players who enjoy the competition, the social interaction and community, and the entertainment value associated with playing and watching others play. According to Nielsen Esports Playbook, 2017, competitive amateur gamers take part in over eight hours of gameplay and watch up to nine hours of esports-related content each week. We believe this is an under-served market that seeks their own opportunities for team-based play on real playing fields. Super League is a critically important component in providing the infrastructure for mainstream esports that is synergistic and accretive to the greater esports ecosystem. Over the past five years, we believe we have become the preeminent brand for amateur esports by providing a proprietary software platform that allows our gamers to compete, socialize and spectate premium amateur esports gameplay and entertainment, both physically and digitally. We celebrate everyday competitive gamers and provide a differentiated way for players and spectators to unite around their city clubs and hometown venues for a better, more inclusive social experience not previously available. Not only do we offer premium amateur esports leagues and community, but we are able to leverage our derivative gameplay content to become a comprehensive amateur esports content network. As we expand our city clubs, partner venue network, breadth of game titles and reach into the home, we bring new players into our customer funnel to drive audience growth, and ultimately, consumer and content monetization. In fiscal year 2019, management focused on the acceleration of development of the building blocks in place for our two primary revenue sources: (1) sponsorships and advertising revenues, the monetization of our content, and (2) direct to consumer revenues, or gamer monetization. Further, as detailed below, we further de-risked the business, achieving game title fluidity, venue diversity, and an enhanced and more scalable technology platform. We also established a premium advertising model for future monetization and expanded our sales team to facilitate delivery, launched our first effort at meaningful consumer monetization, and expanded globally, both digitally and physically. We offer a variety of ways gamers can engage digitally across our Super League content network and our network of hometown venues serving as the playing fields for recreational esports. In the first quarter of 2020, we expanded our city-based gaming club and league system from 16 to 24 cities across North America, including Canada and Mexico, and we expect further expansion beyond North America in the future. The fundamental drivers of our business model and monetization strategy are creating deep community engagement through our highly contextualized, local experiences that, when coupled with the critical mass of our large digital audiences, provides the depth and volume for premium content and offer monetization differentiated from a more traditional, commoditized advertising model. The combination of our physical venue network and digital programming channels, with Super League’s technology platform at the hub, creates the opportunity for not just a share of the player’s wallet, but also the advertiser’s wallet. We do this by offering brand sponsors and advertisers a premium marketing channel to reach elusive Generation Z and Millennial gamers and offering players ways to access exclusive tournaments, rewards and programming through our Super League consumer subscription offer and other consumer offerings. Sponsorships and advertising revenues, the monetization of our content. Traditionally, we have created our own gameplay experiences to generate audience and content and attracted brand and sponsorship dollars to those offers. This continues to be a core source of revenue. Our potential partners also include game publishers, retailers and brands across various categories who engage us to develop their own customized branded gameplay experiences, powered by our flexible gaming and content technology platform for their own customers. Additionally, we can monetize our content commercially through advertising revenues on our own digital channels and by selling our content to third-parties. Direct to Consumer - Gamer monetization. The second way we monetize content is through direct-to-consumer pay walls for access to premium digital and physical experiences and viewing content. We have historically offered a freemium model where consumers can join Super League for free-to-play, casual competitive experiences and charged for access to premium gameplay experiences. We intend to expand our breadth of consumer digital offers in 2020. To date, our revenues have been weighted towards experience monetization, however we expect to see content monetization begin to emerge as a revenue opportunity. Key Performance Indicators. We focus on five key performance indicators (“KPIs”), as outlined below, to assess our progress and drive revenue growth. The number of game titles and number of retail partner venues drive audience, introducing more players and spectators to Super League’s gaming and content platform. Growth in physical and digital experiences across a wider portfolio can increase the number of registered users, including subscribers, and number of gameplay hours which will have a significant impact on our content library. This focus on audience and content generation ultimately impacts our viewership, which has an amplification effect on potential revenue streams and customer acquisition. We significantly outperformed the KPI goals we established at the beginning of 2019, setting us up for fiscal 2020 with a focus on accelerated revenue growth. During 2019, we achieved the following KPI related results: ● Game titles: We ended fiscal 2018 with four game titles in our portfolio and as of the end of fiscal 2019, had over 20 game titles, including the addition of Capcom's Street Fighter® V: Arcade Edition during the second quarter of 2019 and Tencent America's Player Unknown's Battlegrounds Mobile (“PUBG Mobile”), during the third quarter of 2019. The increase in game titles reflects the flexibility of our technology platform and our platform’s ability to rapidly ingest game titles across a wide spectrum of game genres. Further, our digital content network, which features user-generated content submitted to us from any gamer, anywhere, has a limitless library of featured titles. The diversity of our portfolio differentiates us as a truly game-agnostic platform speaking to a wide spectrum of players and viewers. ● Retail Partner Venues: While we are just seeding the build out and monetization of our retail footprint, our national-level announcements with Top golf and ggCircuit LAN centers, as well as our expanded agreement with ggCircuit, which allows us to expand internationally, provides us with access to hundreds of physical venue locations. We ended fiscal 2018 with 46 active venues and grew to over 500 total active venues as of December 31, 2019. Our domestic and global footprint establishes us as a leader in aggregating local esports fields for everyday competitive gamers. ● Registered Users: We ended fiscal 2018 with approximately 300,000 registered users. During the year ended December 31, 2019, we increased our registered users by approximately 227%, to 980,000 registered users. This increase in registered users represents more gamers from whom we can gather user generated content and convert into subscribers and/or upsell into other paid offers. ● Gameplay Hours: As of December 31, 2019, including our live gaming experiences and our expanding digital gameplay channels, we generated approximately 15.0 million hours of gameplay experiences, as compared to approximately 1.8 million full year 2018 gameplay hours. We are just beginning to explore the ways we can repackage and distribute this significant derivative content library for further monetization. ● Viewership: Proving that we can attract viewers to our platform and leverage the audiences our brand partners provide, we generated 120.0 million views during fiscal year 2019, compared to our full-year 2018 views of 925,000, leveraging our own programming and experiences and the significant expansion of our audience reach in connection with the acquisition of Framerate. The increase in views resulted in the exponential growth of our monetizable advertising inventory. Additionally, our increase in views was achieved largely via user generated content submitted to us by our community, significantly limiting the production cost and overall investment required to achieve the growth in viewership in 2019. Initial Public Offering On February 27, 2019, we completed our IPO, pursuant to which we issued and sold an aggregate of 2,272,727 shares of our common stock at a public offering price of $11.00 per share pursuant to a registration statement on Form S-1, declared effective by the Securities and Exchange Commission on February 25, 2019 (File No. 333-229144). We raised net proceeds of approximately $22,458,000 after underwriting discounts, commissions and other offering costs of $2,542,000. The principal purposes of the IPO were to obtain additional capital to support our operations, to create a public market for our common stock and to facilitate our future access to the public equity markets. We have and continue to use the net proceeds received from the offering for working capital and general corporate purposes, including sales and marketing activities, product development and capital expenditures. We have and may continue to use a portion of the net proceeds for the strategic acquisition of, or investment in, technologies, solutions or businesses that may complement our business and or accelerate our growth. The amounts and timing of our actual expenditures, including expenditure related to sales and marketing and product development will depend on numerous factors, including the status of our product development efforts, our sales and marketing activities, expansion internationally, the amount of cash generated or used by our operations, competitive pressures and other factors described under “Risk Factors” in our Prospectus filed pursuant to Rule 424(b) under the Securities Act with the SEC on February 27, 2019, as well as Item I, Part 1A of this Report. Our management has broad discretion in the application of the net proceeds, and investors will be relying on our judgment regarding the application of the net proceeds from the IPO. Concurrent with the closing of the IPO on February 27, 2019, in accordance with the underlying agreements, all outstanding principal and interest for the 9.00% convertible notes outstanding, totaling $13,793,000, was automatically converted into 1,475,164 shares of the Company’s common stock at a conversion price of $9.35. Acquisition of Framerate, Inc. On June 3, 2019, the Company and SLG Merger Sub, Inc., a Delaware corporation and wholly-owned subsidiary of the Company (“Merger Sub”), entered into an agreement and plan of merger (the “Merger Agreement”) with Framerate, Inc., a Delaware corporation (“Framerate”), pursuant to which Framerate merged with and into Merger Sub, with Merger Sub continuing as the surviving corporation (the “Acquisition”). Framerate is a cross-platform esports social video network delivering the best in gameplay highlights, news and entertainment to today’s generation of video gamers. The company’s focus on user generated content and social distribution changes the way traditional esports video content is produced, distributed and shared by millions of esports fans worldwide. The acquisition of Framerate represents a strategic step in our audience-building efforts with an average of 15 million video views a month during the second half of 2019, built around everyday gamers uploading their personal esports highlight reels for recognition across our wide audience. The Acquisition was consummated on June 6, 2019 when the certificate of merger of Merger Sub and Framerate was filed with the Secretary of State of the State of Delaware (the “Effective Date”). As consideration for the Acquisition, we ratably paid and/or issued to the former shareholders of Framerate an aggregate of $1.5 million in cash and $1.0 million worth of shares of our common stock at a price per share of $7.4395 (the “Closing Shares”). In addition to the issuance of the Closing Shares, the Merger Agreement provides for the issuance of up to an additional $980,000 worth of shares of our common stock at the same price per share as the Closing Shares (the “Earn-Out Shares”) in the event Framerate achieves certain performance-based milestones during the two-year period following the closing of the Acquisition, or June 6, 2021. Upon achievement of the applicable performance-based milestones, if any, one-half of the Earn-Out Shares will be issuable on the one-year anniversary of the Effective Date, and the remaining one-half will be issuable on the second anniversary of the Effective Date. The Acquisition was approved by the board of directors of each of Super League Gaming, Inc. and Framerate, and was approved by the stockholders of Framerate. Refer to Note 5 to our financial statements included elsewhere herein for additional information about the Acquisition. Expanded Agreement with ggCircuit, LLC On September 23, 2019, Super League and ggCircuit, LLC (“ggCircuit”), an esports services company that provides gaming center management software solutions and other esports offerings, entered into an expanded commercial partnership agreement (“Expanded Agreement”) pursuant to which Super League became the primary consumer-facing brand within ggCircuit’s leading gaming center software platform, known as “ggLeap.” Under the terms of the Expanded Agreement, commencing with the November 2019 ggLeap software update release, the consumer facing components of ggLeap, including its leaderboards, its competitive seasons and its local loyalty programs, were rebranded as “Super League Gaming,” and are managed by Super League. ggLeap is a B2B software platform and B2C application created and owned by ggCircuit. ggLeap is licensed and distributed to owners and operators of video gaming centers throughout the world. It helps gaming centers manage the PCs in their venue, administer loyalty programs for local players, and provides the interface and local operating system through which players log into computers and launch all of their gameplay sessions within the gaming centers where ggLeap is deployed. The December 2019 software release included, the pilot launch of a consumer subscription offer, “Super League Prime,” through which players in gaming centers will be able to access special member benefits along with an underpinning global loyalty program for all in players to earn points and prizing for local rewards. In consideration for the rights granted by ggCircuit to Super League, including the right to commercially exploit Super League Prime and to feature the “Super League Gaming” brand on the applicable ggCircuit customer platform, Super League paid an upfront fee of $340,000 and, commencing in the first quarter of 2020, will pay quarterly fees over the term of the Expanded Agreement ranging from $0 to $150,000, based on contractual revenue levels. Pursuant to the terms and conditions of the Expanded Agreement, revenues generated in connection with applicable activities under the Expanded Agreement will be shared between Super League and ggCircuit based on contractual revenue sharing percentages. The initial term of the Expanded Agreement commences on the effective date and concludes on the fifth anniversary of the effective date, subject to certain automatic renewal provisions. The upfront fee is included in intangible assets and other, net in the accompanying balance sheet and is being amortized over the initial term of the Expanded Agreement of five years, commencing October 1, 2019. Wanda Cinemas Games Partnership In January 2020, we announced a new partnership with Wanda Cinemas Games, a subsidiary of Chinese media conglomerate Wanda Media. The new alliance will initially bring live, competitive gaming experiences to Wanda’s 700+ owned and operated theaters in multiple cities across China, with more activations to be announced in the future. This new venture provides Super League with the opportunity to greatly expand our reach into the world’s largest market of 1.2 billion gamers, more than the entire population of the United States. In the agreement, Wanda theatres will be transformed into esports venues hosting live Super League events and tournaments throughout China, driving an entirely new gaming experience for the massive Wanda customer base. Passionate players will see their local movie theatre serve as a competitive and social playing field for the video games they love. The unique gaming experiences created by Super League will propel Wanda venues to the center of the global esports phenomena. The partnership will continue to fuel Super League’s focus on the vast opportunity to monetize gamers and the content they generate. Prime Subscription Offer In December 2019, we launched in beta Super League Prime, our consumer subscription offer, in North America, with an international launch scheduled for 2020. Super League Prime is a subscription offer that recognizes and rewards players, both locally and globally, through ggCircuit-enabled gaming centers. Players can earn rewards for both the length and quality of their gameplay and gain exposure on national and local leaderboards. All participating players can earn a basic level of loyalty points for prizing redemption locally in-venue. Players who upgrade to our paid monthly subscription offer enjoy additional benefits including the ability to earn points faster, access to exclusive competitions and the Super League global prize vault, and added benefits from our brand sponsors. Critical Accounting Estimates Our financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. Preparation of our financial statements requires management to make judgments and estimates. Some accounting policies have a significant impact on amounts reported in our financial statements. The SEC has defined a company’s critical accounting policies as the ones that are most important to the portrayal of a company’s financial condition and results of operations, and which require a company to make its most difficult and subjective judgments. A summary of significant accounting policies and a description of accounting policies that are considered critical may be found in the audited financial statements and notes thereto included elsewhere herein. The following accounting policies were identified during the periods presented, based on activities occurring during the periods presented, as critical and requiring significant judgments and estimates. Revenue Recognition Revenue is recognized when we transfer promised goods or services to customers in an amount that reflects the consideration to which we expect to be entitled in exchange for those goods and services. In this regard, revenue is recognized when: (i) the parties to the contract have approved the contract (in writing, orally, or in accordance with other customary business practices) and are committed to perform their respective obligations; (ii) we can identify each party’s rights regarding the goods or services to be transferred; (iii) we can identify the payment terms for the goods or services to be transferred; (iv) the contract has commercial substance (that is, the risk, timing, or amount of the entity’s future cash flows is expected to change as a result of the contract); and (v) it is probable that the entity will collect substantially all of the consideration to which we will be entitled in exchange for the goods or services that will be transferred to the customer. Super League generates revenues and related cash flows from (i) brand and media sponsorships, (ii) Platform-As-A-Service arrangements, (iii) advertising and third-party content and (iv) direct to consumer offers including tournament fees for participation in our physical and online multiplayer gaming experiences, digital subscriptions and merchandise sales. Brand and Media Sponsorships. We generate brand and media sponsorship revenues primarily from sales of various forms of sponsorships and promotional campaigns for our online platforms and from sponsorship at our in-person esports experiences. Brand and media sponsorship revenue arrangements may include: exclusive or non-exclusive title sponsorships, marketing benefits, official product status exclusivity, product visibly and additional infrastructure placement, social media rights (including rights to create and post social content and clips), rights to on-screen activations and promotions, display material rights, media rights, hospitality and tickets and merchandising rights. Brand and media sponsorship arrangements typically include contract terms for time periods ranging from several weeks to multi-year arrangements. For brand and media sponsorship arrangements that include performance obligations satisfied over time, customers typically simultaneously receive and consume the benefits under the arrangement as we satisfy our performance obligations, over the applicable contract term. As such, revenue is recognized over the contract term based upon estimates of progress toward complete satisfaction of the contract performance obligations (typically utilizing a time, effort or delivery-based method of estimation). Platform-As-A-Service. We generate platform-as-a-service (“PaaS”) revenues pursuant to arrangements with brand and media partners, retail venues, game publishers and broadcasters that allow our partners to run amateur esports experiences, and or capture specifically curated gameplay content that is customized for our partners’ distribution channels, leveraging the flexibility of, and powered by our Super League gaming and content technology platform. Revenue for PaaS arrangements for one-off branded experiences and/or the development of content tailored specifically for our partners’ distribution channels that provide for a contractual delivery or performance date, is recognized when performance is substantially complete and or delivery occurs. Revenue for PaaS arrangements that include performance obligations satisfied over time whereby customers simultaneously receive and consume the benefits under the agreement as we satisfy our performance obligations over the applicable contract term, is recognized over the contract term based upon estimates of progress toward complete satisfaction of the contract performance obligations (typically utilizing a time, effort or delivery-based method of estimation). Advertising and Third-Party Content Revenue. We generate content through digital and physical experiences that offer opportunities for generating advertising revenue on our proprietary digital channels. In addition, we license our content to third parties seeking esports content for their own distribution channels. For advertising and third-party content arrangements that include performance obligations satisfied over time, customers typically simultaneously receive and consume the benefits under the arrangement as we satisfy our performance obligations, over the applicable contract term. As such, revenue is recognized over the contract term based upon estimates of progress toward complete satisfaction of the contract performance obligations (typically utilizing a time, effort or delivery-based method of estimation). Direct to Consumer Revenue. Direct to consumer revenues include tournament fees, digital subscriptions and merchandise. Direct to consumer revenues have primarily consisted of the sale of season passes to gamers for participation in our in-person and or online multiplayer gaming experiences. For the periods presented herein, season passes for gaming experiences were comprised of multi-week packages and one-time, single experience admissions. Digital subscription revenues include revenues related to our Minehut asset acquisition in June 2018, which provides various Minecraft server hosting services on a subscription basis to the Minecraft gaming community, and Super League Prime subscription offer which was launched in beta in the fourth quarter of 2019. Revenue from single experiences is recognized when the experience occurs. Revenue from multi-week packages is recognized over time as the multi-week experiences occur based on estimates of the progress toward complete satisfaction of the applicable offer and related performance obligations. Subscription revenue is recognized over the applicable subscription term. We make estimates and judgments when determining whether the collectability of accounts receivable is reasonably assured. We assess the collectability of receivables based on a number of factors, including past transaction history and the credit-worthiness of our customers. If it is determined that collection is not reasonably assured, amounts due are recognized when collectability becomes reasonably assured, assuming all other revenue recognition criteria have been met, which is generally upon receipt of cash for transactions where collectability may have been an issue. Management’s estimates regarding collectability impact the actual revenues recognized each period and the timing of the recognition of revenues. Our assumptions and judgments regarding future collectability could differ from actual events and thus materially impact our financial position and results of operations. Depending on the complexity of the underlying revenue arrangement and related terms and conditions, significant judgments, assumptions and estimates may be required to determine each parties rights regarding the goods or services to be transferred, each parties performance obligations, whether performance obligations are satisfied at a point in time or over time, the timing of satisfaction of performance obligations, and the appropriate period or periods in which, or during which, the completion of the earnings process occurs. Depending on the magnitude of specific revenue arrangements, if different judgments, assumptions and estimates are made regarding revenue arrangements in any specific period, our periodic financial results may be materially affected. Stock-Based Compensation Expense Compensation expense for stock-based awards is measured at the grant date, based on the estimated fair value of the award, and is recognized as an expense, typically on a straight-line basis over the employee’s requisite service period (generally the vesting period of the equity award), which is generally two to four years. Compensation expense for awards with performance conditions that affect vesting is recorded only for those awards expected to vest or when the performance criteria are met. The fair value of restricted stock and restricted stock unit awards is determined by the product of the number of shares or units granted and the grant date market price of the underlying common stock. The fair value of stock option and common stock purchase warrant awards is estimated on the date of grant utilizing the Black-Scholes-Merton option pricing model. The Company accounts for forfeitures of awards as they occur. Grants of equity-based awards (including warrants) to non-employees in exchange for consulting or other services are accounted for using the fair value of the consideration received (i.e., the value of the goods or services) or the fair value of the equity instruments issued, whichever is more reliably measurable. Determining the fair value of stock-based awards at the grant date requires significant estimates and judgments, including estimating the market price volatility of our common stock, determination of grant dates, future employee stock option exercise behavior and requisite service periods. Accounting for Business Combinations In connection with the application of purchase accounting for the acquisition of Framerate, as described above, we estimated the fair values of the assets acquired and liabilities assumed. A fair value measurement is determined as the price we would receive to sell an asset or pay to transfer a liability in an orderly transaction between market participants at the measurement date. In the absence of active markets for the identical assets or liabilities, such measurements involve developing assumptions based on market observable data and, in the absence of such data, internal information that is consistent with what market participants would use in a hypothetical transaction that occurs at the measurement date. In the context of purchase accounting, the determination of fair value often involves significant judgments and estimates by management, including the selection of valuation methodologies, estimates of future revenues, costs and cash flows, discount rates, and selection of comparable companies. The estimated fair values reflected in the purchase accounting rely on management’s judgment and the expertise of a third-party valuation firm engaged to assist in concluding on the fair value measurements. Results of Operations Results of Operations for Fiscal Years 2019 and 2018 The following table sets forth a summary of our statements of operations for the years ended December 31, 2019 and 2018: Comparison of the Results of Operations for Fiscal Years 2019 and Revenue Revenue for fiscal year 2019 increased $38,000, or 4%, compared to fiscal year 2018. Revenues for the periods presented was comprised of the following: Sponsorships and Advertising: ● Brand and Media Sponsorships. Period to period changes in brand and media sponsorship revenues are attributable to fluctuations in brand and media sponsorship activities period to period, which is based on the specific partnership arrangements with activities during a particular period, the related performance obligations satisfied during the period and the contractual consideration associated with the activities during the period. Brand and media sponsorship revenues for fiscal year 2019 included revenues for our Red Bull North America, Inc. (“Red Bull”) brand partnership, Red Bull Allstars experience in April 2019, Logitech G Challenge and Play/Train/Win online tournaments, Sony related build competitions and related experiences and our Red Games Lego Brawls live stream sponsorship activation. Brand and media sponsorship revenues for fiscal year 2018 was primarily comprised of revenues from our Logitech, Inc. and Red Bull brand sponsorships and our 2018 Red Bull Allstars experience. ● Platform-As-A-Service. We generate PaaS revenues pursuant to arrangements with brand and media partners, retail venues, game publishers and broadcasters that allow our partners to hold amateur esports experiences, and or capture specifically curated gameplay content that is customized for our partners’ distribution channels, leveraging the flexibility of, and powered by our Super League gaming and content technology platform. PaaS revenue for fiscal year 2019 included revenues from our Samsung Fortnite event held in New York in March 2019, Capcom, Inc. related to our Street Fighter® V: Arcade Edition partnership, Sony related to certain build competitions and related experiences, Sprint related to our Sprint 5G LA activation, our Cox Paladins gameplay experience and our Tencent Games and OnePlus Mobile Player Unknown’s Battlegrounds Mobile, or PUBG Mobile, premium content, competitive experiences and sponsorship activation. ● Advertising and Content Sales. Revenues for fiscal year 2019 included revenues from campaigns launched related to our Framerate acquisition and advertising revenues from Snapchat related content sales and our Minehut digital property. Revenues for fiscal year 2018 included revenues from the sale of gameplay and other content generated by us to Nickelodeon (third-party broadcaster) to supplement their YouTube channel programming. We expect to continue to expand our advertising revenue and revenue from the sale of our proprietary and third-party content derived from our technology platform in future periods, as we expand our advertising inventory, viewership and related sales activities. Direct to Consumer: ● The decrease in direct to consumer revenue was primarily due to a decrease in the number of paid events held during fiscal year 2019, as compared to the prior year period. During fiscal year 2019, we held paid events and a higher number of events that were free to play, consistent with our strategic focus on increasing the volume of new gamers and spectators introduced into our customer funnel, to increase the number of registered users on our platform, drive consumer conversion, and increase the overall awareness of the Super League brand and technology platform offerings. We intend to continue to offer a combination of paid and free to play experiences going forward. Digital subscription revenues included in direct to consumer revenues for fiscal year 2019 were primarily comprised of subscription revenues related to our Minehut digital property acquired in June 2018, which provides various Minecraft server hosting services on a subscription basis to the Minecraft gaming community. Cost of Revenue Cost of revenue for fiscal year 2019 decreased $171,000 or 25% compared to fiscal year 2018, as compared to a 4% increase in revenues for the same periods. The trend in cost of sales for the periods presented was primarily due to operational efficiencies and lower direct costs incurred for fiscal year 2019 in connection with our physical and digital experiences. Operating Expenses Selling, Marketing and Advertising. The increase in selling, marketing and advertising expense was primarily due to a 27% increase in personnel costs associated with the continued expansion of our operations requiring additional internal resources across our product, creative and commercial departments, and an increase in marketing and promotional experiences focused on widening our customer funnel and attracting increased numbers of registered users to our platform. The increase included increased costs related to contract labor, influencers, event operations, content capture and other costs to execute various marketing and promotional experiences during the period. The increase was partially offset by a decrease in amortization of noncash in-kind advertising costs, totaling $667,000, which were initially capitalized pursuant to a June 2017 third-party investment agreement. The investment agreement included in-kind advertising for use in future periods, valued at $1.0 million, as a component of the consideration paid to us in exchange for equity in the Company. The prepaid advertising cost was amortized over an 18-month period ending as of December 31, 2018. Technology Platform and Infrastructure. Technology platform and infrastructure costs include (i) allocated personnel costs, including salaries, noncash stock compensation, taxes and benefits related to our internal software developers and engineers, employed by Super League, engaged in the operation, maintenance, management, administration, testing, development and enhancement of our proprietary gaming and content technology platform, (ii) third-party contract software development and engineering resources engaged in developing and enhancing our proprietary gaming and content technology platform, (iii) the amortization of capitalized internal use software costs, and (iv) technology platform related cloud services and broadband costs. Capitalized internal use software development costs are amortized on a straight-line basis over the software’s estimated useful life. The period over period increase primarily reflects an increase in engineering headcount since the end of the prior year in connection with the expansion of our engineering and internal use software development activities and an increase in technology platform related cloud services costs. General and Administrative. General and administrative expense for the periods presented was comprised of the following: A summary of the main drivers of the net increase in general and administrative expenses for the periods presented is as follows: ● General and administrative personnel costs increased 45%, primarily due to approximately $455,000 of management performance-based bonuses paid in connection with the achievement of certain performance-based milestones during fiscal year 2019, including the closing of the IPO and other operational performance targets. The increase in personnel costs also reflects an increase in recruiting expense and a 4% net increase in personnel expense compared to the prior year period in connection with the expansion of our operations. During fiscal year 2019 and 2018, across all departments, we had average full-time equivalent employees of 51 and 44, respectively. ● Office and facilities expense increased 9%, primarily due to an increase in leased office space commencing in June 2018 in connection with the expansion of our SLG.TV studio operations. ● Noncash stock compensation expense included in general and administrative expense increased 69%, primarily due to certain performance options and warrants previously granted to certain executives, which vested upon the achievement of certain performance-based milestones, pursuant to October 2018 amended employee agreements and/or vesting conditions in the underlying equity grant agreements. Performance targets included the completion of our IPO in February 2019 and other operational performance targets. During fiscal year 2019, approximately 300,000 of performance-based stock options and warrants vested with grant date fair values ranging from $8.28 to $8.50, resulting in noncash stock compensation expense of $2,617,000. The remaining increase also reflects $58,000 of stock-based compensation expense related to our acquisition of Framerate, as described at Note 8 to the financial statements included elsewhere herein. ● Depreciation and amortization expense decreased 48% due primarily to a decrease in scheduled amortization related to fully depreciated assets with useful lives that expired during fiscal 2019 or prior, and the acceleration of depreciation related to certain networking and related equipment disposed of during fiscal 2019. ● Professional fees and other general and administrative expenses increased 12% and 179%, respectively, primarily due to a significant increase in directors and officer's insurance premiums in connection with our February 2019 IPO, and an increase in legal, audit and other administrative public company costs. Other Income (expense) Other income (expense), net, for fiscal year 2019 and 2018, totaling $9,909,000 and $4,467,000, respectively, was primarily comprised of interest expense related to the convertible notes outstanding during the periods presented as follows: Interest Expense. Interest expense for the periods presented primarily relates to the issuance of 9.00% secured convertible promissory notes, commencing in February 2018 through August 2018, as described below under Liquidity and Capital Resources. Principal and interest as of February 27, 2019, the closing date of the IPO and December 31, 2018 totaled $13,793,000 and $13,606,000, respectively. Concurrent with the closing of the IPO on February 27, 2019, in accordance with the related agreements, all outstanding principal and interest for the 9.00% convertible notes outstanding was automatically converted into 1,475,164 shares of the Company’s common stock at a conversion price of $9.35. As of and subsequent to February 27, 2019, we have no debt outstanding. As a result of the automatic conversion of the 2018 Notes (defined below) and the application of conversion accounting, the Company recorded an immediate charge to interest expense of $1,384,000, representing the write-off of the unamortized balance of debt discounts associated with the 2018 warrants and cash commissions and warrants issued to third parties. Unamortized debt discounts at December 31, 2018 totaled $2,684,000, respectively. The non-detachable conversion feature embedded in the 2018 Notes provides for a conversion rate that was below market value at the commitment date, and therefore, represented a beneficial conversion feature (“BCF”). The BCF is generally recognized separately at issuance by allocating a portion of the debt proceeds equal to the intrinsic value of the BCF to additional paid-in capital. The resulting convertible debt discount is recognized as interest expense using the effective yield method. However, the conversion feature associated with the 2018 Notes was not exercisable until the consummation of an initial public offering by the Company of its common stock, and therefore, was not required to be recognized in earnings until the IPO related contingency was resolved, which occurred on the IPO Closing Date. The commitment date is the IPO Closing Date and the commitment date stock price was $11.00 per share. The intrinsic value of the BCF on the IPO Closing Date, which was limited to the net proceeds allocated to the debt on a relative fair value basis, was approximately $7,067,000, and is reflected as additional interest expense in the statement of operations for the year ended December 31, 2019. Liquidity and Capital Resources General Cash and cash equivalents totaled $8.4 million and $2.8 million at December 31, 2019 and 2018, respectively. We have experienced net losses and negative cash flows from operations since our inception. As of December 31, 2019 and 2018, we had working capital of approximately $8.7 million and ($8.0) million, respectively, and sustained cumulative losses since inception attributable to common stockholders of approximately $85.8 million. Total noncash charges included in accumulated deficit since inception, primarily related to noncash stock compensation, restricted stock units issued in connection with a license agreement, amortization of the discount on the 2018 Notes (defined below) and in-kind advertising expense, totaled approximately $34.6 million. On February 27, 2019, we completed our IPO, pursuant to which we issued and sold an aggregate of 2,272,727 shares of our common stock at a public offering price of $11.00 per share pursuant to a registration statement on Form S-1, declared effective by the Securities and Exchange Commission on February 25, 2019 (File No. 333-229144). We raised net proceeds of approximately $22,458,000 after underwriting discounts, commissions and other offering costs of $2,542,000. During Fiscal 2018, the Company issued 9.00% secured convertible promissory notes, as described below, in an aggregate principal amount of approximately $13,000,000. Concurrent with the closing of the IPO on February 27, 2019, in accordance with the related agreements, all outstanding principal and interest for the 9.00% convertible notes outstanding was automatically converted into shares of the Company’s common stock as described below. Approximately 1.3 million of the warrants issued in conjunction with the 2018 Notes are callable at the election of the Company at any time following the completion of our IPO. To date, our principal sources of capital used to fund our operations have been the net proceeds we received from sales of equity securities and proceeds received from the issuance of convertible debt, as described herein. We have and will continue to use significant capital for the growth and development of our business. Our management team expects operating losses to continue in the near term in connection with the pursuit of our strategic objectives. As such, we believe our current cash position, absent receipt of additional capital either from operations or that may be available from future issuance(s) of common stock or debt financings, is not sufficient to fund our planned operations for the twelve months following the date of this Report. We believe these conditions raise substantial doubt about our ability to continue as a going concern. In addition, we may encounter unforeseen difficulties that may deplete our capital resources more rapidly than anticipated, including those set forth under the heading “Risk Factors” included in Part 1, Item 1A of this Report. We are focused on expanding our service offerings and revenue growth opportunities through internal development, collaborations, and through one or more strategic acquisitions. Management is currently exploring several alternatives for raising capital to facilitate our growth and execute our business strategy, including strategic partnerships or other forms of equity or debt financings. We continue to evaluate potential strategic acquisitions. To finance such strategic acquisitions, we may find it necessary to raise additional equity capital, incur additional debt, or both. Any efforts to seek additional funding could be made through issuances of equity or debt, or other external financing. However, additional funding may not be available on favorable terms, or at all. The capital and credit markets have experienced extreme volatility and disruption periodically and such volatility and disruption may occur in the future. If we fail to obtain additional financing when needed, we may not be able to execute our business plans which, in turn, would have a material adverse impact on our financial condition, our ability to meet our obligations, and our ability to pursue our business strategies. Cash Flows for Fiscal Years 2019 and 2018 The following table summarizes the change in cash balances for the periods presented: Cash Flows from Operating Activities. Net cash used in operating activities during fiscal year 2019 was $13,646,000, which primarily reflected our net GAAP loss of $30,679,000, net of adjustments to reconcile net GAAP loss to net cash used in operating activities of $17,033,000, which included $6,217,000 of noncash stock compensation charges, $2,871,000 of noncash accrued interest and accretion of debt discount, $7,067,0000 of noncash interest expense related to the recognition of the beneficial conversion feature upon the automatic conversion of the 2018 Notes upon close of the IPO, and depreciation and amortization of $862,000. Changes in working capital primarily reflected the impact of the prepayment of increased directors and officer’s insurance premiums in connection with the consummation of our IPO and the settlement of payables in the ordinary course. Net cash used in operating activities during fiscal year 2018 was $10,680,000, which primarily reflected our net loss of $20,627,000, net of adjustments to reconcile net loss to net cash used in operating activities of $9,947,000, which included $3,942,000 of non-cash stock compensation, noncash amortization of prepaid in-kind advertising totaling $667,000 and $1,106,000 of non-cash depreciation and amortization charges. Changes in working capital primarily reflected increases in receivables and the settlement of payables in the ordinary course of business during the period. Cash Flows from Investing Activities. Cash flows from investing activities were comprised of the following for the periods presented: Acquisition of Framerate, Inc. On June 3, 2019, the Company and Merger Sub, entered into the Merger Agreement with Framerate, pursuant to which Framerate merged with and into Merger Sub, with Merger Sub continuing as the surviving corporation. The Acquisition was consummated on the Effective Date when the certificate of merger of Merger Sub and Framerate was filed with the Secretary of State of the State of Delaware. As consideration for the Acquisition, we ratably paid and/or issued to the former shareholders of Framerate an aggregate of $1.5 million in cash and $1.0 million worth of shares of our common stock, at a price per share of $7.4395, which price was equal to the volume weighted average price of our common stock over the five trading days preceding the date of the Merger Agreement, as reported on the Nasdaq Capital Market. In addition to the issuance of the Closing Shares, the Merger Agreement provides for the issuance of up to an additional $980,000 worth of shares of our common stock at the same price per share as the Closing Shares in the event Framerate achieves certain performance-based milestones during the two-year period following the closing of the Acquisition, or June 6, 2021. One-half of the Earn-Out Shares will be issuable on the one-year anniversary of the Effective Date, and the remaining one-half will be issuable on the second anniversary of the Effective Date. Expanded Agreement with ggCircuit. On September 23, 2019, the Company and ggCircuit entered into an Expanded Agreement pursuant to which Super League became the primary consumer facing brand within ggCircuit’s B2B gaming center software platform. In consideration for the rights granted by ggCircuit to Super League, Super League paid an upfront fee of $340,000 in the fourth quarter of 2019. The upfront fee is included as "Licenses" in intangible assets and other assets, net, in the accompanying balance sheet and is being amortized over the initial term of the Expanded Agreement of five years, commencing October 1, 2019. Capitalized Internal Use Software Costs. Software development costs incurred to develop internal-use software during the application development stage are capitalized and amortized on a straight-line basis over the software’s estimated useful life, which is generally three years. Software development costs incurred during the preliminary stages of development are charged to expense as incurred. Maintenance and training costs are charged to expense as incurred. Upgrades or enhancements to existing internal-use software that result in additional functionality are capitalized and amortized on a straight-line basis over the applicable estimated useful life. Cash Flows from Financing Activities. Cash flows from financing activities were comprised of the following for the periods presented: Initial Public Offering. On February 27, 2019, we completed our IPO, pursuant to which we issued and sold an aggregate of 2,272,727 shares of our common stock at a public offering price of $11.00 per share. We raised net proceeds of approximately $22,458,000 after deducting underwriting discounts, commissions and other offering costs of $2,542,00. The net proceeds received from the offering have been used for working capital and general corporate purposes, including sales and marketing activities, product development and capital expenditures. We have, and may in the future, use a portion of the net proceeds for the acquisition of, or investment in, technologies, solutions or businesses that may compliment or business and or accelerate or growth. The amounts and timing of our actual expenditure, including expenditure related to sales and marketing and product development will depend on numerous factors, including the status of our product development efforts, our sales and marketing activities, expansion internationally, the amount of cash generated or used by our operations, competitive pressures and other factors described under “Risk Factors” in our Prospectus filed pursuant to Rule 424(b) under the Securities Act with the SEC on February 27, 2019, as well as Item I, Part 1A of this Report. Our management has broad discretion in the application of the net proceeds, and investors will be relying on our judgment regarding the application of the net proceeds from the IPO. Pursuant to the related underwriting agreement, in connection with the completion of the IPO, for the purchase price of $50.00, we issued a warrant to purchase shares of our common stock equal to 3.0% of the shares sold in the IPO, or 68,182 shares, at an exercise price of $11.00 per share (the “Underwriters’ Warrants”). The Underwriters’ Warrants are exercisable during the period commencing from the date of the close of the IPO and ending five years from the closing date of the IPO. The Underwriters’ Warrants represent additional noncash offering costs, with an estimated grant date fair value of $547,000, which was reflected in additional-paid-in capital when issued and as a corresponding offering cost in the statement of shareholders equity for the year ended December 31, 2019. Convertible Debt Issuances. In February and April 2018, we issued 9.00% secured convertible promissory notes with a collective face value of $3,000,000 (the “Initial 2018 Notes”). The Initial 2018 Notes (i) accrued simple interest at the rate of 9.00% per annum, (ii) matured on the earlier of December 31, 2018 or the close of a $15,000,000 equity financing (“Qualifying Equity Financing”) by us, and (iii) all outstanding principal and accrued interest was automatically convertible into equity or equity-linked securities sold in a Qualifying Equity Financing based upon a conversion rate equal to (x) a 10% discount to the price per share of a Qualifying Equity Financing, with (y) a floor of $10.80 per share. In addition, the holders of the Initial 2018 Notes were collectively issued warrants to purchase approximately 55,559 shares of common stock, at an exercise price of $10.80 per share and a term of five years (the “Initial 2018 Warrants”). In May through August 2018, we issued additional 9.00% secured convertible promissory notes with a collective face value of $10,000,000 (the “Additional 2018 Notes”). In May 2018, all of the Initial 2018 Notes and related accrued interest, totaling $3,056,182, were converted into the Additional 2018 Notes, resulting in an aggregate principal amount of $13,056,182 (hereinafter collectively, the “2018 Notes”). The holders of the converted Initial 2018 Notes retained their respective Initial 2018 Warrants. The 2018 Notes (i) accrued simple interest at the rate of 9.00% per annum, (ii) matured on the earlier of the closing of an IPO of our common stock on a national securities exchange or April 30, 2019, and (iii) all outstanding principal and accrued interest was automatically convertible into shares of common stock upon the closing of the IPO at the lesser of (x) $10.80 per share or (y) a 15% discount to the price per share of the IPO. In addition, the holders of the 2018 Notes were collectively issued 1,396,383 warrants to purchase common stock equal to 100% of the aggregate principal amount of the 2018 Notes divided by $9.35 per share (the “2018 Warrants”). The 2018 Warrants are exercisable for a term of five years, commencing on the close of the IPO, at an exercise price equal to the lesser of (x) $10.80 per share or (y) a 15% discount to the IPO price per share and are callable at our election at any time following the closing of an IPO. Concurrent with the closing of the IPO on February 27, 2019, in accordance with the related agreements, all outstanding principal and interest for the 9.00% convertible notes outstanding, totaling $13,793,000, was automatically converted into 1,475,164 shares of the Company’s common stock at a conversion price of $9.35. As of December 31, 2019, there is no debt outstanding. Refer to Note 6 to the accompany financial statements elsewhere in this Report for additional information. Contractual Obligations As of December 31, 2019, except as described below, we had no significant commitments for capital expenditures, nor do we have any committed lines of credit, noncancelable operating leases obligations, other committed funding or long-term debt, and no guarantees. The operating lease for our corporate headquarters expired on May 31, 2017 and was subsequently amended to operate on a month-to-month basis. In consideration for the rights granted by ggCircuit to Super League in connection with the Expanded Agreement described above, including the right to commercially exploit Super League Prime and to feature the “Super League Gaming” brand on the applicable ggCircuit customer platform, commencing in the first quarter of 2020, Super League will pay quarterly fees over the term of the Expanded Agreement ranging from $0 to $150,000, based on contractual revenue levels. Off-Balance Sheet Commitments and Arrangements We have not entered into any off-balance sheet financial guarantees or other off-balance sheet commitments to guarantee the payment obligations of any third parties. We have not entered into any derivative contracts that are indexed to our shares and classified as stockholder’s equity or that are not reflected in our financial statements included elsewhere herein. Furthermore, we do not have any retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to such entity. We do not have any variable interest in any unconsolidated entity that provides financing, liquidity, market risk or credit support to us or engages in leasing, hedging or product development services with us. Contingencies Certain conditions may exist as of the date the financial statements are issued, which may result in a loss to the Company, but which will only be resolved when one or more future events occur or fail to occur. The Company’s management, in consultation with its legal counsel as appropriate, assesses such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against the Company or unasserted claims that may result in such proceedings, the Company, in consultation with legal counsel, evaluates the perceived merits of any legal proceedings or unasserted claims, as well as the perceived merits of the amount of relief sought or expected to be sought therein. If the assessment of a contingency indicates it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in the Company’s financial statements. If the assessment indicates a potentially material loss contingency is not probable, but is reasonably possible, or is probable, but cannot be estimated, then the nature of the contingent liability, together with an estimate of the range of possible loss, if determinable and material, would be disclosed. Loss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the guarantees would be disclosed. Recent Accounting Pronouncements Refer to Note 2 to the financial statements included elsewhere herein. Relaxed Ongoing Reporting Requirements Upon the completion of our IPO, we elected to report as an “emerging growth company” (as defined in the JOBS Act) under the reporting rules set forth under the Exchange Act. For so long as we remain an “emerging growth company,” we may take advantage of certain exemptions from various reporting requirements that are applicable to other Exchange Act reporting 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; ● taking advantage of extensions of time to comply with certain new or revised financial accounting standards; ● being permitted to comply with reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements; and ● being exempt from the requirement to hold a non-binding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. We are subject to ongoing public reporting requirements that are less rigorous than Exchange Act rules for companies that are not “emerging growth companies,” and our stockholders could receive less information than they might expect to receive from more mature public companies. We expect to take advantage of these reporting exemptions until we are no longer an emerging growth company. We will remain an “emerging growth company” for up to five years, although if the market value of our Common Stock that is held by non-affiliates exceeds $700 million as of any June 30 before that time, we would cease to be an “emerging growth company” as of the following December 31.

<s>[INST] General Super League Gaming, Inc. (“Super League,” the “Company,” “we” or “our”) is a global leader in the mission to bring live and digital esports entertainment and experiences directly to everyday competitive gamers around the world. Utilizing our proprietary technology platform, Super League operates physical and digital experiences in partnership with publishers of toptier game titles and owners/operators of a distributed footprint of venues, a network of digital social and viewing channels, and an association/organization of citybased amateur gaming clubs and teams. In addition to providing premium experiences by operating cityvscity amateur esports leagues and producing thousands of social gaming experiences across North America and our everexpanding international footprint, the Super League Network features multiple forms of content celebrating the love of play via social media, live streaming and videoondemand, along with continuous gameplay and leaderboards. Inside our network is Framerate, a large independent social video esports network powered by usergenerated highlight reels, and our exclusive proprietary platform Minehut, providing a social and gameplay forum for the avid Minecraft community. Through our partnerships with highprofile venue owners such as Wanda Theatres in China, and Topgolf and Cinemark Theatres in North America, along with ggCircuit, an esports services company that provides gaming center management software solutions and access to a global network of gaming centers, Super League is committed to supporting the development of local, grassroots player communities, while providing a global, scalable infrastructure for esports competition and engagement. We address not only a wide range of gamers across game titles, ages and skill levels, but also a wide range of contentcapture beyond just gameplay. This positions Super League as more than a tournament operator; we are a lifestyle and media company focused on capturing, generating, aggregating and distributing content across the genre of all things esports. Executive Summary We believe Super League is on the leading edge of the rapidly growing competitive video gaming industry, which has become an established and vital part of the entertainment landscape. According to Reuters Plus, 2018, gaming is now the world’s favorite form of entertainment, as the gaming industry generated more revenue in 2017 than television, movies and music. At the professional level, thousands of professional players on hundreds of teams compete in dozens of high stakes competitions that draw significant audiences, both in person and online. In addition, the value of brand sponsorships, media rights and prize money continue to rise, as are professional team valuations and the purchase price for securing franchises in professional leagues. With NewZoo reporting 2.6 billion gamers globally, we believe there is a larger opportunity for the world of mainstream competitive players who want their own esports experience. These amateur gamers are players who enjoy the competition, the social interaction and community, and the entertainment value associated with playing and watching others play. According to Nielsen Esports Playbook, 2017, competitive amateur gamers take part in over eight hours of gameplay and watch up to nine hours of esportsrelated content each week. We believe this is an underserved market that seeks their own opportunities for teambased play on real playing fields. Super League is a critically important component in providing the infrastructure for mainstream esports that is synergistic and accretive to the greater esports ecosystem. Over the past five years, we believe we have become the preeminent brand for amateur esports by providing a proprietary software platform that allows our gamers to compete, socialize and spectate premium amateur esports gameplay and entertainment, both physically and digitally. We celebrate everyday competitive gamers and provide a differentiated way for players and spectators to unite around their city clubs and hometown venues for a better, more inclusive social experience not previously available. Not only do we offer premium amateur esports leagues and community, but we are able to leverage our derivative gameplay content to become a comprehensive amateur esports content network. As we expand our city clubs, partner venue network, breadth of game titles and reach into the home, we bring new players into our customer funnel to drive audience growth, and ultimately, consumer and content monetization. In fiscal year 2019, management focused on the acceleration of development of the building blocks in place for our two primary revenue sources: (1) sponsorships and advertising revenues, the monetization of [/INST] Negative. </s>

KURA SUSHI USA, INC.

2019-11-26

2019-08-31

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 “Selected Financial Data” and our financial statements and the related notes and other financial information included elsewhere in this report. Some of the information contained in this discussion and analysis or set forth elsewhere in this report, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. You should review the “Special Note Regarding Forward-Looking Statements” and “Risk Factors” sections of this 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. Overview Kura Sushi USA, Inc. is a fast-growing, technology-enabled Japanese restaurant concept that provides guests with a distinctive dining experience by serving authentic Japanese cuisine through an engaging revolving sushi service model, which we refer to as the “Kura Experience”. We encourage healthy lifestyles by serving freshly prepared Japanese cuisine using high-quality ingredients that are free from artificial seasonings, sweeteners, colorings, and preservatives. We aim to make quality Japanese cuisine accessible to our guests across the United States through affordable prices and an inviting atmosphere. Business Trends We have expanded our restaurant base from eight restaurants in California as of the beginning of fiscal year 2016 to 23 restaurants in five states as of the end of fiscal year 2019. We opened four restaurants in fiscal year 2018 and six restaurants in fiscal year 2019. We expect to open six new restaurants in fiscal year 2020 and therefore, we expect our revenue and restaurant operating costs to significantly increase in fiscal year 2020. Additionally, we expect our general and administrative expenses will increase as a percentage of sales in our fiscal year 2020 due to additional costs associated with being a public company. Key Financial Definitions Sales. Sales represent sales of food and beverages in restaurants. Restaurant sales in a given period are directly impacted by the number of restaurants we operate and comparable restaurant sales growth. Food and beverage costs. Food and beverage costs are variable in nature, change with sales volume and are influenced by menu mix and subject to increases or decreases based on fluctuations in commodity costs. Other important factors causing fluctuations in food and beverage costs include seasonality and restaurant-level management of food waste. Food and beverage costs are a substantial expense and are expected to grow proportionally as our sales grows. Labor and related expenses. Labor and related expenses include all restaurant-level management and hourly labor costs, including wages, employee benefits and payroll taxes. Similar to the food and beverage costs that we incur, labor and related expenses are expected to grow proportionally as our sales grows. Factors that influence fluctuations in our labor and related expenses include minimum wage and payroll tax legislation, the frequency and severity of workers’ compensation claims, healthcare costs and the performance of our restaurants. Occupancy and related expenses. Occupancy and related expenses include rent for all restaurant locations and related taxes. Depreciation and amortization expenses. Depreciation and amortization expenses are periodic non-cash charges that consist of depreciation of fixed assets, including equipment and capitalized leasehold improvements. Depreciation is determined using the straight-line method over the assets’ estimated useful lives, ranging from three to 20 years. Other costs. Other costs include utilities, repairs and maintenance, credit card fees, royalty payments to Kura Japan, stock-based compensation expenses for restaurant-level employees and other restaurant-level expenses. General and administrative expenses. General and administrative expenses include expenses associated with corporate and regional supervision functions that support the operations of existing restaurants and development of new restaurants, including compensation and benefits, travel expenses, stock-based compensation expenses for corporate-level employees, legal and professional fees, marketing costs, information systems, corporate office rent and other related corporate costs. General and administrative expenses are expected to grow as our sales grows, including incremental legal, accounting, insurance and other expenses incurred as a public company. Interest expense. Interest expense includes cash and non-cash charges related to our line of credit and capital lease obligations. Interest income. Interest income includes income earned on our investments. Income tax expense (benefit). Provision for income taxes represents federal, state and local current and deferred income tax expense. Results of Operations The following table presents selected comparative results of operations from our audited financial statements for the fiscal year ended August 31, 2019 compared to the fiscal year ended August 31, 2018, and the fiscal year ended August 31, 2018 compared to the fiscal year ended August 31, 2017. Our financial results for these periods are not necessarily indicative of the financial results that we will achieve in future periods. Certain totals for the table below may not sum to 100% due to rounding. Fiscal Year Ended August 31, 2019 Compared to Fiscal Year Ended August 31, 2018 Sales. Sales were $64.2 million for fiscal year 2019 compared to $51.7 million for fiscal year 2018, representing an increase of approximately $12.5 million, or 24.2%. The increase in sales was primarily driven by six new restaurants that opened during fiscal year 2019 and a full year of sales related to the four restaurants that opened in fiscal year 2018, as well as a 6.2% comparable restaurant sales growth and increase in menu prices. The increase was partially offset by the loss of sales from the closure of the Laguna Hills restaurant in the last month of fiscal year 2018. Food and beverage costs. Food and beverage costs were $21.0 million for fiscal year 2019 compared to $17.6 million for fiscal year 2018, representing an increase of approximately $3.4 million, or 19.6%. The increase in food and beverage costs was primarily driven by sales from the six new restaurants that opened during fiscal year 2019 and a full year of expenses related to the four restaurants that opened in fiscal year 2018. As a percentage of sales, food and beverage costs decreased to 32.8% in fiscal year 2019, compared to 34.0% in fiscal year 2018. The decrease in food and beverage costs as a percentage of sales was primarily driven by the increases in our menu prices. Labor and related costs. Labor and related costs were $19.9 million for fiscal year 2019 compared to $16.0 million for fiscal year 2018, representing an increase of approximately $3.9 million, or 24.7%. The increase in labor and related costs was driven by additional labor costs incurred with respect to the six new restaurants that opened during fiscal year 2019 and a full year of expenses related to the four restaurants that opened in fiscal year 2018, as well as wage increases. As a percentage of sales, labor and related costs remained consistent at 31.0% in fiscal year 2019, compared to 30.9% in fiscal year 2018. Occupancy and related expenses. Occupancy and related expenses were $4.6 million for fiscal year 2019 compared to $3.0 million for fiscal year 2018, representing an increase of approximately $1.6 million, or 52.4%. The increase was primarily a result of additional lease expense incurred with respect to six new restaurants that opened during fiscal year 2019 and a full year of expenses related to the four restaurants that opened in fiscal year 2018. As a percentage of sales, occupancy and other operating expenses increased to 7.1% in fiscal year 2019, compared to 5.8% in fiscal year 2018. The increase in occupancy and related expenses as a percentage of sales was primarily driven by the increase in pre-opening rent expense in fiscal year 2019. Depreciation and amortization expenses. Depreciation and amortization expenses incurred as part of restaurant operating costs were $2.1 million for fiscal year 2019 compared to $1.6 million for fiscal year 2018, representing an increase of approximately $0.5 million, or 26.5%. The increase was primarily due to depreciation of property and equipment related to the opening of six new restaurants in fiscal 2019 and a full year of expense related to the four restaurants opened in fiscal 2018. As a percentage of sales, depreciation and amortization expenses at the restaurant-level remained consistent at 3.2% in fiscal year 2019 as compared to 3.1% in fiscal year 2018. Depreciation and amortization expenses incurred at the corporate-level were immaterial for fiscal years 2019 and 2018, and as a percentage of sales remained relatively consistent at 0.2% and 0.1%, respectively. Other costs. Other costs were $7.1 million for fiscal year 2019 compared to $5.4 million for fiscal year 2018, representing an increase in approximately $1.7 million, or 31.2%. The increase was primarily due to $1.4 million in costs related to the opening of six new restaurants in fiscal 2019, such as credit card fees, kitchen supplies, advertising and promotions, royalty fees and utilities. The remaining year-over-year increase is due to repair and maintenance costs and other individually insignificant items. As a percentage of sales, other costs increased to 11.0% in fiscal year 2019 from 10.4% during fiscal year 2018. See “Note 5 - Related Party Transactions” for additional information on royalty payments. General and administrative expenses. General and administrative expenses were $7.7 million for fiscal year 2019 compared to $6.0 million for fiscal year 2018, representing an increase of approximately $1.7 million, or 29.9%. This increase in general and administrative expenses was primarily due to employee compensation-related expenses associated with increased wages and additional headcount to support our growth in operations, as well as increase in public company costs and $75 thousand in expenses related to a legal settlement. As a percentage of sales, general and administrative expenses increased to 12.1% in fiscal year 2019 from 11.5% in fiscal year 2018, primarily due to the increase in the expenses mentioned above. Interest expense. Interest expense increased approximately $0.1 million, or 46.9%, in fiscal year 2019. The increase in interest expense was primarily due to interest expense on the line of credit that the Company drew down on during the third quarter of fiscal year 2019. The Company paid down the line of credit in the fourth quarter of fiscal year 2019. Income tax expense. Income tax expense was $0.1 million in fiscal year 2019 and was insignificant in fiscal year 2018. The increase in income tax expense was primarily due to income tax benefits from the increase in general business credits and the impact from the Tax Reform and Jobs Act in fiscal year 2018. For further discussion of our income taxes, see “Note 9 - Income Taxes”. Fiscal Year Ended August 31, 2018 Compared to Fiscal Year Ended August 31, 2017 Sales. Sales were $51.7 million for fiscal year 2018 compared to $37.3 million for fiscal year 2017, representing an increase of approximately $14.5 million, or 38.9%. The increase in sales was primarily driven by $12.8 million from four new restaurants that opened during fiscal year 2018 and the three new restaurants that opened in the last two quarters of fiscal year 2017. Additionally, restaurants included in the comparable restaurant base contributed $1.7 million to the increase in sales during fiscal year 2018. Food and beverage costs. Food and beverage costs were $17.6 million for fiscal year 2018 compared to $13.4 million for fiscal year 2017, representing an increase of approximately $4.2 million, or 31.4%. The increase in food and beverage costs was primarily driven by sales from the four new restaurants opened during fiscal year 2018 and the three new restaurants that were opened in the last two quarters of fiscal year 2017. As a percentage of sales, food and beverage costs decreased to 34.0% in fiscal year 2018, compared to 35.9% in fiscal year 2017. Labor and related costs. Labor and related costs were $16.0 million for fiscal year 2018 compared to $12.1 million for fiscal year 2017, representing an increase of approximately $3.9 million, or 32.0%. The increase in labor and related costs was driven by additional labor costs incurred with respect to the four new restaurants opened during fiscal year 2018 and the three new restaurants that were opened in the last two quarters of fiscal year 2017. As a percentage of sales, labor and related costs decreased to 30.9% in fiscal year 2018, compared to 32.5% in fiscal year 2017. The decrease was primarily due to opening three new restaurants in fiscal year 2018 and three new restaurants in the last two quarters in fiscal year 2017 in states with lower wage rates. Occupancy and related expenses. Occupancy and related expenses were $3.0 million for fiscal year 2018 compared to $2.1 million for fiscal year 2017, representing an increase of approximately $0.9 million, or 45.1%. The increase was primarily a result of an additional $0.6 million of rental costs incurred with respect to four new restaurants opened during fiscal year 2018, and an additional $0.2 million for the three restaurants that opened in the last two quarters of fiscal year 2017. As a percentage of sales, occupancy and other operating expenses increased to 5.8% in fiscal year 2018, compared to 5.6% for fiscal year 2017. Depreciation and amortization expenses. Depreciation and amortization expenses incurred as part of restaurant operating costs were $1.6 million for fiscal year 2018 compared to $1.3 million for fiscal year 2017, representing an increase of approximately $0.3 million, or 20.8%. The increase was primarily due to depreciation of property and equipment related to the opening of four new restaurants. As a percentage of sales, depreciation and amortization expenses at the restaurant-level decreased to 3.1% in fiscal year 2018 from 3.6% in fiscal year 2017, primarily due to higher sales from the four new restaurants that opened during fiscal year 2018 and the three new restaurants that opened in the last two quarters of fiscal year 2017. Depreciation and amortization expenses incurred at the corporate-level were immaterial for fiscal years 2017 and 2018, and as a percentage of sales remained relatively consistent at 0.1%. Other costs. Other costs were $5.4 million for fiscal year 2018 compared to $3.9 million for fiscal year 2017, representing an increase in approximately $1.5 million, or 38.3%. The increase was primarily due to an increase of $0.4 million in credit card fees as a result of higher sales, as well as $0.3 million in royalty payments to Kura Japan as a result of executing a licensing agreement with Kura Japan in fiscal year 2018. The remaining year-over-year increase is due to individually insignificant items. As a percentage of sales, other costs decreased to 10.4% in fiscal year 2018 from 10.5% in fiscal year 2017, primarily due to the increase in sales year-over-year. Additional information on royalty payments is set forth in Note 5 to our audited financial statements included elsewhere in this report. General and administrative expenses. General and administrative expenses were $6.0 million for fiscal year 2018 compared to $3.4 million for fiscal year 2017, representing an increase of approximately $2.6 million, or 77.3%. This increase in general and administrative expenses was primarily due to $1.8 million in higher salary and employee compensation-related expenses associated with the hiring of additional executives and administrative employees to support our growth in operations. The remaining year-over-year increase is due to increases in professional services, travel expenses and corporate-level recruiting costs to support our growth plans and the opening of our new restaurants. As a percentage of sales, general and administrative expenses increased to 11.5% in fiscal year 2018 from 9.0% in fiscal year 2017, primarily due to the increase in the expenses mentioned above. Interest expense. Interest expense increased approximately $0.1 million, or 50.5%, in fiscal year 2018. The increase in interest expense was primarily due to interest incurred from additional capital leases as a result of restaurant openings during fiscal year 2018. Income tax expense. Income tax expense was insignificant in fiscal year 2018 compared to $0.2 million in fiscal year 2017, representing a decrease of approximately $0.2 million or 98.0%. This decrease in income tax expense was primarily due to income tax benefits from the increase in general business credits. Key Performance Indicators In assessing the performance of our business, we consider a variety of financial and performance measures. The key measures for determining how our business is performing include sales, EBITDA, Adjusted EBITDA, Restaurant-level Contribution, Restaurant-level Contribution margin, Average Unit Volumes (AUVs), comparable restaurant sales growth, and number of restaurant openings. Sales Sales represents sales of food and beverages in restaurants, as shown on our statements of operations. Several factors affect our restaurant sales in any given period including the number of restaurants in operation, guest traffic and average check. EBITDA and Adjusted EBITDA EBITDA is defined as net income before interest, income taxes and depreciation and amortization. Adjusted EBITDA is defined as EBITDA plus stock-based compensation expense, pre-opening rent expense, pre-opening costs, non-cash rent expense and asset disposals, closure costs and restaurant impairments, as well as certain items that are not indicative of core operating results. EBITDA and Adjusted EBITDA are non-GAAP measures which are intended as supplemental measures of our performance and are neither required by, nor presented in accordance with, GAAP. We believe that EBITDA and Adjusted EBITDA provide useful information to management and investors regarding certain financial and business trends relating to our financial condition and operating results. We believe that the use of EBITDA and Adjusted EBITDA provides an additional tool for investors to use in evaluating ongoing operating results and trends and in comparing the Company’s financial measures with those of comparable companies, which may present similar non-GAAP financial measures to investors. However, you should be aware when evaluating EBITDA and Adjusted EBITDA that in the future we may incur expenses similar to those excluded when calculating these measures. In addition, our presentation of these measures should not be construed as an inference that our future results will be unaffected by unusual or non-recurring items. Our computation of Adjusted EBITDA may not be comparable to other similarly titled measures computed by other companies, because all companies may not calculate Adjusted EBITDA in the same fashion. Because of these limitations, EBITDA and Adjusted EBITDA should not be considered in isolation or as a substitute for performance measures calculated in accordance with GAAP. We compensate for these limitations by relying primarily on our GAAP results and using EBITDA and Adjusted EBITDA on a supplemental basis. You should review the reconciliation of net income to EBITDA and Adjusted EBITDA below and not rely on any single financial measure to evaluate our business. The following table reconciles net income to EBITDA and Adjusted EBITDA for the fiscal years ended August 31, 2019, August 31, 2018, and August 31, 2017, respectively: (a) Stock-based compensation expense includes non-cash stock-based compensation, which is comprised of restaurant-level stock-based compensation included in other costs in the statements of operations and of corporate-level stock-based compensation included in general and administrative expenses in the statements of operations. In fiscal year 2019, restaurant-level stock-based compensation was $80 thousand and corporate-level stock-based compensation was $510 thousand. In fiscal year 2018, restaurant-level stock-based compensation was $14 thousand and corporate-level stock-based compensation was $91 thousand. (b) Pre-opening rent expense includes rent expenses incurred between date of possession and opening day of our restaurants (c) Pre-opening costs represent labor costs for new employees (trainees) and includes hourly wages, payroll taxes and benefits, travel expenses for trainees and trainers and recruitment fees for the training period (d) Non-cash rent expense includes rent expense pro-rated from the opening date of our restaurants that did not require cash outlay in the respective periods (e) Impairment of long-lived assets, net includes losses incurred due to the impairment of property and equipment related to a restaurant closure partially offset by a reimbursement from the landlord for the termination of the lease. (f) Other adjustments include a $75 thousand expense related to a legal settlement. Restaurant-level Contribution and Restaurant-level Contribution Margin Restaurant-level Contribution is defined as operating income plus depreciation and amortization, stock-based compensation expense, pre-opening rent expense, pre-opening costs, non-cash rent expense, asset disposals, closure costs and restaurant impairments, general and administrative expenses, less corporate-level stock-based compensation expense. Restaurant-level Contribution margin is defined as Restaurant-level Contribution divided by sales. Restaurant-level Contribution and Restaurant-level Contribution margin are intended as supplemental measures of our performance and are neither required by, nor presented in accordance with, GAAP. We believe that Restaurant-level Contribution and Restaurant-level Contribution margin provide useful information to management and investors regarding certain financial and business trends relating to our financial condition and operating results. We expect Restaurant-level Contribution to increase in proportion to the number of new restaurants we open and our comparable restaurant sales growth. We present Restaurant-level Contribution because it excludes the impact of general and administrative expenses, which are not incurred at the restaurant-level. We also use Restaurant-level Contribution to measure operating performance and returns from opening new restaurants. Restaurant-level Contribution margin allows us to evaluate the level of Restaurant-level Contribution generated from sales. However, you should be aware that Restaurant-level Contribution and Restaurant-level Contribution margin are financial measures which are not indicative of overall results for the Company, and Restaurant-level Contribution and Restaurant-level Contribution margin do not accrue directly to the benefit of stockholders because of corporate-level expenses excluded from such measures. In addition, when evaluating Restaurant-level Contribution and Restaurant-level Contribution margin, you should be aware that in the future we may incur expenses similar to those excluded when calculating these measures. Our presentation of these measures should not be construed as an inference that our future results will be unaffected by unusual or non-recurring items. Our computation of Restaurant-level Contribution and Restaurant-level Contribution margin may not be comparable to other similarly titled measures computed by other companies, because all companies may not calculate Restaurant-level Contribution and Restaurant-level Contribution margin in the same fashion. Restaurant-level Contribution and Restaurant-level Contribution margin have limitations as analytical tools, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. The following table reconciles operating income to Restaurant-level Contribution and Restaurant-level Contribution margin for the fiscal years ended August 31, 2019, August 31, 2018 and August 31, 2017, respectively: (a) Stock-based compensation expense includes non-cash stock-based compensation, which is comprised of restaurant-level stock-based compensation included in other costs in the statements of operations and of corporate-level stock-based compensation included in general and administrative expenses in the statements of operations. In fiscal year 2019, restaurant-level stock-based compensation was $80 thousand and corporate-level stock-based compensation was $510 thousand. In fiscal year 2018, restaurant-level stock-based compensation was $14 thousand and corporate-level stock-based compensation was $91 thousand. (b) Pre-opening rent expense includes rent expenses incurred between date of possession and opening day of our restaurants (c) Pre-opening costs represent labor costs for new employees (trainees) and includes hourly wages, payroll taxes and benefits, travel expenses for trainees and trainers and recruitment fees for the training period. (d) Non-cash rent expense includes rent expense pro-rated from the opening date of our restaurants that did not require cash outlay in the respective periods. (e) Impairment of long-lived assets, net includes losses incurred due to the impairment of property and equipment related to a restaurant closure partially offset by a reimbursement from the landlord for the termination of the lease. Average Unit Volumes (AUVs) “Average Unit Volumes” or “AUVs” consist of the average annual sales of all restaurants that have been open for 18 months or longer at the end of the fiscal year presented due to new restaurants experiencing a period of higher sales upon opening. AUVs are calculated by dividing (x) annual sales for the fiscal year presented for all such restaurants by (y) the total number of restaurants in that base. We make fractional adjustments to sales for restaurants that were not open for the entire fiscal year presented (such as a restaurant closed for renovation) to annualize sales for such period of time. This measurement allows management to assess changes in consumer spending patterns at our restaurants and the overall performance of our restaurant base. The AUVs measure is calculated excluding the Laguna Hills, California restaurant, which closed in fiscal year 2018. The following table shows the AUVs for the fiscal years ended August 31, 2019, August 31, 2018, and August 31, 2017 respectively: Comparable Restaurant Sales Growth Comparable restaurant sales growth refers to the change in year-over-year sales for the comparable restaurant base. We include restaurants in the comparable restaurant base that have been in operation for at least 18 months prior to the start of the accounting period presented due to new restaurants experiencing a period of higher sales upon opening, including those temporarily closed for renovations during the year. For restaurants that were temporarily closed for renovations during the year, we make fractional adjustments to sales such that sales are annualized in the associated period. The comparable restaurant sales growth measure is calculated excluding the Laguna Hills, California restaurant, which closed in fiscal year 2018. Measuring our comparable restaurant sales growth allows us to evaluate the performance of our existing restaurant base. Various factors impact comparable restaurant sales, including: • consumer recognition of our brand and our ability to respond to changing consumer preferences; • overall economic trends, particularly those related to consumer spending; • our ability to operate restaurants effectively and efficiently to meet consumer expectations; • pricing; • guest traffic; • per-guest spend and average check; • marketing and promotional efforts; • local competition; and • opening of new restaurants in the vicinity of existing locations. Since opening new restaurants will be a significant component of our sales growth, comparable restaurant sales growth is only one measure of how we evaluate our performance. The following table shows the comparable restaurant sales growth for the fiscal years ended August 31, 2019, August 31, 2018 and August 31, 2017, respectively: Number of Restaurant Openings The number of restaurant openings reflects the number of restaurants opened during a particular reporting period. Before we open new restaurants, we incur pre-opening costs. New restaurants may not be profitable, and their sales performance may not follow historical patterns. The number and timing of restaurant openings has had, and is expected to continue to have, an impact on our results of operations. The following table shows the growth in our restaurant base for the fiscal years ended August 31, 2019, August 31, 2018 and August 31, 2017, respectively: Liquidity and Capital Resources Our primary uses of cash are for operational expenditures and capital investments, including new restaurants, costs incurred for restaurant remodels and restaurant fixtures. Historically, our main sources of liquidity have been cash flows from operations and annual capital contributions from Kura Japan. Kura Japan made capital contributions to us of $5.0 million in each of fiscal years 2018 and 2017. No capital contributions were received in fiscal year 2019. The significant components of our working capital are liquid assets such as cash, cash equivalents and receivables, reduced by accounts payable and accrued expenses. Our working capital position benefits from the fact that we generally collect cash from sales to guests the same day or, in the case of credit or debit card transactions, within several days of the related sale, while we typically have longer payment terms with our vendors. We believe that cash provided by operating activities, cash on hand and availability under our existing line of credit will be sufficient to fund our lease obligations, capital expenditures and working capital needs for at least the next 12 months. Summary of Cash Flows Our primary sources of liquidity and cash flows are operating cash flows and cash on hand. We use this to fund investing expenditures for new restaurant openings, reinvest in our existing restaurants, and increase our working capital. Our working capital position benefits from the fact that we generally collect cash from sales to guests the same day, or in the case of credit or debit card transactions, within several days of the related sale, and we typically have at least 30 days to pay our vendors. The following table summarizes our cash flows for the periods presented: Cash Flows Provided by Operating Activities Net cash provided by operating activities during the fiscal year 2019 was $6.0 million, which results from net income of $1.5 million, non-cash charges of $2.2 million for depreciation and amortization, $0.6 million for stock-based compensation, offset by $0.1 million of increase in deferred tax assets, and net cash inflows of approximately $1.8 million from changes in operating assets and liabilities. The net cash inflows from changes in operating assets and liabilities were primarily the result of increases of $1.6 million for accounts payable, $1.1 million for deferred rent and tenant allowances, $1.1 million for accrued expenses and other current liabilities and $0.5 million in salary and wages payable, partially offset by an increase of $1.1 million in prepaid expenses and other current assets, $0.8 million in deposits and other assets and $0.4 million in accounts receivable. The increase in the above-mentioned items was primarily due to the six new restaurants opened during the fiscal year 2019. Net cash provided by operating activities during the fiscal year 2018 was $5.2 million, which resulted from net income of $1.7 million, non-cash charges of $1.7 million for depreciation and amortization, $0.1 million for stock-based compensation, $0.2 million for loss on disposal of property and equipment, and net cash inflows of $1.5 million from changes in operating assets and liabilities. The net cash inflows from changes in operating assets and liabilities were primarily the result of increases of $0.6 million in deferred rent and tenant allowances, $0.3 million in accounts payable and $0.3 million in accrued expenses and other current liabilities. The increase in deferred rent and tenant allowances was primarily due to the number of restaurant openings during the year. The increase in accounts payable and accrued expenses and other current liabilities was primarily due to the timing of cash payments and increased activities to support overall business growth. The increase in salary and wages payable is due to hiring of executives in fiscal year 2018. Net cash provided by operating activities during the fiscal year 2017 was $2.9 million, which resulted from net income of $0.7 million, non-cash charges of $1.4 million for depreciation and amortization, $0.2 million for deferred income taxes, and net cash inflows of $0.7 million from changes in operating assets and liabilities. The net cash inflows from changes in operating assets and liabilities were primarily the result of increases of $0.5 million in accounts payable and $0.5 million in deferred rent and tenant allowances, partially offset by an increase of $0.5 million in accounts receivables. The increase in deferred rent and tenant allowances, as well as accounts receivables, was primarily due to the number of restaurant openings during the fiscal year 2017. The increase in accounts payable was primarily due to the timing of cash payments and increased activities to support overall business growth. Cash Flows Used in Investing Activities Net cash used in investing activities during the fiscal year 2019 was $11.4 million, primarily due to purchases of property and equipment. The increase in purchases of property and equipment in fiscal year 2019 is primarily related to capital expenditures for current and future restaurant openings, renovations, maintaining our existing restaurants and other projects. Net cash used in investing activities during the fiscal year 2018 was $6.6 million, primarily due to purchases of property and equipment of $7.1 million, partially offset by $0.5 million in proceeds from disposal of property and equipment. The increase in purchases of property and equipment in fiscal year 2018 is primarily related to capital expenditures for current and future restaurant openings, renovations, maintaining our existing restaurants and other projects. Net cash used in investing activities during the fiscal year 2017 was $6.0 million, primarily due to purchases of property and equipment of $6.0 million. Cash Flows Provided by (Used in) Financing Activities Net cash provided by financing activities during fiscal year 2019 was $37.6 million primarily due to $43.4 million received as proceeds from our IPO, net of discounts and commission and $3.9 million in borrowings under our line of credit, partially offset by $1.0 million repayment of principal on capital leases, $4.8 million payment of costs associated with IPO, and repayment of $3.9 million in borrowings. Net cash provided by financing activities during the fiscal year 2018 was $4.2 million primarily due to $5.0 million cash received for additional capital investment from Kura Japan, partially offset by $0.8 million repayments of principal balances on capital leases of equipment. Net cash provided by financing activities during the fiscal year 2017 was $4.6 million primarily due to $5.0 million cash received for additional capital investment from Kura Japan, partially offset by $0.4 million in repayments of principal balances on capital leases of equipment. Contractual Obligations The following table presents our commitments and contractual obligations as of August 31, 2019, as well as our long-term obligations: (1) Represent future minimum lease payments for our restaurant operations and corporate office. Operating lease payments excludes contingent rent payments that may be due under certain of our leases based on a percentage of sales in excess of specified thresholds. (2) Reflects the aggregate principal and interest payments during the lease terms, which includes $0.2 million of interest payments. (3) Reflects contractual purchase commitments for goods related to restaurant operations and commitments for construction of new restaurants. Off-Balance Sheet Arrangements As of August 31, 2019, we did not have any material off-balance sheet arrangements, except for restaurant operating leases. Critical Accounting Policies and Estimates Our discussion and analysis of operating results and financial condition are based upon our financial statements. The preparation of our financial statements in accordance with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, sales, expenses and related disclosures of contingent assets and liabilities. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. Our critical accounting policies are those that materially affect our financial statements and involve subjective or complex judgments by management. Although these estimates are based on management’s best knowledge of current events and actions that may impact us in the future, actual results may be materially different from the estimates. We believe the following critical accounting policies are affected by significant judgments and estimates used in the preparation of our financial statements and that the judgments and estimates are reasonable. Operating and Capital Leases We currently lease all of our restaurant locations, corporate offices, and some of the equipment used in our restaurants. At the inception of each lease, we determine the appropriate classification as an operating lease or a capital lease. This lease accounting evaluation may require significant judgment in determining the fair value and useful life of the leased property and appropriate lease term, which typically does not change once determined at the inception of the lease. All of our restaurant and office leases are classified as operating leases and equipment leases are classified as capital leases. Our office leases provide for fixed minimum rent payments. Most of our restaurants provide for fixed minimum rent payments and some require additional contingent rent payments based upon sales in excess of specified thresholds. When achievement of such sales thresholds is deemed probable, contingent rent is accrued in proportion to the sales recognized in the period. For operating leases that include free-rent periods and rent escalation clauses, we recognize rent expense based on the straight-line method. For the purpose of calculating rent expenses under the straight-line method, the lease term commences on the date we obtain control of the property. The difference between the rent expense and rent payments is recorded as deferred rent in the accompanying balance sheet. Allowance for tenant allowances is included in deferred rent liability and recognized over the lease term as a reduction of rent expenses. Assets we acquired under capital lease arrangements are recorded at the lower of the present value of future minimum lease payments or fair value of the assets at the inception of the lease. Capital lease assets are amortized over the shorter of the useful life of the assets or the lease term, and the amortization expense is included in the depreciation and amortization financial statement line item on the accompanying financial statements. Impairment of Long-Lived Assets Changes in projections or estimates, a deterioration of operating results and the related cash flow effect could decrease the estimated fair value of long-lived assets and result in impairments. We assess potential impairments of our long-lived assets in accordance with the provisions of Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 360-Property, Plant and Equipment. An impairment review is performed whenever events or changes in circumstances indicate that the carrying value of the assets may not be recoverable. Factors considered by us include, but are not limited to: significant underperformance relative to expected historical or projected future operating results; significant changes in the manner of use of the acquired assets or the strategy for the overall business; and significant negative industry or economic trends. We recognized $0.2 million impairment loss during the fiscal year ended August 31, 2018. No impairment loss was recognized during fiscal years ended August 31, 2019 and August 31, 2017. Common Stock Valuations Prior to our IPO, in the absence of a public trading market, the fair value of our common stock was determined by our board of directors, with input from management, taking into account the most recent valuations performed by an independent third-party valuation specialist. The valuations of our common stock were determined in accordance with the guidelines outlined in the American Institute of Certified Public Accountants Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. The assumptions we use in the valuation models were highly complex and subjective. These assumptions were based on future expectations combined with management judgment, and considered numerous objective and subjective factors to determine the fair value of our common stock as of the date of each option grant, including the following factors: • our operating and financial performance; • the prevailing business conditions and projections; • the hiring of key personnel; • the likelihood of achieving a liquidity event for the shares of common stock underlying these stock options, such as an initial public offering, given prevailing market conditions; • any adjustment necessary to recognize a lack of marketability of the common stock underlying the granted options; • the market performance of comparable publicly-traded companies; and • the U.S. and global capital market conditions. In valuing our common stock at various dates in fiscal years 2018 and 2019, our board determined the equity value of our business using various valuation methods including combinations of income and market approaches. The income approach estimates value based on the expectation of future cash flows that a company will generate. These future cash flows are discounted to their present values using a discount rate derived from an analysis of the cost of capital of comparable publicly traded companies in our industry or similar lines of business as of each valuation date and is adjusted to reflect the risks inherent in our cash flows. The market approach estimates value considering an analysis of guideline public companies. The guideline public company method estimates value by applying a representative revenue multiple from a peer group of companies in similar lines of business to us to our forecasted sales. The equity values implied by the income and market approaches reasonably approximated each other as of each valuation date. For financial reporting purposes, we considered the amount of time between the valuation date and the grant date to determine whether to use the latest common stock valuation. This determination included an evaluation of whether the subsequent valuation indicated that any significant change in valuation had occurred between the previous valuation and the grant date. Subsequent to the IPO, we relied on the closing price of our Class A common stock as reported by the Nasdaq Stock Market on the date of grant to determine the fair value of our Class A common stock. There were no equity award grants subsequent to our IPO. Jumpstart Our Business Startups Act of 2012 We qualify as an “emerging growth company” as defined in Section 2(a)(19) of the Securities Act, as modified by the JOBS Act. 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. In other words, 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. Subject to certain conditions set forth in the JOBS Act, we are also eligible for and intend to take advantage of certain exemptions from various reporting requirements applicable to other public companies that are not emerging growth companies, including (i) the exemption from the auditor attestation requirements with respect to internal control over financial reporting under Section 404 of the Sarbanes-Oxley Act, (ii) the exemptions from say-on-pay, say-on-frequency and say-on-golden parachute voting requirements and (iii) reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements. We may take advantage of these exemptions until we are no longer an emerging growth company. We will continue to be an emerging growth company until the earliest to occur of (i) the last day of the fiscal year in which the market value of our Class A common stock that is held by non-affiliates exceeds $700 million as of June 30 of that fiscal year, (ii) the last day of the fiscal year in which we had total annual gross revenue of $1 billion or more during such fiscal year (as indexed for inflation), (iii) the date on which we have issued more than $1 billion in non-convertible debt in the prior three-year period or (iv) the last day of the fiscal year following the fifth anniversary of the date of the completion of our IPO.

<s>[INST] You should read the following discussion and analysis of our financial condition and results of operations together with the “Selected Financial Data” and our financial statements and the related notes and other financial information included elsewhere in this report. Some of the information contained in this discussion and analysis or set forth elsewhere in this report, including information with respect to our plans and strategy for our business, includes forwardlooking statements that involve risks and uncertainties. You should review the “Special Note Regarding ForwardLooking Statements” and “Risk Factors” sections of this 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. Overview Kura Sushi USA, Inc. is a fastgrowing, technologyenabled Japanese restaurant concept that provides guests with a distinctive dining experience by serving authentic Japanese cuisine through an engaging revolving sushi service model, which we refer to as the “Kura Experience”. We encourage healthy lifestyles by serving freshly prepared Japanese cuisine using highquality ingredients that are free from artificial seasonings, sweeteners, colorings, and preservatives. We aim to make quality Japanese cuisine accessible to our guests across the United States through affordable prices and an inviting atmosphere. Business Trends We have expanded our restaurant base from eight restaurants in California as of the beginning of fiscal year 2016 to 23 restaurants in five states as of the end of fiscal year 2019. We opened four restaurants in fiscal year 2018 and six restaurants in fiscal year 2019. We expect to open six new restaurants in fiscal year 2020 and therefore, we expect our revenue and restaurant operating costs to significantly increase in fiscal year 2020. Additionally, we expect our general and administrative expenses will increase as a percentage of sales in our fiscal year 2020 due to additional costs associated with being a public company. Key Financial Definitions Sales. Sales represent sales of food and beverages in restaurants. Restaurant sales in a given period are directly impacted by the number of restaurants we operate and comparable restaurant sales growth. Food and beverage costs. Food and beverage costs are variable in nature, change with sales volume and are influenced by menu mix and subject to increases or decreases based on fluctuations in commodity costs. Other important factors causing fluctuations in food and beverage costs include seasonality and restaurantlevel management of food waste. Food and beverage costs are a substantial expense and are expected to grow proportionally as our sales grows. Labor and related expenses. Labor and related expenses include all restaurantlevel management and hourly labor costs, including wages, employee benefits and payroll taxes. Similar to the food and beverage costs that we incur, labor and related expenses are expected to grow proportionally as our sales grows. Factors that influence fluctuations in our labor and related expenses include minimum wage and payroll tax legislation, the frequency and severity of workers’ compensation claims, healthcare costs and the performance of our restaurants. Occupancy and related expenses. Occupancy and related expenses include rent for all restaurant locations and related taxes. Depreciation and amortization expenses. Depreciation and amortization expenses are periodic noncash charges that consist of depreciation of fixed assets, including equipment and capitalized leasehold improvements. Depreciation is determined using the straightline method over the assets’ estimated useful lives, ranging from three to 20 years. Other costs. Other costs include utilities, repairs and maintenance, credit card fees, royalty payments to Kura Japan, stockbased compensation expenses for restaurantlevel employees and other restaurantlevel expenses. General and administrative expenses. General and administrative expenses include expenses associated with corporate and regional supervision functions that support the operations of existing restaurants and development of new restaurants, including compensation and benefits, travel expenses, stockbased compensation expenses for corporatelevel employees, legal and professional fees, marketing costs, information systems, corporate office rent and other related corporate costs. General and administrative expenses are expected to grow as our sales grows, including incremental legal, accounting, insurance and other expenses incurred as a public company. Interest expense. Interest expense includes cash and noncash charges related to our line of credit and capital lease obligations. [/INST] Positive. </s>

DOW INC.

2020-02-07

2019-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS On April 1, 2019, DowDuPont Inc. (“DowDuPont” and effective June 3, 2019, n/k/a DuPont de Nemours, Inc. or "DuPont") completed the separation of its materials science business and Dow Inc. became the direct parent company of The Dow Chemical Company and its consolidated subsidiaries (“TDCC” and together with Dow Inc., “Dow” or the “Company”), owning all of the outstanding common shares of TDCC. For filings related to the period commencing April 1, 2019 and thereafter, TDCC was deemed the predecessor to Dow Inc., and the historical results of TDCC are deemed the historical results of Dow Inc. for periods prior to and including March 31, 2019. As a result of the parent/subsidiary relationship between Dow Inc. and TDCC, and the expectation that the financial statements and disclosures of each company will be substantially similar, the companies are filing a combined report for this Annual Report on Form 10-K. The information reflected in the report is equally applicable to both Dow Inc. and TDCC, except where otherwise noted. The separation was contemplated by the merger of equals transaction effective August 31, 2017, under the Agreement and Plan of Merger, dated as of December 11, 2015, as amended on March 31, 2017. TDCC and E. I. du Pont de Nemours and Company and its consolidated subsidiaries (“Historical DuPont”) each merged with subsidiaries of DowDuPont and, as a result, TDCC and Historical DuPont became subsidiaries of DowDuPont (the “Merger”). Subsequent to the Merger, TDCC and Historical DuPont engaged in a series of internal reorganization and realignment steps to realign their businesses into three subgroups: agriculture, materials science and specialty products. Dow Inc. was formed as a wholly owned subsidiary of DowDuPont to serve as the holding company for the materials science business. As of the effective date and time of the distribution, DowDuPont does not beneficially own any equity interest in Dow and no longer consolidates Dow and its consolidated subsidiaries into its financial results. The consolidated financial results of Dow for all periods presented reflect the distribution of TDCC’s agricultural sciences business (“AgCo”) and specialty products business (“SpecCo”) as discontinued operations, as well as reflect the receipt of Historical DuPont’s ethylene and ethylene copolymers businesses (other than its ethylene acrylic elastomers business) (“ECP”) as a common control transaction from the closing of the Merger on August 31, 2017. See Notes 3 and 4 to the Consolidated Financial Statements and Dow Inc.'s Amendment No. 4 to the Registration Statement on Form 10 filed with the U.S. Securities and Exchange Commission ("SEC") on March 8, 2019 for additional information. Throughout this Annual Report on Form 10-K, unless otherwise indicated, amounts and activity are presented on a continuing operations basis. Except as otherwise indicated by the context, the terms "Union Carbide" means Union Carbide Corporation, a wholly owned subsidiary of the Company, and "Dow Silicones" means Dow Silicones Corporation (formerly known as Dow Corning Corporation, which changed its name effective as of February 1, 2018), a wholly owned subsidiary of the Company. Items Affecting Comparability of Financial Results As a result of the separation from DowDuPont, pro forma net sales and pro forma Operating EBIT are provided in this section and based on the consolidated financial statements of TDCC, adjusted to give effect to the separation from DowDuPont as if it had been consummated on January 1, 2017. Pro forma adjustments include (1) the margin impact of various manufacturing, supply and service related agreements entered into with DuPont and Corteva, Inc. ("Corteva") in connection with the separation which provide for different pricing than the historical intercompany and intracompany pricing practices of TDCC and Historical DuPont (only included for 2018 and the first three months of 2019), (2) the inclusion of ECP for the period of January 1, 2017 through August 31, 2017, (3) the removal of the amortization of ECP's inventory step-up recognized in connection with the Merger, (4) the elimination of the impact of events directly attributable to the Merger, internal reorganization and business realignment, separation, distribution and other related transactions (e.g., one-time transaction costs), and (5) the elimination of the effect of a consummated divestiture agreed to with certain regulatory agencies as a condition of approval for the Merger. These adjustments impacted the consolidated results as well as the reportable segments. See Note 27 to the Consolidated Financial Statements for a summary of the pro forma adjustments impacting segment measures for the years ended December 31, 2019, 2018 and 2017. Page About Dow Results of Operations Segment Results Packaging & Specialty Plastics Industrial Intermediates & Infrastructure Performance Materials & Coatings Corporate Outlook Liquidity and Capital Resources Other Matters Critical Accounting Estimates Environmental Matters Asbestos-Related Matters of Union Carbide Corporation ABOUT DOW Dow combines global breadth, asset integration and scale, focused innovation and leading business positions to achieve profitable growth. The Company’s ambition is to become the most innovative, customer centric, inclusive and sustainable materials science company. Dow’s portfolio of plastics, industrial intermediates, coatings and silicones businesses delivers a broad range of differentiated science-based products and solutions for its customers in high-growth market segments, such as packaging, infrastructure and consumer care. Dow operates 109 manufacturing sites in 31 countries and employs approximately 36,500 people. In 2019, the Company had annual sales of $43 billion, of which 36 percent of the Company’s sales were to customers in U.S. & Canada; 34 percent were in Europe, Middle East, Africa and India ("EMEAI"); while the remaining 30 percent were to customers in Asia Pacific and Latin America. In 2019, the Company and its consolidated subsidiaries did not operate in countries subject to U.S. economic sanctions and export controls as imposed by the U.S. State Department or in countries designated by the U.S. State Department as state sponsors of terrorism, including Iran, the Democratic People's Republic of Korea (North Korea), Sudan and Syria. The Company has policies and procedures in place designed to ensure that it and its consolidated subsidiaries remain in compliance with applicable U.S. laws and regulations. OVERVIEW The following is a summary of the results from continuing operations and other notable events for the Company for the year ended December 31, 2019: The Company reported net sales in 2019 of $43 billion, down 13 percent from $49.6 billion in 2018, with declines across all geographic regions and operating segments. These declines were due to a decrease in local price of 11 percent, a volume decline of 2 percent and a 1 percent unfavorable currency impact, partially offset by a 1 percent increase in Portfolio & Other. Local price decreased 11 percent compared with the same period last year, with decreases in all operating segments, including double-digit declines in Packaging & Specialty Plastics and Industrial Intermediates & Infrastructure (both down 12 percent). Local price decreased in all geographic regions, including double-digit declines in Latin America (down 14 percent), Asia Pacific (down 12 percent) and U.S. & Canada (down 11 percent). Volume decreased 2 percent compared with 2018, driven primarily by lower hydrocarbon co-product sales. Packaging & Specialty Plastics and Performance Materials & Coatings reported volume declines (both down 3 percent) while Industrial Intermediates & Infrastructure was flat. Volume decreased in EMEAI (down 4 percent) and Latin America and U.S. & Canada (both down 3 percent), partially offset by an increase in Asia Pacific (up 5 percent). Currency had an unfavorable impact of 1 percent on net sales, driven primarily by EMEAI (down 3 percent). Research and development ("R&D") expenses were $765 million in 2019, down from $800 million in 2018. Selling, general and administrative ("SG&A") expenses for Dow Inc. and TDCC were $1,590 million and $1,585 million, respectively, in 2019, down from $1,782 million in 2018. R&D and SG&A expenses decreased primarily due to cost reductions, cost synergies, stranded cost removal and lower performance-based compensation costs. Restructuring, goodwill impairment and asset related charges - net were $3,219 million in 2019, primarily reflecting post-merger restructuring actions under the DowDuPont Cost Synergy Program, a goodwill impairment charge of $1,039 million related to the Coatings & Performance Monomers reporting unit and $1,755 million of pretax charges related to Sadara Chemical Company ("Sadara"). Integration and separation costs for Dow Inc. and TDCC were $1,063 million and $1,039 million, respectively, in 2019, down from $1,179 million in 2018, reflecting the wind-down of post-Merger integration and business separation activities. Equity in earnings (losses) of nonconsolidated affiliates was a loss of $94 million in 2019, down from earnings of $555 million in 2018, primarily due to increased equity losses from Sadara and lower equity earnings from the Kuwait joint ventures and the Thai joint ventures. Sundry income (expense) - net for Dow Inc. and TDCC was income of $461 million and income of $573 million, respectively, in 2019, compared with income of $96 million in 2018. Sundry income (expense) - net increased primarily due to an increase in foreign currency exchange gains as well as a net gain related to litigation matters. Net income (loss) available for Dow Inc. and TDCC common stockholder(s) was a loss of $1,359 million and $1,237 million, respectively, in 2019, compared with income of $4,641 million in 2018. Earnings (loss) per share for Dow Inc. was a loss of $1.84 per share in 2019, compared with income of $6.21 per share in 2018. In 2019, Dow Inc. declared and paid dividends of $2.10 per share ($1,550 million), to common stockholders, and TDCC paid a $535 million dividend to DowDuPont. In 2019, Dow Inc. repurchased $500 million of the Company's common stock. In 2019, the Company reduced gross debt by nearly $3 billion. In October 2019, the Company received a $0.8 billion cash payment related to the Nova Chemicals Corporation ("Nova") ethylene asset matter. Other notable events and highlights from the year ended December 31, 2019 include: • On April 1, 2019, Dow successfully completed its separation from DowDuPont, becoming a more focused and streamlined materials science company. • In April 2019, Dow Inc. was named to the Dow Jones Industrial Average. • On April 25, 2019, the Company announced plans to expand its alkoxylation capacity at its existing facility in Tarragona, Spain, directly benefiting the EMEAI region. • On August 13, 2019, Dow announced that it reached an agreement for the divestiture of its acetone derivatives business to ALTIVIA Ketones & Additives, LLC, an affiliate of ALTIVIA, a privately held producer of chemicals headquartered in Houston, Texas. The transaction closed on November 1, 2019, and included the Company's acetone derivatives related inventory and production assets located in Institute, West Virginia, in addition to the site infrastructure, land and utilities. • On August 20, 2019, as part of the Company's current slate of low capital intensity, high-return incremental growth investments, Dow announced it will retrofit proprietary fluidized catalytic dehydrogenation technology into one of its mixed-feed crackers in Plaquemine, Louisiana, to produce on-purpose propylene. • Dow announced two new agreements that contribute to its commitment to incorporate at least 100,000 tonnes of recycled plastics in its product offerings sold in the European Union by 2025. The first was announced on August 29, 2019 with the Fuenix Ecogy Group for the supply of pyrolysis oil feedstock, which is made from plastic waste. The second agreement was announced on September 24, 2019 with UPM Biofuels for the supply of wood-based UPM BioVerno renewable naphtha. These feedstocks will be used to produce new polymers and bio-based polyethylene at Dow's production facilities in Terneuzen, The Netherlands. • Dow was named to the Dow Jones Sustainability World Index - marking the 20th time the Company has been named to this global benchmark. • Dow was named to Fortune's 2019 Change the World list, recognizing the Company's program to pilot the use of recycled plastics in roads as part of the Company's long-standing commitment to reduce plastic waste and drive sustainable solutions. • Dow was named to the 2019 Disability Equality Index® "Best Places to Work," by receiving the top score for the third year in a row. • Dow received four R&D 100 Awards from R&D Magazine for innovative technologies including: IMAGIN3DTM Polyethylene OBC, SYL-OFFTM SL-25 Release Modifier, SILASTICTM MS-4007 Moldable Optical Silicone and GREAT STUFFTM SMART DISPENSERTM. • Dow received four 2019 Sustainability Awards from the Business Intelligence Group, including the Sustainability Initiative of the Year Award for the RENUVATM Mattress Project and the Sustainability Products of the Year Award for Dow PRIMALTM Bio-based Acrylic Emulsion, DOWSILTM TC-3015 Re-workable Thermal Conductive Silicone Gel and RENUVATM Polyols. • Dow received five prestigious Edison Awards for breakthrough technologies, setting a record for the Company, with two gold, two silver and one bronze award including: gold to ENGAGETM PV Polyolefin Elastomers, gold to Tenter Frame Biaxially Orientable Polyethylene Resin, silver to ECOFASTTM Pure Sustainable Textile Treatment, silver to VORARADTM Downhole Radium Sequestration Technology and bronze to OPULUXTM HGT. • On June 13, 2019, Samuel R. Allen was elected to Dow's Board of Directors, effective August 1, 2019. In addition to the highlights above, the following events occurred subsequent to December 31, 2019: • On January 29, 2020, the Company announced plans to add another furnace to its ethylene production facility in Alberta, Canada, incrementally expanding capacity by approximately 130,000 metric tons. Dow will co-invest in the expansion with a regional customer, evenly sharing project costs and ethylene output, with the additional ethylene to be consumed by existing polyethylene manufacturing assets in the region. The expansion is expected to come online in the first half of 2021. RESULTS OF OPERATIONS Net Sales The following tables summarize net sales, pro forma net sales and sales variance by operating segment and geographic region from the prior year: 1. Portfolio & Other includes the sales impact of various manufacturing, supply and service related agreements entered into with DuPont and Corteva in connection with the separation, which provide for different pricing than the historical intercompany and intracompany pricing practices of TDCC and Historical DuPont. 1. Portfolio & Other primarily reflects sales related to the receipt of ECP as a common control transaction from the closing of the Merger on August 31, 2017, and the divestiture of the global Ethylene Acrylic Acid copolymers and ionomers business ("EAA Business"), divested on September 1, 2017 (both impacting Packaging & Specialty Plastics). In addition, Portfolio & Other includes the ownership restructure of Dow Silicones announced on June 1, 2016 (impacting Performance Materials & Coatings). 2019 Versus 2018 The Company reported net sales of $43 billion in 2019, down 13 percent from $49.6 billion in 2018, primarily driven by a decrease in local price, decreased volume and the unfavorable impact of currency. Sales declines were broad-based and occurred in all segments and geographic regions. Local price decreased 11 percent, primarily in response to lower feedstock and raw material costs and pricing pressures. Local price decreased in Packaging & Specialty Plastics and Industrial Intermediates & Infrastructure (both down 12 percent) and in Performance Materials & Coatings (down 6 percent). Local price decreased in all geographic regions. Volume decreased 2 percent with declines in all geographic regions except Asia Pacific (up 5 percent). Volume declines were primarily driven by lower hydrocarbon co-product sales. Volume decreased in Packaging & Specialty Plastics and Performance Materials & Coatings (both down 3 percent), while Industrial Intermediates & Infrastructure volume was flat. Currency unfavorably impacted net sales by 1 percent compared with the prior year, driven primarily by EMEAI (down 3 percent). Portfolio & Other improved sales by 1 percent. 2018 Versus 2017 The Company reported net sales of $49.6 billion in 2018, up 13 percent from $43.7 billion in 2017, driven by higher sales volume, reflecting additional capacity from U.S. Gulf Coast growth projects and increased supply from Sadara, increased local price, the receipt of ECP and the favorable impact of currency. Sales growth was broad-based, with increases in all segments and geographic regions. Volume increased 6 percent compared with the prior year, as increases in Packaging & Specialty Plastics (up 5 percent) and Industrial Intermediates & Infrastructure (up 13 percent) more than offset a decline in Performance Materials & Coatings (down 2 percent). Volume increased in all geographic regions, including a double-digit increase in Asia Pacific (up 19 percent). Local price was up 4 percent compared with the prior year, with increases in all geographic regions, driven by pricing initiatives and higher feedstock and raw material prices. Local price increased in all segments, with the most notable increases in Industrial Intermediates & Infrastructure (up 5 percent) and Performance Materials & Coatings (up 10 percent). Portfolio & Other contributed 2 percent of the sales increase, primarily reflecting the receipt of ECP. Currency was up 1 percent compared with the prior year, driven by a favorable impact in EMEAI and Asia Pacific. 1. Portfolio & Other includes the sales impact of various manufacturing, supply and service related agreements entered into with DuPont and Corteva in connection with the separation, which provide for different pricing than the historical intercompany and intracompany pricing practices of TDCC and Historical DuPont. 2019 Versus 2018 - Pro Forma The Company reported pro forma net sales for 2019 of $43 billion, down 14 percent from $49.9 billion for 2018, primarily driven by a decrease in local price, decreased volume and the unfavorable impact of currency. Sales declines were broad-based and occurred in all segments and geographic regions. Local price decreased 11 percent, primarily in response to lower feedstock and raw material costs and pricing pressures. Local price decreased in Packaging & Specialty Plastics and Industrial Intermediates & Infrastructure (both down 12 percent) and in Performance Materials & Coatings (down 6 percent). Local price decreased in all geographic regions. Volume decreased 2 percent with declines in all geographic regions except Asia Pacific (up 5 percent). Volume decreased in Packaging & Specialty Plastics (down 3 percent) and Performance Materials & Coatings (down 1 percent), and increased in Industrial Intermediates & Infrastructure (up 1 percent). Currency unfavorably impacted net sales by 1 percent compared with the prior year, driven primarily by EMEAI (down 3 percent). Portfolio & Other was flat compared with the prior year. 2018 Versus 2017 - Pro Forma The Company reported pro forma net sales of $49.9 billion in 2018, up 11 percent from pro forma net sales of $44.8 billion in 2017, with increases across all segments and geographic regions. Double-digit net sales increases were reported in Industrial Intermediates & Infrastructure (up 19 percent) and Performance Materials & Coatings (up 11 percent). Net sales increased in Asia Pacific (up 22 percent), EMEAI (up 12 percent), Latin America (up 9 percent) and U.S. & Canada (up 6 percent). Volume increased 6 percent compared with pro forma results in the prior year, reflecting additional capacity from U.S. Gulf Coast growth projects and increased supply from Sadara. Volume increases in Packaging & Specialty Plastics (up 5 percent) and Industrial Intermediates & Infrastructure (up 13 percent) more than offset a decline in Performance Materials & Coatings (down 2 percent). Volume increased in all geographic regions, including a double-digit increase in Asia Pacific (up 18 percent). Local price was up 4 percent compared with pro forma results in the prior year with increases in all geographic regions, driven by pricing initiatives and higher feedstock and raw material prices. Local price increased across all segments, including a double-digit increase in Performance Materials & Coatings (up 10 percent). Currency was up 1 percent compared with the prior year, driven primarily by EMEAI (up 3 percent). Cost of Sales Cost of sales ("COS") was $36.7 billion in 2019, down $4.4 billion from $41.1 billion in 2018. COS decreased in 2019 primarily due to lower feedstock and other raw material costs, decreased sales volume, cost synergies, stranded cost removal and a favorable adjustment to the warranty accrual of an exited business, which were partially offset by $75 million of transaction-related costs resulting from the separation from DowDuPont (related to the Corporate segment) and $399 million of environmental charges related to Packaging & Specialty Plastics ($5 million), Industrial Intermediates & Infrastructure ($8 million), Performance Materials & Coatings ($50 million) and Corporate ($336 million). COS as a percentage of sales was 85.3 percent in 2019 compared with 82.8 percent in 2018. COS was $41.1 billion in 2018, up $4.7 billion from $36.4 billion in 2017, primarily due to increased sales volume, which reflected additional capacity from U.S. Gulf Coast growth projects and increased supply from Sadara, higher feedstock and other raw material costs and increased planned maintenance turnaround costs which more than offset lower commissioning expenses related to U.S. Gulf Coast growth projects and cost synergies. COS as a percentage of sales was 82.8 percent in 2018 compared with 83.1 percent in 2017. Personnel Count The Company permanently employed approximately 36,500 people at December 31, 2019, down from approximately 37,600 people at December 31, 2018 and 39,200 people at December 31, 2017 primarily due to the Company's restructuring programs. Research and Development Expenses R&D expenses were $765 million in 2019, compared with $800 million in 2018 and $803 million in 2017. R&D expenses in 2019 decreased compared with 2018 primarily due to cost reductions and lower performance-based compensation costs. R&D expenses in 2018 were essentially flat compared with 2017. Selling, General and Administrative Expenses SG&A expenses for Dow Inc. and TDCC were $1,590 million and $1,585 million, respectively, in 2019, compared with $1,782 million in 2018 and $1,795 million in 2017. In 2019, SG&A expenses decreased primarily due to cost reductions, cost synergies, stranded cost removal and lower performance-based compensation costs. SG&A expenses were favorably impacted by a recovery of a portion of legal costs related to the Nova litigation award in the third quarter of 2019. In 2018, SG&A expenses decreased primarily due to additional cost reductions and lower performance-based compensation costs which more than offset a full year of expense from the ECP business and the absence of the recovery of costs related to the Nova patent infringement award in 2017. See Note 17 to the Consolidated Financial Statements for additional information on the Nova litigation awards. Amortization of Intangibles Amortization of intangibles was $419 million in 2019, down from $469 million in 2018, primarily due to certain intangible assets becoming fully amortized. Amortization of intangibles in 2018 increased from $400 million in 2017, primarily due to the receipt of ECP. See Note 14 to the Consolidated Financial Statements for additional information on intangible assets. Restructuring, Goodwill Impairment and Asset Related Charges - Net Restructuring, goodwill impairment and asset related charges - net were $3,219 million in 2019, $221 million in 2018 and $2,739 million in 2017. DowDuPont Cost Synergy Program In September and November 2017, DowDuPont approved post-merger restructuring actions under the DowDuPont Cost Synergy Program (the "Synergy Program") which was designed to integrate and optimize the organization following the Merger and in preparation for the business separations. The Company expected (prior to the impact of any discontinued operations) to record total pretax restructuring charges of approximately $1.3 billion, which included initial estimates of approximately $525 million to $575 million of severance and related benefit costs; $400 million to $440 million of asset write-downs and write-offs, and $290 million to $310 million of costs associated with exit and disposal activities. The restructuring charges below reflect charges from continuing operations. As a result of the Synergy Program, the Company recorded pretax restructuring charges of $399 million in 2017, consisting of severance and related benefit costs of $307 million, asset write-downs and write-offs of $87 million and costs associated with exit and disposal activities of $5 million. The restructuring charges by segment were as follows: $36 million in Packaging & Specialty Plastics, $12 million in Industrial Intermediates & Infrastructure, $11 million in Performance Materials & Coatings and $340 million in Corporate. For the year ended December 31, 2018, the Company recorded pretax restructuring charges of $184 million, consisting of severance and related benefit costs of $137 million, asset write-downs and write-offs of $33 million and costs associated with exit and disposal activities of $14 million. The restructuring charges by segment were as follows: $13 million in Packaging & Specialty Plastics, $11 million in Industrial Intermediates & Infrastructure, $7 million in Performance Materials & Coatings and $153 million in Corporate. For the year ended December 31, 2019, the Company recorded pretax restructuring charges of $292 million, consisting of severance and related benefit costs of $123 million, asset write-downs and write-offs of $143 million and costs associated with exit and disposal activities of $26 million. The restructuring charges by segment were as follows: $1 million in Packaging & Specialty Plastics, $7 million in Industrial Intermediates & Infrastructure, $28 million in Performance Materials & Coatings and $256 million in Corporate. The Company expects the Synergy Program to be substantially complete by the end of the second quarter of 2020. Goodwill Impairment Upon completion of the goodwill impairment testing in the fourth quarter of 2019, the Company determined the fair value of the Coatings & Performance Monomers reporting unit was lower than its carrying amount. As a result, the Company recorded an impairment charge of $1,039 million in the fourth quarter of 2019 related to Performance Materials & Coatings. Upon completion of the goodwill impairment testing in the fourth quarter of 2017, the Company determined the fair value of the Coatings & Performance Monomers reporting unit was lower than its carrying amount. As a result, the Company recorded an impairment charge of $1,491 million in the fourth quarter of 2017, related to Performance Materials & Coatings. Asset Related Charges 2019 Charges In 2019, the Company recognized additional pretax impairment charges of $58 million related primarily to capital additions made to a biopolymers manufacturing facility in Santa Vitoria, Minas Gerais, Brazil ("Santa Vitoria"), which was impaired in 2017. The impairment charges by segment were as follows: $44 million in Packaging & Specialty Plastics, $9 million in Performance Materials & Coatings and $5 million in Corporate. On August 13, 2019, the Company entered into a definitive agreement to sell its acetone derivatives business to ALTIVIA Ketones & Additives, LLC. The transaction closed on November 1, 2019 and included the Company's acetone derivatives related inventory and production assets, located in Institute, West Virginia, in addition to the site infrastructure, land, utilities and certain railcars. The Company remains at the Institute site as a tenant. As a result of the divestiture, the Company recognized a pretax impairment charge of $75 million in the third quarter of 2019. The impairment charge by segment was as follows: $24 million in Packaging & Specialty Plastics and $51 million in Corporate. In the fourth quarter of 2019, the Company concluded that its equity method investment in Sadara was other-than-temporarily impaired. The Company also reserved certain accounts and notes receivable and accrued interest balances due to uncertainty on the timing of collection. As a result, the Company recorded a $1,755 million pretax charge related to Sadara. The charge by segment was as follows: $370 million in Packaging & Specialty Plastics, $1,168 million in Industrial Intermediates & Infrastructure and $217 million in Corporate. 2018 Charges In 2018, the Company recognized an additional pretax impairment charge of $34 million related primarily to capital additions at its Santa Vitoria manufacturing facility. The impairment charge was related to Packaging & Specialty Plastics. 2017 Charges In 2017, the Company recognized a $622 million pretax impairment charge related to its Santa Vitoria manufacturing facility. The Company determined it would not pursue an expansion of the facility’s ethanol mill into downstream derivative products, primarily as a result of cheaper ethane-based production as well as the Company’s new assets coming online on the U.S. Gulf Coast which can be used to meet growing market demands in Brazil. As a result of this decision, cash flow analysis indicated the carrying amount of the impacted assets was not recoverable. The impairment charge was related to Packaging & Specialty Plastics. The Company also recognized other pretax impairment charges of $246 million in the fourth quarter of 2017, including charges related to manufacturing assets of $159 million, an equity method investment of $81 million and other assets of $6 million. The impairment charges by segment were as follows: $58 million in Packaging & Specialty Plastics, $5 million in Industrial Intermediates & Infrastructure, $83 million in Performance Materials & Coatings and $100 million in Corporate. Refer to Note 7 to the Consolidated Financial Statements for additional information on restructuring, goodwill impairment and asset related charges. Integration and Separation Costs Integration and separation costs, which reflect costs related to the Merger and the ownership restructure of Dow Silicones (through May 31, 2018), as well as post-Merger integration and business separation activities, were $1,063 million and $1,039 million for Dow Inc. and TDCC, respectively, in 2019, $1,179 million in 2018 and $798 million in 2017, and were related to Corporate. In 2018 and 2019, integration and separation costs were higher as a result of post-merger integration and business separation activities. Equity in Earnings of Nonconsolidated Affiliates The Company’s share of the earnings (losses) of nonconsolidated affiliates in 2019 was a loss of $94 million, compared with earnings of $555 million in 2018 and $394 million in 2017. In 2019, equity earnings decreased primarily due to lower equity earnings from the Kuwait joint ventures (due to lower monethylene glycol and polyethylene prices) and the Thai joint ventures and increased equity losses from Sadara. See Note 13 to the Consolidated Financial Statements for additional information on the Company’s evaluation of its equity method investment in Sadara for other-than-temporary impairment. In 2018, equity earnings increased from 2017 as higher earnings from the Kuwait joint ventures and lower equity losses from Sadara were partially offset by lower equity earnings from the Thai joint ventures. Sundry Income (Expense) - Net Sundry income (expense) - net includes a variety of income and expense items such as foreign currency exchange gains and losses, dividends from investments, gains and losses on sales of investments and assets, non-operating pension and other postretirement benefit plan credits or costs, and certain litigation matters. TDCC Sundry income (expense) - net for 2019 was income of $573 million, compared with income of $96 million in 2018 and expense of $154 million in 2017. In 2019, sundry income (expense) - net included an increase in foreign currency exchange gains, non-operating pension and postretirement benefit plan credits and gains on sales of assets and investments, as well as a net gain of $205 million related to litigation matters, which included a $170 million gain related to a legal settlement with Nova (related to Packaging & Specialty Plastics), and an $85 million gain related to an adjustment of the Dow Silicones breast implant liability (related to Corporate), which were partially offset by a $50 million charge (net of indemnifications of $37 million), related to the settlement of the Dow Silicones commercial creditor matters (related to Corporate). In 2019, sundry income (expense) - net also included a $102 million loss on the early extinguishment of debt and a gain of $2 million on post-closing adjustments related to previous divestitures (both related to Corporate). See Notes 8, 16, 17, 21 and 27 to the Consolidated Financial Statements for additional information. In 2018, sundry income (expense) - net included non-operating pension and other postretirement benefit plan credits, a $20 million gain related to the Company's sale of its equity interest in MEGlobal (related to Corporate) and gains on sales of assets and investments, which more than offset foreign currency exchange losses, a loss of $54 million on the early extinguishment of debt (related to Corporate) and a loss of $20 million for post-closing adjustments related to the Dow Silicones ownership restructure (related to Performance Materials & Coatings). See Notes 8, 16 and 21 to the Consolidated Financial Statements for additional information. In 2017, sundry income (expense) - net included a $227 million gain on the divestiture of the EAA Business (related to Packaging & Specialty Plastics), a $137 million gain related to the Nova patent infringement matter (related to Packaging & Specialty Plastics), a $7 million gain on post-closing adjustments related to the split-off of the chlorine value chain (related to Corporate) and gains on sales of assets and investments. These gains were more than offset by $676 million of non-operating pension and other postretirement benefit costs, primarily driven by a $687 million settlement charge for a U.S. non-qualified pension plan (related to Corporate), and foreign currency exchange losses. See Notes 6, 8, 17 and 21 to the Consolidated Financial Statements for additional information. Dow Inc. Sundry income (expense) - net for 2019 was income of $461 million, compared with income of $96 million in 2018 and an expense of $154 million in 2017. In addition to the amounts previously discussed above for TDCC, sundry income (expense) - net in 2019 included a $51 million loss on post-closing adjustments related to a previous divestiture and $69 million in charges associated with agreements entered into with DuPont and Corteva as part of the separation and distribution, which provides for cross-indemnities and allocations of obligations and liabilities for periods prior to, at and after completion of the separation (both related to Corporate). See Notes 4, 8, 17, 21 and 27 to the Consolidated Financial Statements for additional information. Interest Expense and Amortization of Debt Discount Dow Inc. Interest expense and amortization of debt discount was $933 million in 2019, down from $1,063 million in 2018, primarily due to debt reductions and lower interest bearing notes issued in the fourth quarter of 2018, which replaced higher interest bearing notes redeemed in the fourth quarter of 2018. Interest expense and amortization of debt discount in 2018 was up from $914 million in 2017, primarily reflecting the effect of lower capitalized interest as a result of decreased capital spending. See Liquidity and Capital Resources in Management's Discussion and Analysis of Financial Condition and Results of Operations and Notes 12 and 16 to the Consolidated Financial Statements for additional information related to debt financing activity. TDCC Interest expense and amortization of debt discount was $952 million in 2019, down from $1,063 million in 2018. Interest expense and amortization of debt discount in 2018 was up from $914 million in 2017. In addition to the amounts previously discussed above for Dow Inc., TDCC had interest expense related to an intercompany loan with Dow Inc. See Note 26 to the Consolidated Financial Statements for additional information. Provision for Income Taxes on Continuing Operations The Company's effective tax rate fluctuates based on, among other factors, where income is earned, the level of income relative to tax attributes and the level of equity earnings, since most earnings from the Company's equity method investments are taxed at the joint venture level. The underlying factors affecting the Company's overall tax rate are summarized in Note 9 to the Consolidated Financial Statements. On December 22, 2017, the Tax Cuts and Jobs Act (“The Act”) was enacted. The Act reduced the U.S. federal corporate income tax rate from 35 percent to 21 percent, required companies to pay a one-time transition tax on earnings of certain foreign subsidiaries that were previously deferred, created new provisions related to foreign sourced earnings, eliminated the domestic manufacturing deduction and moved to a hybrid territorial system. At December 31, 2017, the Company had not completed its accounting for the tax effects of The Act; however, the Company made a reasonable estimate of the effects on its existing deferred tax balances and the one-time transition tax. In accordance with Staff Accounting Bulletin 118, income tax effects of The Act were refined upon obtaining, preparing, and analyzing additional information during the measurement period. At December 31, 2018, the Company had completed its accounting for the tax effects of The Act. In the fourth quarter of 2019, the Company recorded the impacts of tax law changes enacted in Switzerland. As a result, deferred tax assets increased by $92 million. The provision for income taxes on continuing operations was $470 million in 2019, compared with $809 million in 2018 and $1,524 million in 2017. The tax rate for 2019 was unfavorably impacted by non-deductible goodwill and investment impairments, geographic mix of earnings and reduced equity earnings. These factors resulted in a negative effective tax rate of 37.7 percent for Dow Inc. in 2019. The tax rate for 2018 was favorably impacted by the reduced U.S. federal corporate income tax rate as a result of The Act and benefits related to the issuance of stock-based compensation and unfavorably impacted by non-deductible restructuring costs and increases in statutory income in Latin America and Canada due to local currency devaluations. These factors resulted in an effective tax rate of 21.6 percent in 2018. The tax rate for 2017 was unfavorably impacted by the enactment of The Act, the impairment of goodwill for which there was no corresponding tax deduction, charges related to tax attributes in the United States and Germany as a result of the Merger and certain non-deductible costs associated with the Merger. The tax rate was favorably impacted by the geographic mix of earnings, equity earnings and the adoption of Accounting Standards Update ("ASU") 2016-09, "Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting," which resulted in the recognition of excess tax benefits related to the issuance of stock-based compensation in the provision for income taxes on continuing operations. These factors resulted in an effective tax rate of 643.0 percent for 2017. Income from Discontinued Operations, Net of Tax Income from discontinued operations, net of tax was $445 million in 2019, $1,835 million in 2018 and $1,882 million in 2017, and was related to the distribution of AgCo and SpecCo to DowDuPont as a result of the separation. See Note 4 to the Consolidated Financial Statements for additional information. Net Income Attributable to Noncontrolling Interests Net income attributable to noncontrolling interests was $87 million in 2019, $134 million in 2018 and $130 million in 2017. Net income attributable to noncontrolling interests decreased in 2019 compared with 2018, primarily due to the Company's acquisition of full ownership in a propylene oxide manufacturing joint venture on October 1, 2019. Net income attributable to noncontrolling interests increased in 2018 compared with 2017, primarily due to the sale of the Company's ownership interests in the SKC Haas Display Films group of companies on June 30, 2017. Net income attributable to noncontrolling interests from discontinued operations of $13 million in 2019, $32 million in 2018 and $28 million in 2017 are included in the amounts above. See Notes 20 and 25 to the Consolidated Financial Statements for additional information. Net Income (Loss) Available for the Common Stockholder(s) Net income (loss) available for Dow Inc. and TDCC common stockholder(s) was a loss of $1,359 million and $1,237 million, respectively, in 2019, compared with income of $4,641 million in 2018 and income of $465 million in 2017. Earnings (loss) per share of Dow Inc. was a loss of $1.84 per share in 2019, compared with income of $6.21 per share in 2018 and income of $0.60 per share in 2017. Following the separation from DowDuPont, TDCC's common shares are owned solely by Dow Inc. SEGMENT RESULTS Effective with the Merger, TDCC's business activities were components of DowDuPont's business operations and were reported as a single operating segment. Following the separation from DowDuPont, the Company changed the manner in which its business activities were managed. The Company's portfolio now includes six global businesses which are organized into the following operating segments: Packaging & Specialty Plastics, Industrial Intermediates & Infrastructure and Performance Materials & Coatings. Corporate contains the reconciliation between the totals for the operating segments and the Company's totals. The Company did not aggregate any operating segments when determining its reportable segments. Following the separation from DowDuPont, the Company changed its practice of transferring ethylene to its downstream derivative businesses at cost to transferring ethylene at market prices. The Company also changed certain of its Corporate segment allocation practices, including costs previously assigned to AgCo and SpecCo ("stranded costs") which are now allocated to the operating segments. These changes to the Company's segment results have been consistently applied to all periods presented. Dow reported geographic information for the following regions: U.S. & Canada, Asia Pacific, Latin America, and EMEAI. As a result of the separation from DowDuPont, the Company changed the geographic alignment for the country of India to be reflected in EMEAI (previously reported in Asia Pacific). The Company’s measure of profit/loss for segment reporting purposes is pro forma Operating EBIT as this is the manner in which the Company's chief operating decision maker ("CODM") assesses performance and allocates resources. The Company defines pro forma Operating EBIT as earnings (i.e., "Income (loss) from continuing operations before income taxes") before interest, plus pro forma adjustments, excluding the impact of significant items. Pro forma Operating EBIT by segment includes all operating items relating to the businesses; items that principally apply to Dow as a whole are assigned to Corporate. The Company also presents pro forma net sales as it is included in management’s measure of segment performance and is regularly reviewed by the CODM. Pro forma net sales includes the impact of ECP from January 1, 2017 through August 31, 2017, as well as the impact of various manufacturing, supply and service related agreements entered into with DuPont and Corteva in connection with the separation which provide for different pricing than the historical intercompany and intracompany pricing practices of TDCC and Historical DuPont. See Note 27 to the Consolidated Financial Statements for reconciliations of these measures and a summary of the pro forma adjustments impacting segment measures, which are consistent with the pro forma adjustments included in the Current Report on Form 8-K filed on June 3, 2019, with the SEC. PACKAGING & SPECIALTY PLASTICS Packaging & Specialty Plastics consists of two highly integrated global businesses: Hydrocarbons & Energy and Packaging and Specialty Plastics. The segment employs the industry’s broadest polyolefin product portfolio, supported by the Company’s proprietary catalyst and manufacturing process technologies, to work at the customer’s design table throughout the value chain to deliver more reliable and durable, higher performing, and more sustainable plastics to customers in food and specialty packaging; industrial and consumer packaging; health and hygiene; caps, closures and pipe applications; consumer durables; automotive; and infrastructure. Ethylene is transferred to downstream derivative businesses at market-based prices, which are generally equivalent to prevailing market prices for large volume purchases.This segment also includes the results of The Kuwait Styrene Company K.S.C.C. and The SCG-Dow Group, as well as a portion of the results of EQUATE Petrochemical Company K.S.C.C. ("EQUATE"), The Kuwait Olefins Company K.S.C.C. ("TKOC"), Map Ta Phut Olefins Company Limited and Sadara, all joint ventures of the Company. The Company is responsible for marketing a majority of Sadara products outside of the Middle East zone through the Company's established sales channels. As part of this arrangement, the Company purchases and sells Sadara products for a marketing fee. 2019 Versus 2018 Packaging & Specialty Plastics net sales were $20,245 million in 2019, down 16 percent from net sales of $24,195 million in 2018. Pro forma net sales were $20,245 million in 2019, a decrease of 16 percent compared with pro forma net sales of $24,237 million in 2018, with local price down 12 percent, volume down 3 percent, and an unfavorable currency impact of 1 percent, primarily in EMEAI. Local price decreased in both businesses and across all geographic regions driven by reduced polyethylene prices and lower prices for Hydrocarbons & Energy co-products. Volume declined for the segment in all geographic regions, except Asia Pacific. Hydrocarbons & Energy volume declines more than offset volume gains in Packaging and Specialty Plastics. Volume decreased in Hydrocarbons & Energy primarily due to planned maintenance turnaround activity in Europe, increased internal consumption of ethylene on the U.S. Gulf Coast and lighter feedslate usage in Europe, leading to lower co-product production. Volume increased in Packaging and Specialty Plastics in Asia Pacific and EMEAI. Packaging and Specialty Plastics volume growth was driven by strong end-market growth in flexible food and specialty packaging, industrial and consumer packaging, and health and hygiene applications. Pro forma Operating EBIT was $2,904 million in 2019, down 19 percent from pro forma Operating EBIT of $3,593 million in 2018. Pro forma Operating EBIT decreased primarily due to lower selling prices, reduced equity earnings at the Kuwait joint ventures due to lower polyethylene margins, lower sales volume in the Hydrocarbons & Energy business and the impact of an outage in Argentina, which more than offset lower feedstock and other raw material costs, volume gains in the Packaging and Specialty Plastics business and cost synergies. 2018 Versus 2017 Packaging & Specialty Plastics net sales were $24,195 million in 2018, up 13 percent from $21,504 million in 2017. Pro forma net sales were $24,237 million in 2018, up from pro forma net sales of $22,546 million in 2017. Pro forma net sales increased 7 percent compared with 2017, with volume up 5 percent, a currency benefit of 1 percent, primarily in EMEAI, and local price up 1 percent. Volume increased in both businesses and across all geographic regions primarily due to new capacity additions on the U.S. Gulf Coast and increased supply from Sadara. Packaging and Specialty Plastics' volume growth was driven by increased demand in industrial and consumer packaging, food and specialty packaging, health and hygiene solutions and elastomer applications. Hydrocarbons & Energy volume increased primarily due to higher sales of ethylene and ethylene co-products. Local price increased in all geographic regions, except U.S. & Canada. Hydrocarbons & Energy local price increased as a result of higher Brent crude oil prices, which increased approximately 30 percent compared with 2017. Packaging and Specialty Plastics local price was flat when compared with 2017 as local price increases in Latin America were offset by declines in EMEAI. Pro forma Operating EBIT was $3,593 million in 2018, down 3 percent from pro forma Operating EBIT of $3,712 million in 2017. Pro forma Operating EBIT decreased as the impact of higher feedstock and other raw materials costs, increased costs from planned maintenance turnarounds and the unfavorable impact of stranded costs more than offset higher sales volume, reflecting additional capacity from growth projects, higher selling prices, the benefit from currency on sales, cost synergies, higher equity earnings and lower startup and commissioning costs. INDUSTRIAL INTERMEDIATES & INFRASTRUCTURE Industrial Intermediates & Infrastructure consists of two customer-centric global businesses - Industrial Solutions and Polyurethanes & Construction Chemicals - that develop important intermediate chemicals that are essential to manufacturing processes, as well as downstream, customized materials and formulations that use advanced development technologies. These businesses primarily produce and market ethylene oxide and propylene oxide derivatives that are aligned to market segments as diverse as appliances, coatings, infrastructure and oil and gas. The global scale and reach of these businesses, world-class technology and R&D capabilities and materials science expertise enable the Company to be a premier solutions provider offering customers value-add sustainable solutions to enhance comfort, energy efficiency, product effectiveness and durability across a wide range of home comfort and appliances, building and construction, adhesives and lubricant applications, among others. This segment also includes a portion of the results of EQUATE, TKOC, Map Ta Phut Olefins Company Limited and Sadara, all joint ventures of the Company. The Company is responsible for marketing a majority of Sadara products outside of the Middle East zone through the Company's established sales channels. As part of this arrangement, the Company purchases and sells Sadara products for a marketing fee. 2019 Versus 2018 Industrial Intermediates & Infrastructure net sales were $13,440 million in 2019, down 13 percent from $15,447 million in 2018. Pro forma net sales were $13,449 million in 2019, down from pro forma net sales of $15,465 million in 2018. Pro forma net sales decreased 13 percent in 2019, with local price down 12 percent and an unfavorable currency impact of 2 percent, primarily in EMEAI, which were partially offset by a 1 percent increase in volume. Price decreased in both businesses and all geographic regions, driven by lower feedstock and other raw material costs and unfavorable supply/demand fundamentals. Polyurethanes & Construction Chemicals reported volume increases in all geographic regions, primarily reflecting increased supply from Sadara and growth in polyurethanes systems applications, which were partially offset by a decline of caustic soda volume due to planned maintenance turnaround activities. Industrial Solutions volume decreased in EMEAI and U.S & Canada and was flat in Latin America and Asia Pacific, primarily driven by reduced availability of glycol ethers, performance solvents and monoethylene glycol due to planned and unplanned events that more than offset higher demand for industrial specialties. Pro forma Operating EBIT was $845 million in 2019, down 52 percent from pro forma Operating EBIT of $1,767 million in 2018. Pro forma Operating EBIT decreased as a result of margin compression across both businesses as well as lower equity earnings from the Kuwait joint ventures and increased equity losses from Sadara, which more than offset cost reductions. 2018 Versus 2017 Industrial Intermediates & Infrastructure net sales were $15,447 million in 2018, up 19 percent from $12,951 million in 2017. Pro forma net sales were $15,465 million in 2018, up from pro forma net sales of $12,951 million in 2017. Pro forma net sales increased 19 percent in 2018, with volume up 13 percent, local price up 5 percent and a currency benefit of 1 percent, primarily in EMEAI. Volume increased in both businesses and across all geographic regions. Polyurethanes & Construction Chemicals reported volume increases in all geographic regions, except Latin America, primarily reflecting increased supply from Sadara. Industrial Solutions volume increased in all geographic regions reflecting greater production from Sadara and increased demand in industrial specialties. Local price increased in both businesses and all geographic regions, except Asia Pacific. Local price increases were driven by higher feedstock and other raw material costs, pricing initiatives and strong demand for caustic soda, propylene glycols and propylene oxide which more than offset price declines in isocyanates. Pro forma Operating EBIT was $1,767 million in 2018, up 20 percent from pro forma Operating EBIT of $1,470 million in 2017. Pro forma Operating EBIT increased as the impact of higher selling prices, cost synergies, higher equity earnings from the Kuwait joint ventures and lower equity losses from Sadara more than offset contraction in isocyanates margins, the unfavorable impact of stranded costs and higher feedstock and other raw material costs. PERFORMANCE MATERIALS & COATINGS Performance Materials & Coatings includes industry-leading franchises that deliver a wide array of solutions into consumer and infrastructure end-markets. The segment consists of two global businesses: Coatings & Performance Monomers and Consumer Solutions. These businesses primarily utilize the Company's acrylics-, cellulosics- and silicone-based technology platforms to serve the needs of the architectural and industrial coatings, home care and personal care end-markets. Both businesses employ materials science capabilities, global reach and unique products and technology to combine chemistry platforms to deliver differentiated offerings to customers. 2019 Versus 2018 Performance Materials & Coatings net sales were $8,923 million in 2019, down 8 percent from net sales of $9,677 million in 2018. Pro forma net sales were $8,961 million in 2019, down 9 percent from pro forma net sales of $9,865 million in 2018 with local price down 6 percent, an unfavorable currency impact of 2 percent and volume down 1 percent. Local price decreased in both businesses and all geographic regions. Local price decreased in Consumer Solutions due to lower siloxanes prices, primarily in Asia Pacific and EMEAI. Coatings & Performance Monomers local price declined in all geographic regions in response to lower feedstock and other raw material costs. Volume for the segment declined in all geographic regions except Asia Pacific. Consumer Solutions volume was flat, with volume growth in Asia Pacific, offset by volume declines in Latin America and EMEAI. Consumer Solutions volume was flat in U.S. & Canada. Coatings & Performance Monomers volume declined in all geographic regions. The decline in volume was driven by increased captive use of coatings products which drove soft demand in coating applications, primarily architectural binders, and lower demand for acrylates and methacrylates due to supply/demand balances. Pro forma Operating EBIT was $918 million in 2019, down 26 percent from pro forma Operating EBIT of $1,246 million in 2018. Pro forma Operating EBIT decreased primarily due to margin compression in both businesses, which more than offset lower planned maintenance turnaround spending and cost synergies. 2018 Versus 2017 Performance Materials & Coatings net sales were $9,677 million in 2018, up from $8,892 million in 2017. Pro forma net sales were $9,865 million in 2018, up from pro forma net sales of $8,892 million in 2017. Pro forma net sales increased 11 percent in 2018, with an increase in local price of 10 percent, a benefit of 2 percent from portfolio actions, a benefit from currency of 1 percent, primarily in EMEAI, and a decrease in volume of 2 percent. Local price increased in both businesses and all geographic regions. Consumer Solutions local price increased primarily due to disciplined price/volume management in upstream silicone intermediates, which more than offset a decrease in volume. Local price increased in Coatings & Performance Monomers in response to higher feedstock and other raw material costs and favorable supply/demand fundamentals. Volume decreased in both businesses and all geographic regions, except Asia Pacific. Volume decreased in Consumer Solutions primarily as a result of targeted reductions of low-margin business, primarily in the home care market sector. Volume decreased slightly for Coatings & Performance Monomers, with a decline in all geographic regions, except Asia Pacific. Pro forma Operating EBIT was $1,246 million in 2018, up 53 percent from pro forma Operating EBIT of $817 million in 2017. Pro forma Operating EBIT improved compared with 2017 as higher selling prices and the favorable impact of cost synergies more than offset the unfavorable impact of stranded costs and higher feedstock and other raw material costs. CORPORATE Corporate includes certain enterprise and governance activities (including insurance operations, environmental operations, etc.); non-business aligned joint ventures; non-business aligned litigation expenses; and discontinued or non-aligned businesses. 2019 Versus 2018 Net sales and pro forma net sales for Corporate, which primarily relate to the Company's insurance operations, were $343 million in 2019, up from net sales and pro forma net sales of $285 million in 2018. Pro forma Operating EBIT was a loss of $315 million in 2019, compared with a pro forma Operating EBIT loss of $370 million in 2018. Compared with 2018, pro forma Operating EBIT improved primarily due to cost reductions and stranded cost removal. 2018 Versus 2017 Net sales and pro forma net sales for Corporate were $285 million in 2018, compared with net sales and pro forma net sales of $383 million in 2017. Pro forma Operating EBIT was a loss of $370 million in 2018, compared with a loss of $422 million in 2017. Compared with 2017, pro forma Operating EBIT improved primarily due to lower discontinued business costs and cost reductions. OUTLOOK Operating Segments & End-Market Expectations In 2020, the Company expects crude oil, natural gas and feedstock costs to remain volatile and sensitive to external macroeconomic and geopolitical factors. The Company currently expects crude oil prices to be, on average, flat to slightly higher than 2019. Crude oil fundamentals suggest ample global supply to meet current demand; however, geopolitical tensions could add a risk premium that potentially supports higher prices. The Company expects natural gas prices to be, on average, lower than 2019. In U.S. & Canada, robust supplies of natural gas are expected to keep domestic prices globally competitive. U.S. exports of liquefied natural gas ("LNG") are expected to increase further in 2020. In Europe, the supply of natural gas is expected to continue to be plentiful, both from pipeline supply and from growing LNG imports. In Packaging & Specialty Plastics, integrated margins are expected to remain stable in U.S. & Canada, supported by delays in new capacity additions, solid underlying demand and regional feedstock cost advantages. Margins in Europe are expected to remain challenged as a result of weaker regional demand and flat to higher feedstock costs. Margins in Asia Pacific commenced 2020 slightly below break-even levels, while full year margins are expected to be comparable to the second half of 2019. Profitability could vary materially depending on global GDP growth, industry operating rates, timing of capacity startups and fluctuations in global crude oil, natural gas and feedstock prices. The Hydrocarbons & Energy business expects to bring online approximately 500,000 metric tons of additional ethylene capacity in Texas as part of its suite of incremental growth investments. The new capacity is expected to come online in the second quarter of 2020. In Industrial Intermediates & Infrastructure, monoethylene glycol ("MEG") margins are expected to remain constrained in 2020 due to new industry capacity additions. End-market conditions for polyurethane intermediates are expected to remain highly competitive, with demand softness expected in key applications related to infrastructure, household appliances, automotive and furniture and bedding. Methyl diphenyl diisocyanate ("MDI") prices are expected to remain at low levels due to additional industry capacity and weak end-market fundamentals. In Performance Materials & Coatings, prices for commodity siloxane products are expected to be similar to those observed in the second half of 2019. Downstream silicones volume is expected to grow in excess of GDP, particularly for applications related to home and personal care, high performance building and construction and pressure-sensitive adhesives. The Company will continue to pursue incremental downstream silicones capacity debottleneck projects to meet demand in consumer driven end-markets. Global architectural coatings demand is expected to remain soft in the do-it-yourself and retail market segments. Industrial coatings are also projected to soften in 2020; however, the Company’s focus will be on capturing opportunities from customers’ shift to waterborne chemistries where Dow has unique technologies and solutions. Other factors impacting operating segment profitability include: • Planned maintenance turnaround spending is expected to be approximately flat compared with 2019. • Equity losses in nonconsolidated affiliates are expected to be slightly unfavorable compared with 2019. With respect to Sadara, which impacts the Packaging & Specialty Plastics and Industrial Intermediates & Infrastructure operating segments, the Company expects to continue to record equity losses due to anticipated funding commitments with the joint venture. Other Income Statement Expectations Additional items that may impact the consolidated statements of income in 2020 include: • The service cost component of pension expense is expected to be flat compared with 2019. The non-operating pension benefit is expected to be a headwind of approximately $125 million compared with 2019. • Interest expense and amortization of debt discount is expected to be approximately $850 million in 2020, reflecting lower gross debt compared with 2019. Projected Uses of Cash Items that may impact the consolidated statements of cash flows in 2020 include: • Integration and separation spending is expected to be approximately $200 million to $250 million. Year over year reductions in integration and separation spending as well as cash payments related to the DowDuPont Cost Synergy Program will result in reduced cash spending of approximately $1 billion compared with 2019. • Cash contributions to global pension plans are expected to be limited to mandatory minimum contributions. The total cash outflow is projected to be approximately $250 million. • Capital expenditures are expected to be $1.5 billion to $1.75 billion. The Company will adjust its spending within this range through the year as economic conditions develop. • The Company expects to loan approximately $500 million to Sadara and all or a portion of the loan could potentially be converted into equity. • The Company expects to preferentially deploy its free cash flow1 in a balanced way between shareholder returns and debt reduction. 1. Dow defines free cash flow as cash flows from operating activities - continuing operations, excluding the impact of ASU 2016-15, less capital expenditures. LIQUIDITY AND CAPITAL RESOURCES The Company had cash and cash equivalents of $2,367 million at December 31, 2019 and $2,724 million at December 31, 2018, of which $986 million at December 31, 2019 and $2,013 million at December 31, 2018, was held by subsidiaries in foreign countries, including United States territories. The decrease in cash and cash equivalents held by subsidiaries in foreign countries is due to repatriation activities. For each of its foreign subsidiaries, the Company makes an assertion regarding the amount of earnings intended for permanent reinvestment, with the balance available to be repatriated to the United States. The cash held by foreign subsidiaries for permanent reinvestment is generally used to finance the subsidiaries' operational activities and future foreign investments. Dow has the ability to repatriate additional funds to the U.S., which could result in an adjustment to the tax liability for foreign withholding taxes, foreign and/or U.S. state income taxes and the impact of foreign currency movements. At December 31, 2019, management believed that sufficient liquidity was available in the United States. The Company has and expects to continue repatriating certain funds from its non-U.S. subsidiaries that are not needed to finance local operations; however, these particular repatriation activities have not and are not expected to result in a significant incremental tax liability to the Company. The Company’s cash flows from operating, investing and financing activities, as reflected in the consolidated statements of cash flows, are summarized in the following table: 1. Updated for ASU 2016-15, "Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments" ("ASU 2016-15") (including related SEC interpretive guidance) and ASU 2016-18, "Statement of Cash Flows (Topic 230): Restricted Cash," which the Company adopted in 2018. Cash Flows from Operating Activities Cash provided by operating activities from continuing operations increased in 2019 compared with 2018. The increase was primarily due to improvements in working capital, a cash receipt related to the Nova ethylene asset matter, advance payments from customers for product supply agreements, lower pension contributions and higher dividends received from nonconsolidated affiliates, which were partially offset by a decrease in cash earnings. Cash provided by operating activities from continuing operations in 2018 improved from cash used for operating activities from continuing operations in 2017, primarily due to the change in the Company's accounts receivable securitization facilities discussed in the section titled "Non-GAAP Cash Flow Measures" and a decrease in cash used for working capital requirements, which were partially offset by the absence of certain cash receipts in 2017. 1. Amounts exclude assets and liabilities of discontinued operations. 1. The increase in days sales outstanding in receivables was primarily due to an increase in accounts receivable as a result of the Company’s accounts receivable securitization facilities moving from off-balance sheet arrangements to secured borrowing arrangements in the second half of 2018. 2. The increase in days sales in inventory is primarily due to a decrease in COS, driven by lower sales and raw material costs, in addition to an increase in average ending inventory. 3. The increase in days payables outstanding is primarily due to a decrease in average accounts payable and a decrease in COS, which were partially offset by an increase in average ending inventory. Cash provided by operating activities from discontinued operations decreased in 2019 compared with 2018. The reduction was primarily due to the separation of AgCo and SpecCo on April 1, 2019. The Company had cash payments and receipts with DuPont and Corteva that related to certain agreements and matters related to the separation from DowDuPont. See Note 4 to the Consolidated Financial Statements for additional information. Cash provided by operating activities from discontinued operations decreased in 2018 compared with 2017, primarily due to changes in working capital requirements. Cash Flows from Investing Activities Cash used for investing activities from continuing operations in 2019 was primarily for capital expenditures, purchases of investments and investments in and loans to nonconsolidated affiliates, which were partially offset by proceeds from sales and maturities of investments. Cash used for investing activities from continuing operations in 2018 was primarily for capital expenditures and purchases of investments, which were partially offset by proceeds from sales and maturities of investments and proceeds from interests in trade accounts receivable conduits. Cash provided by investing activities from continuing operations in 2017 was primarily from proceeds from interests in trade accounts receivable conduits, proceeds from sales and maturities of investments and proceeds from divestitures, including the divestiture of the EAA Business, which were partially offset by capital expenditures, purchases of investments and investments in and loans to nonconsolidated affiliates, primarily with Sadara. The Company loaned Sadara $473 million in 2019 (zero in 2018 and $735 million in 2017) and a portion of these loans has been converted to equity. In the fourth quarter of 2019, the Company reserved certain notes receivable and accrued interest balances with Sadara due to uncertainty around timing of collection. The Company expects to loan Sadara approximately $500 million in 2020 and all or a portion of the loan could potentially be converted into equity. Additionally, the Company anticipates providing future financial support to Sadara through loans or capital contributions which will be subject to collectability assessments. See Note 13 to the Consolidated Financial Statements for additional information. The Company's capital expenditures related to continuing operations, including capital expenditures of consolidated variable interest entities, were $1,961 million in 2019, $2,091 million in 2018 and $2,807 million in 2017. The Company expects capital spending in 2020 to be in the range of $1.5 billion to $1.75 billion. The Company will adjust its spending within this range through the year as economic conditions develop. Capital spending in 2019, 2018 and 2017 included spending related to certain U.S. Gulf Coast investment projects including: a world-scale ethylene production facility and an ELITE™ Enhanced Polyethylene production facility, both of which commenced operations in 2017; a NORDEL™ Metallocene EPDM production facility, a Low Density Polyethylene ("LDPE") production facility, a High Melt Index ("HMI") AFFINITY™ polymer production facility and debottlenecking of an existing bi-modal gas phase polyethylene production facility, all of which commenced operations in 2018; and an expansion of the Company's new ethylene production facility expected to commence operations in 2020, bringing the facility's total ethylene capacity to 2,000 kilotonnes per annum and making it the largest ethylene cracker in the world. Cash used for investing activities from discontinued operations in 2019 was primarily for capital expenditures, partially offset by proceeds from the sales of property, businesses and ownership interests in nonconsolidated affiliates. Cash used for investing activities from discontinued operations in 2018 was primarily for capital expenditures, partially offset by proceeds from the sales of property and businesses. Cash provided by investing activities from discontinued operations in 2017 was primarily due to proceeds from the sale of property and businesses, which was partially offset by capital expenditures. Cash Flows from Financing Activities Cash used for financing activities from continuing operations in 2019 included payments on long-term debt and dividends paid to DowDuPont, which were partially offset by proceeds from issuance of long-term debt. In addition, Dow Inc. received cash as part of the separation from DowDuPont, which was more than offset by dividends paid to stockholders and purchases of treasury stock. Cash used for financing activities from continuing operations in 2018 included dividends paid to DowDuPont and payments of long-term debt, which were partially offset by proceeds from issuance of long-term debt. Cash used for financing activities in continuing operations in 2017 included dividends paid to stockholders through the close of the Merger, a dividend paid to DowDuPont in the fourth quarter of 2017, and payments of long-term debt. See Notes 16 and 19 to the Consolidated Financial Statements for additional information related to the issuance and retirement of debt and the Company's share repurchases and dividends. Cash used for financing activities from discontinued operations in 2019, 2018 and 2017 primarily related to distributions to noncontrolling interests and employee taxes paid for share-based payment arrangements. Non-GAAP Cash Flow Measures Cash Flows from Operating Activities - Continuing Operations - Excluding Impact of ASU 2016-15 Cash flows from operating activities - continuing operations, excluding the impact of ASU 2016-15, is defined as cash provided by (used for) operating activities - continuing operations, excluding the impact of ASU 2016-15 and related interpretive guidance. Management believes this non-GAAP financial measure is relevant and meaningful as it presents cash flows from operating activities inclusive of all trade accounts receivable collection activity, which Dow utilizes in support of its operating activities. Free Cash Flow Dow defines free cash flow as cash flows from operating activities - continuing operations, excluding the impact of ASU 2016-15, less capital expenditures. Under this definition, free cash flow represents the cash generated by Dow from operations after investing in its asset base. Free cash flow, combined with cash balances and other sources of liquidity, represent the cash available to fund obligations and provide returns to shareholders. Free cash flow is an integral financial measure used in Dow's financial planning process. Pro Forma Operating EBITDA Dow defines pro forma operating EBITDA as pro forma earnings (i.e. "Pro forma income from continuing operations before income taxes") before interest, depreciation and amortization, excluding the impact of significant items. Cash Flow Conversion (Pro Forma Operating EBITDA to Cash Flow From Operations) Dow defines cash flow conversion (or pro forma Operating EBITDA to cash flow from operations) as cash flows from operating activities - continuing operations, excluding the impact of ASU 2016-15, divided by pro forma Operating EBITDA. Management believes cash flow conversion is an important financial metric as it helps the Company determine how efficiently it is converting its earnings into cash flow. These financial measures are not recognized in accordance with U.S. GAAP and should not be viewed as alternatives to U.S. GAAP financial measures of performance. All companies do not calculate non-GAAP financial measures in the same manner and, accordingly, Dow's definitions may not be consistent with the methodologies used by other companies. 1. Pro forma adjustments include: (1) the margin impact of various manufacturing, supply and service related agreements entered into with DuPont and Corteva in connection with the separation which provide for different pricing than the historical intercompany and intracompany pricing practices of TDCC and Historical DuPont (included for 2019 and 2018 only), (2) the inclusion of ECP for the period of January 1, 2017 through August 31, 2017, (3) the removal of the amortization of ECP's inventory step-up recognized in connection with the Merger (4) the elimination of the impact of events directly attributable to the Merger, internal reorganization and business realignment, separation, distribution and other related transactions (e.g., one-time transaction costs) and (5) the elimination of the effect of a consummated divestiture agreed to with certain regulatory agencies as a condition of approval for the Merger. See Note 27 to the Consolidated Financial Statements for additional information. Liquidity & Financial Flexibility The Company’s primary source of incremental liquidity is cash flows from operating activities. The generation of cash from operations and the Company's ability to access capital markets is expected to meet the Company’s cash requirements for working capital, capital expenditures, debt maturities, contributions to pension plans, dividend distributions to stockholders, share repurchases and other needs. In addition to cash from operating activities, the Company’s current liquidity sources also include TDCC's U.S. and Euromarket commercial paper programs, committed credit facilities, a committed accounts receivable facility, a U.S. retail note program (“InterNotes®”) and other debt markets. Additional details on sources of liquidity are as follows: Commercial Paper TDCC issues promissory notes under its U.S. and Euromarket commercial paper programs. TDCC had $151 million of commercial paper outstanding at December 31, 2019 ($10 million at December 31, 2018). TDCC maintains access to the commercial paper market at competitive rates. Amounts outstanding under TDCC's commercial paper programs during the period may be greater or less than the amount reported at the end of the period. Subsequent to December 31, 2019, TDCC issued approximately $1.5 billion of commercial paper. Committed Credit Facilities The Company also has the ability to access liquidity through TDCC's committed and available credit facilities. At December 31, 2019, TDCC had total committed credit facilities of $9.4 billion and available credit facilities of $7.4 billion. See Note 16 to the Consolidated Financial Statements for additional information on committed and available credit facilities. In connection with the ownership restructure of Dow Silicones on May 31, 2016, Dow Silicones incurred $4.5 billion of indebtedness under a certain third party credit agreement ("Term Loan Facility"). In the second quarter of 2019, Dow Silicones voluntarily repaid $2.5 billion of principal on the Term Loan Facility. In September 2019, Dow Silicones amended the Term Loan Facility to extend the maturity date on the remaining principal balance of $2 billion, making amounts borrowed under the Term Loan Facility repayable in September 2021. In addition, this amendment includes options to extend the maturity date through September 2023, at Dow Silicones' election, which the Company intends to exercise. See Note 16 to the Consolidated Financial Statements for additional information on the Term Loan Facility. Letters of Credit TDCC utilizes letters of credit to support commitments made in the ordinary course of business. While the terms and amounts of letters of credit change, TDCC generally has approximately $400 million of outstanding letters of credit at any given time. Shelf Registration - U.S. On July 26, 2019, Dow Inc. and TDCC filed a shelf registration statement with the SEC. The shelf indicates that Dow Inc. may offer common stock; preferred stock; depositary shares; debt securities; guarantees; warrants to purchase common stock, preferred stock and debt securities; and stock purchase contracts and stock purchase units, with pricing and availability of any such offerings depending on market conditions. The shelf also indicates that TDCC may offer debt securities, guarantees and warrants to purchase debt securities, with pricing and availability of any such offerings depending on market conditions. Also on July 26, 2019, TDCC filed a new prospectus supplement under this shelf registration to register an unlimited amount of securities for issuance under InterNotes®. Debt As the Company continues to maintain its strong balance sheet and financial flexibility, management is focused on net debt (a non-GAAP financial measure), as the Company believes this is the best representation of its financial leverage at this point in time. As shown in the following table, net debt is equal to total gross debt minus "Cash and cash equivalents" and "Marketable securities." At December 31, 2019, net debt as a percent of total capitalization for Dow Inc. and TDCC increased to 50.9 percent and 49.6 percent, respectively, compared with 33.7 percent for both companies at December 31, 2018. The increase is primarily due to a reduction in stockholders' equity for both companies as a result of the separation from DowDuPont and a net loss in 2019, which was partially offset by a decrease in debt. In 2019, the Company issued $2 billion of senior unsecured notes in an offering under Rule 144A of the Securities Act of 1933. The offering included $750 million aggregate principal amount of 4.80 percent notes due 2049; $750 million aggregate principal amount of 3.625 percent notes due 2026; and $500 million aggregate principal amount of 3.15 percent notes due 2024. In addition, the Company redeemed $1.5 billion of 4.25 percent notes issued by the Company with maturity in 2020 and $1.25 billion of 4.125 percent notes issued by the Company with maturity in 2021. In October 2019, TDCC launched exchange offers for $4 billion of all the outstanding, unregistered senior notes that were issued in private offerings on November 30, 2018 and May 20, 2019, for identical, registered notes under the Securities Act of 1933 (the “Exchange Offers”). The Exchange Offers are with respect to the Company’s 3.15 percent notes due 2024, 4.55 percent notes due 2025, 3.625 percent notes due 2026, 4.80 percent notes due 2028, 5.55 percent notes due 2048 and 4.80 percent notes due 2049, and fulfilled the Company’s obligations contained in the registration rights agreements entered into in connection with the issuance of the aforementioned notes. The Company may at any time repurchase certain debt securities in the open market or in privately negotiated transactions subject to: the applicable terms under which any such debt securities were issued, certain internal approvals of the Company, and applicable laws and regulations of the relevant jurisdiction in which any such potential transactions might take place. This in no way obligates the Company to make any such repurchases nor should it be considered an offer to do so. TDCC’s public debt instruments and primary, private credit agreements contain, among other provisions, certain customary restrictive covenant and default provisions. TDCC’s most significant debt covenant with regard to its financial position is the obligation to maintain the ratio of its consolidated indebtedness to consolidated capitalization at no greater than 0.65 to 1.00 at any time the aggregate outstanding amount of loans under the Five Year Competitive Advance and Revolving Credit Facility Agreement ("Revolving Credit Agreement") equals or exceeds $500 million. The ratio of TDCC’s consolidated indebtedness as defined in the Revolving Credit Agreement was 0.51 to 1.00 at December 31, 2019. Management believes TDCC was in compliance with all of its covenants and default provisions at December 31, 2019. On April 1, 2019, DowDuPont completed the separation of its materials science business and Dow Inc. became the direct parent company of TDCC. In conjunction with the separation, Dow Inc. is obligated, substantially concurrently with the issuance of any guarantee in respect of outstanding or committed indebtedness under the Revolving Credit Agreement, to enter into a supplemental indenture with TDCC and the trustee under TDCC’s existing 2008 base indenture governing certain notes issued by TDCC. Under such supplemental indenture, Dow Inc. will guarantee all outstanding debt securities and all amounts due under such existing base indenture and will become subject to certain covenants and events of default under the existing base indenture. In addition, the Revolving Credit Agreement includes an event of default which would be triggered in the event Dow Inc. incurs or guarantees third party indebtedness for borrowed money in excess of $250 million or engages in any material activity or directly owns any material assets, in each case, subject to certain conditions and exceptions. Dow Inc. may, at its option, cure the event of default by delivering an unconditional and irrevocable guarantee to the administrative agent within thirty days of the event or events giving rise to such event of default. No such events have occurred or have been triggered at the time of the filing of this Annual Report on Form 10-K. See Note 16 to the Consolidated Financial Statements for information related to TDCC’s notes payable and long-term debt activity and information on TDCC’s covenants and default provisions. Management expects that the Company will continue to have sufficient liquidity and financial flexibility to meet all of its business obligations. Credit Ratings TDCC's credit ratings at January 31, 2020 were as follows: Downgrades in TDCC’s credit ratings will increase borrowing costs on certain indentures and could impact its ability to access debt capital markets. Dividends Dow Inc. The following table provides dividends paid to common stockholders for the years ended December 31, 2019, 2018 and 2017: 1. Reflects Dow Inc. activity subsequent to the separation from DowDuPont. 2. In 2018, the common stock of Dow Inc. and TDCC was owned solely by DowDuPont and therefore the Company did not have publicly traded stock. 3. Reflects TDCC activity prior to the Merger. TDCC Effective with the Merger, TDCC no longer has publicly traded common stock. From the Merger date through March 31, 2019, TDCC's common shares were owned solely by DowDuPont. Pursuant to the Merger Agreement, TDCC committed to fund a portion of DowDuPont's dividends paid to common stockholders and certain governance expenses. In addition, share repurchases by DowDuPont were partially funded by TDCC through 2018. Funding was accomplished through intercompany loans. On a quarterly basis, TDCC's Board of Directors reviewed and determined a dividend distribution to DowDuPont to settle the intercompany loans. The dividend distribution considered the level of TDCC’s earnings and cash flows and the outstanding intercompany loan balances. For the year ended December 31, 2019, TDCC declared and paid dividends to DowDuPont of $535 million ($3,711 million for the year ended December 31, 2018 and $1,056 for the year ended December 31, 2017). See Note 26 to the Consolidated Financial Statements for additional information. Effective with the separation from DowDuPont on April 1, 2019, TDCC became a wholly owned subsidiary of Dow Inc. TDCC has committed to fund Dow Inc.'s dividends paid to common stockholders, share repurchases and certain governance expenses. Funding is accomplished through intercompany loans. TDCC's Board of Directors reviews and determines a dividend distribution to Dow Inc. to settle the intercompany loans. For the year ended December 31, 2019, TDCC declared and paid dividends to Dow Inc. of $201 million. At December 31, 2019, TDCC's intercompany loan balance with Dow Inc. was zero. See Note 26 to the Consolidated Financial Statements for additional information. Share Repurchase Program Dow Inc. On April 1, 2019, Dow Inc.'s Board of Directors ratified the share repurchase program originally approved on March 15, 2019, authorizing up to $3 billion to be spent on the repurchase of the Company's common stock, with no expiration date. In 2019, Dow Inc. repurchased $500 million of the Company's common stock. At December 31, 2019, approximately $2.5 billion of the share repurchase program authorization remained available for repurchases. Dow Inc. expects to repurchase $250 million of the Company's common stock in 2020. TDCC In 2013, TDCC's Board of Directors approved a share repurchase program. As a result of subsequent authorizations approved by TDCC's Board of Directors, the total authorized amount of the share repurchase program was $9.5 billion. Effective with the Merger, the share repurchase program was canceled. Over the duration of the program, a total of $8.1 billion was spent on the repurchase of TDCC Common Stock. Pension Plans The Company has both funded and unfunded defined benefit pension plans that cover employees in the United States and a number of other countries. As a result of the Company’s separation from DowDuPont, the number of significant defined benefit pension plans administered by the Company decreased from 45 plans to 35 plans, with approximately $270 million of net unfunded pension liabilities transferred to DowDupont. Plans administered by other subsidiaries of DowDuPont that were transferred to the Company were not significant. There were no changes in the number of significant other postretirement benefit plans administered by the Company as a result of the separation. Existing Company plans that were significantly impacted by the transfer of active plan participants to DowDuPont were remeasured, resulting in curtailment gains and losses and recognition of special termination benefits. In 2019, 2018 and 2017, the Company contributed $261 million, $1,651 million and $1,672 million to its continuing operations pension plans respectively, including contributions to fund benefit payments for its non-qualified pension plans ($266 million, $1,656 million and $1,676 million, including contributions to plans of discontinued operations). In the third quarter of 2018, the Company made a $1,100 million discretionary contribution to its principal U.S. pension plan, which is included in the 2018 contribution amount above. The discretionary contribution was primarily based on the Company's funding policy, which permits contributions to defined benefit pension plans when economics encourage funding, and reflected considerations relating to tax deductibility and capital structure. The provisions of a U.S. non-qualified pension plan require the payment of plan obligations to certain participants upon a change in control of the Company, which occurred at the time of the Merger. Certain participants could elect to receive a lump-sum payment or direct the Company to purchase an annuity on their behalf using the after-tax proceeds of the lump sum. In the fourth quarter of 2017, the Company paid $940 million to plan participants and $230 million to an insurance company for the purchase of annuities, which were included in "Pension contributions" in the consolidated statements of cash flows. The Company also paid $205 million for income and payroll taxes for participants electing the annuity option. The Company recorded a settlement charge of $687 million associated with the payout in the fourth quarter of 2017. The Company expects to contribute approximately $250 million to its pension plans in 2020. See Note 21 to the Consolidated Financial Statements for additional information concerning the Company’s pension plans. Restructuring, Goodwill Impairment and Asset Related Charges - Net The activities related to the Synergy Program are expected to result in additional cash payments of approximately $70 million, primarily through the second quarter of 2020, consisting of severance and related benefit costs and costs associated with exit and disposal activities, including environmental remediation (see Note 7 to the Consolidated Financial Statements). The Company expects to incur additional costs in the future related to its restructuring activities. Future costs are expected to include demolition costs related to closed facilities; these costs will be recognized as incurred. The Company also expects to incur additional employee-related costs, including involuntary termination benefits, related to its other optimization activities. These costs cannot be reasonably estimated at this time. Integration and Separation Costs Integration and separation costs, which reflect costs related to the Merger, post-Merger integration and business separation activities and costs related to the ownership restructure of Dow Silicones, were $1,063 million and $1,039 million in 2019 for Dow Inc. and TDCC, respectively, $1,179 million in 2018 and $798 million in 2017. Integration and separation costs related to post-Merger integration and business separation activities are expected to continue in 2020 for activities primarily involving the separation of information technology infrastructure and physical plant operations. Integration and separation costs are expected to result in additional cash expenditures of approximately $200 million to $250 million through the end of 2020. Contractual Obligations The following table summarizes the Company’s contractual obligations, commercial commitments and expected cash requirements for interest at December 31, 2019. Additional information related to these obligations can be found in Notes 16, 17, 18 and 21 to the Consolidated Financial Statements. 1. Excludes unamortized debt discount and issuance costs of $331 million. Includes finance lease obligations of $395 million. Assumes the option to extend will be exercised for the $2 billion Dow Silicones Term Loan Facility. 2. Cash requirements for interest on long-term debt was calculated using current interest rates at December 31, 2019, and includes $2,344 million of various floating rate notes. 3. Includes imputed interest of $416 million. 4. Includes outstanding purchase orders and other commitments greater than $1 million obtained through a survey conducted within the Company. 5. Includes liabilities related to asbestos litigation, environmental remediation, legal settlements and other noncurrent liabilities. In addition to these items, Dow Inc. includes liabilities related to noncurrent obligations with DuPont and Corteva. The table excludes uncertain tax positions due to uncertainties in the timing of the effective settlement of tax positions with the respective taxing authorities and deferred tax liabilities as it is impractical to determine whether there will be a cash impact related to these liabilities. The table also excludes deferred revenue as it does not represent future cash requirements arising from contractual payment obligations. The Company expects to meet its contractual obligations through its normal sources of liquidity and believes it has the financial resources to satisfy these contractual obligations. Off-Balance Sheet Arrangements Off-balance sheet arrangements are obligations the Company has with nonconsolidated entities related to transactions, agreements or other contractual arrangements. The Company holds variable interests in joint ventures accounted for under the equity method of accounting. The Company is not the primary beneficiary of these joint ventures and therefore is not required to consolidate these entities (see Note 25 to the Consolidated Financial Statements). In addition, see Note 15 to the Consolidated Financial Statements for information regarding the transfer of financial assets. Guarantees arise during the ordinary course of business from relationships with customers, committed accounts receivable facilities and nonconsolidated affiliates when the Company undertakes an obligation to guarantee the performance of others if specific triggering events occur. The Company had outstanding guarantees at December 31, 2019 of $3,952 million, compared with $4,273 million at December 31, 2018. Additional information related to guarantees can be found in the “Guarantees” section of Note 17 to the Consolidated Financial Statements. Fair Value Measurements See Note 21 to the Consolidated Financial Statements for information related to fair value measurements of pension and other postretirement benefit plan assets; see Note 23 for information related to other-than-temporary impairments; and, see Note 24 for additional information concerning fair value measurements. OTHER MATTERS Recent Accounting Guidance See Note 2 to the Consolidated Financial Statements for a summary of recent accounting guidance. Critical Accounting Estimates The preparation of financial statements and related disclosures in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) requires management to make judgments, assumptions and estimates that affect the amounts reported in the consolidated financial statements and accompanying notes. Note 1 to the Consolidated Financial Statements describes the significant accounting policies and methods used in the preparation of the consolidated financial statements. Following are the Company’s accounting policies impacted by judgments, assumptions and estimates: Litigation The Company is subject to legal proceedings and claims arising out of the normal course of business including product liability, patent infringement, employment matters, governmental tax and regulation disputes, contract and commercial litigation and other actions. The Company routinely assesses the legal and factual circumstances of each matter, the likelihood of any adverse outcomes to these matters, as well as ranges of probable losses. A determination of the amount of the reserves required, if any, for these contingencies is made after thoughtful analysis of each known claim. The Company has an active risk management program consisting of numerous insurance policies secured from many carriers covering various timeframes. These policies may provide coverage that could be utilized to minimize the financial impact, if any, of certain contingencies. The required reserves may change in the future due to new developments in each matter. For further discussion, see Note 17 to the Consolidated Financial Statements. Asbestos-Related Matters of Union Carbide Corporation Union Carbide is and has been involved in a large number of asbestos-related suits filed primarily in state courts during the past four decades. These suits principally allege personal injury resulting from exposure to asbestos-containing products and frequently seek both actual and punitive damages. The alleged claims primarily relate to products that Union Carbide sold in the past, alleged exposure to asbestos-containing products located on Union Carbide’s premises, and Union Carbide’s responsibility for asbestos suits filed against a former Union Carbide subsidiary, Amchem Products, Inc. ("Amchem"). Each year, Ankura Consulting Group, LLC ("Ankura") performs a review for Union Carbide based upon historical asbestos claims, resolution and asbestos-related defense and processing costs, through the terminal year of 2049. Union Carbide compares current asbestos claim and resolution activity, including asbestos-related defense and processing costs, to the results of the most recent Ankura study at each balance sheet date to determine whether the asbestos-related liability continues to be appropriate. For additional information, see Part I, Item 3. Legal Proceedings; Asbestos-Related Matters of Union Carbide Corporation in Management’s Discussion and Analysis of Financial Condition and Results of Operations; and Notes 1 and 17 to the Consolidated Financial Statements. Environmental Matters The Company determines the costs of environmental remediation of its facilities and formerly owned facilities based on evaluations of current law and existing technologies. Inherent uncertainties exist in such evaluations primarily due to unknown environmental conditions, changing governmental regulations and legal standards regarding liability, and emerging remediation technologies. The recorded liabilities are adjusted periodically as remediation efforts progress, or as additional technical or legal information becomes available. At December 31, 2019, the Company had accrued obligations of $1,155 million for probable environmental remediation and restoration costs, including $207 million for the remediation of Superfund sites. This is management’s best estimate of the costs for remediation and restoration with respect to environmental matters for which the Company has accrued liabilities, although it is reasonably possible that the ultimate cost with respect to these particular matters could range up to approximately one and a half times that amount. For further discussion, see Environmental Matters in Management’s Discussion and Analysis of Financial Condition and Results of Operations and Notes 1 and 17 to the Consolidated Financial Statements. Goodwill The Company performs goodwill impairment testing at the reporting unit level. Reporting units are the level at which discrete financial information is available and reviewed by business management on a regular basis. The Company tests goodwill for impairment annually (in the fourth quarter), or more frequently when events or changes in circumstances indicate it is more likely than not that the fair value of a reporting unit has declined below its carrying value. Goodwill is evaluated for impairment using qualitative and/or quantitative testing procedures. The separation from DowDuPont on April 1, 2019, did not impact the composition of the Company's six reporting units: Coatings & Performance Monomers, Consumer Solutions, Hydrocarbons & Energy, Industrial Solutions, Packaging and Specialty Plastics and Polyurethanes & Construction Chemicals. The ECP businesses received as part of the separation from DowDuPont are included in the Hydrocarbons & Energy and Packaging and Specialty Plastics reporting units. At December 31, 2019, goodwill was carried by five out of six of the Company's reporting units. The Company has the option to first perform qualitative testing to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. Qualitative factors assessed at the Company level include, but are not limited to, GDP growth rates, long-term hydrocarbon and energy prices, equity and credit market activity, discount rates, foreign exchange rates and overall financial performance. Qualitative factors assessed at the reporting unit level include, but are not limited to, changes in industry and market structure, competitive environments, planned capacity and new product launches, cost factors such as raw material prices, and financial performance of the reporting unit. If the Company chooses not to complete a qualitative assessment for a given reporting unit or if the initial assessment indicates that it is more likely than not that the estimated fair value of a reporting unit is less than its carrying value, additional quantitative testing is required. Quantitative testing requires the fair value of the reporting unit to be compared with its carrying value. If the reporting unit's carrying value exceeds its fair value, an impairment charge is recognized for the difference. The Company utilizes a discounted cash flow methodology to calculate the fair value of its reporting units. This valuation technique has been selected by management as the most meaningful valuation method due to the limited number of market comparables for the Company's reporting units. However, where market comparables are available, the Company includes EBIT/EBITDA multiples as part of the reporting unit valuation analysis. The discounted cash flow valuations are completed using the following key assumptions: projected revenue growth rates or compounded annual growth rates, discount rates, tax rates, terminal values, currency exchange rates, and forecasted long-term hydrocarbon and energy prices, by geographic region and by year, which include the Company's key feedstocks as well as natural gas and crude oil (due to its correlation to naphtha). Currency exchange rates and long-term hydrocarbon and energy prices are established for the Company as a whole and applied consistently to all reporting units, while revenue growth rates, discount rates and tax rates are established by reporting unit to account for differences in business fundamentals and industry risk. These key assumptions drive projected EBIT/EBITDA and EBIT/EBITDA margins, which are key elements of management’s internal control over the reporting unit valuation analysis. 2019 Goodwill Impairment Testing In the fourth quarter of 2019, quantitative testing was performed on two reporting units and a qualitative assessment was performed for the remaining reporting units. For the qualitative assessments, management considered the factors at both the Company level and the reporting unit level. Based on the qualitative assessment, management concluded it is not more likely than not that the fair value of the reporting unit is less than the carrying value of the reporting unit. Upon completion of the quantitative testing in the fourth quarter of 2019, the Company determined the Coatings & Performance Monomers ("C&PM") reporting unit was impaired. During 2019, the C&PM reporting unit did not consistently meet expected financial performance targets, primarily due to the industry’s increased captive use of coatings products, which led to volume reductions, reduced margins for products across the portfolio due to changes in customer buying patterns and supply and demand balances, as well as a continued trend of customer consolidation in end markets, which reduced growth opportunities. As a result, the C&PM reporting unit lowered its future revenue and profitability projections, which were used in determining the fair value of the C&PM reporting unit using a discounted cash flow methodology. These discounted cash flows did not support the carrying value of the C&PM reporting unit. As a result, the Company recorded a goodwill impairment charge of $1,039 million in the fourth quarter of 2019. The C&PM reporting unit did not carry a goodwill balance at December 31, 2019. The fair value of the other reporting unit exceeded its carrying value and no other goodwill impairments were identified as a result of the 2019 testing. Pension and Other Postretirement Benefits As a result of the Company’s separation from DowDuPont, the number of defined benefit pension plans administered by the Company decreased from 45 plans to 35 plans, with approximately $270 million of net unfunded pension liabilities transferring to DowDuPont. Plans administered by other subsidiaries of DowDuPont that were transferred to the Company were not significant. There were no changes in the number of other postretirement benefit plans administered by the Company as a result of the separation. The amounts recognized in the consolidated financial statements related to pension and other postretirement benefits are determined from actuarial valuations. Inherent in these valuations are assumptions including expected return on plan assets, discount rates at which the liabilities could have been settled at December 31, 2019, rate of increase in future compensation levels, mortality rates and health care cost trend rates. These assumptions are updated annually and are disclosed in Note 21 to the Consolidated Financial Statements. In accordance with U.S. GAAP, actual results that differ from the assumptions are accumulated and amortized over future periods and, therefore, affect expense recognized and obligations recorded in future periods. The U.S. pension plans represent 71 percent of the Company’s pension plan assets and 70 percent of the pension obligations. The Company uses the spot rate approach to determine the discount rate utilized to measure the service cost and interest cost components of net periodic pension and other postretirement benefit costs for the U.S. and other selected countries. Under the spot rate approach, the Company calculates service costs and interest costs by applying individual spot rates from the Willis Towers Watson RATE:Link yield curve (based on high-quality corporate bond yields) for each selected country to the separate expected cash flow components of service cost and interest cost; service cost and interest cost for all other plans (including all plans prior to adoption) are determined on the basis of the single equivalent discount rates derived in determining those plan obligations. The following information relates to the U.S. plans only; a similar approach is used for the Company’s non-U.S. plans. The Company determines the expected long-term rate of return on assets by performing a detailed analysis of historical and expected returns based on the strategic asset allocation approved by the Company's Investment Committee and the underlying return fundamentals of each asset class. The Company’s historical experience with the pension fund asset performance is also considered. The expected return of each asset class is derived from a forecasted future return confirmed by historical experience. The expected long-term rate of return is an assumption and not what is expected to be earned in any one particular year. The weighted-average long-term rate of return assumption used for determining net periodic pension expense for 2019 was 7.92 percent. The weighted-average assumption to be used for determining 2020 net periodic pension expense is 7.95 percent. Future actual pension expense will depend on future investment performance, changes in future discount rates and various other factors related to the population of participants in the Company’s pension plans. The discount rates utilized to measure the pension and other postretirement obligations of the U.S. qualified plans are based on the yield on high-quality corporate fixed income investments at the measurement date. Future expected actuarially determined cash flows for the Company’s U.S. plans are individually discounted at the spot rates under the Willis Towers Watson U.S. RATE:Link 60-90 corporate yield curve (based on 60th to 90th percentile high-quality corporate bond yields) to arrive at the plan’s obligations as of the measurement date. The weighted average discount rate utilized to measure pension obligations decreased to 3.41 percent at December 31, 2019, from 4.39 percent at December 31, 2018. At December 31, 2019, the U.S. qualified plans were underfunded on a projected benefit obligation basis by $4,768 million. The underfunded amount increased $702 million compared with December 31, 2018. The increase in the underfunded amount in 2019 was primarily due to the impact of lower discount rates, which was partially offset by the reduction in the number of active U.S. pension plan participants after the Company's separation from DowDuPont. The Company did not make contributions to the U.S. qualified plans in 2019. The assumption for the long-term rate for the compensation levels for the U.S. qualified plans was unchanged. The Company uses a generational mortality table to determine the duration of its pension and other postretirement obligations. The following discussion relates to the Company’s significant pension plans. The Company bases the determination of pension expense on a market-related valuation of plan assets that reduces year-to-year volatility. This market-related valuation recognizes investment gains or losses over a five-year period from the year in which they occur. Investment gains or losses for this purpose represent the difference between the expected return calculated using the market-related value of plan assets and the actual return based on the market value of plan assets. Since the market-related value of plan assets recognizes gains or losses over a five-year period, the future value will be impacted when previously deferred gains or losses are recorded. Over the life of the plans, both gains and losses have been recognized and amortized. At December 31, 2019, net gains of $566 million remain to be recognized in the calculation of the market-related value of plan assets. These net gains will result in decreases in future pension expense as they are recognized in the market-related value of assets. The net increase in the market-related value of assets due to the recognition of prior gains (losses) is presented in the following table: At December 31, 2019, the Company expects pension expense from continuing operations to increase in 2020 by approximately $125 million. The increase in pension expense is primarily due to the decrease in discount rates and curtailment gains of $27 million recognized in 2019 that are not expected to recur in 2020. A 25 basis point increase or decrease in the long-term return on assets assumption would change the Company’s total pension expense for 2020 by $59 million. A 25 basis point increase in the discount rate assumption would lower the Company's total pension expense for 2020 by $54 million. A 25 basis point decrease in the discount rate assumption would increase the Company's total pension expense for 2020 by $56 million. A 25 basis point change in the long-term return and discount rate assumptions would have an immaterial impact on the other postretirement benefit expense for 2020. Income Taxes Deferred tax assets and liabilities are determined based on temporary differences between the financial reporting and tax bases of assets and liabilities, applying enacted tax rates expected to be in effect for the year in which the differences are expected to reverse. Based on the evaluation of available evidence, both positive and negative, the Company recognizes future tax benefits, such as net operating loss carryforwards and tax credit carryforwards, to the extent that realizing these benefits is considered to be more likely than not. At December 31, 2019, the Company had a net deferred tax asset balance of $1,866 million, after valuation allowances of $1,262 million. In evaluating the ability to realize the deferred tax assets, the Company relies on, in order of increasing subjectivity, taxable income in prior carryback years, the future reversals of existing taxable temporary differences, tax planning strategies and forecasted taxable income using historical and projected future operating results. At December 31, 2019, the Company had deferred tax assets for tax loss and tax credit carryforwards of $1,920 million, $295 million of which is subject to expiration in the years 2020 through 2024. In order to realize these deferred tax assets for tax loss and tax credit carryforwards, the Company needs taxable income of approximately $27,010 million across multiple jurisdictions. The taxable income needed to realize the deferred tax assets for tax loss and tax credit carryforwards that are subject to expiration between 2020 through 2024 is approximately $3,388 million. The Company recognizes the financial statement effects of an uncertain income tax position when it is more likely than not, based on technical merits, that the position will be sustained upon examination. At December 31, 2019, the Company had uncertain tax positions for both domestic and foreign issues of $319 million. The Company accrues for non-income tax contingencies when it is probable that a liability to a taxing authority has been incurred and the amount of the contingency can be reasonably estimated. At December 31, 2019, the Company had a non-income tax contingency reserve for both domestic and foreign issues of $44 million. Indemnification Assets and Liabilities In connection with the 2019 separation from DowDupont and the 2016 ownership restructure of Dow Silicones, Dow entered into agreements that established each party’s indemnification obligations for certain tax, environmental, litigation and other matters, subject to certain conditions and limits. The Company records indemnification assets when collection is deemed probable and engages with indemnifying parties and assesses publicly available information to evaluate collectability. The underlying tax, environmental, litigation and other liabilities for which the Company claims indemnification are subject to significant judgment and potential disputes could adversely impact collectability. The Company assesses the collectability of indemnification assets when events or changes in circumstances indicate the carrying values may not be recoverable. At December 31, 2019, indemnification assets were $210 million and $100 million for Dow Inc. and TDCC respectively (zero for both at December 31, 2018). The Company records indemnification liabilities when it is probable that a liability has been incurred and the amount can be reasonably estimated. At December 31, 2019, indemnification liabilities related to the agreements were $848 million for Dow Inc. and zero for TDCC (zero for both at December 31, 2018). This represents management’s best estimate of the Company’s obligations under the agreements, although it is reasonably possible that future events could cause the actual values to be higher or lower than those projected or those recorded. For further discussion, see Notes 4 and 17 to the Consolidated Financial Statements. Environmental Matters Environmental Policies Dow is committed to world-class environmental, health and safety (“EH&S”) performance, as demonstrated by industry-leading performance, a long-standing commitment to Responsible Care®, and a strong commitment to achieve the Company's 2025 Sustainability Goals - goals that set the standard for sustainability in the chemical industry by focusing on improvements in the Company’s local corporate citizenship and product stewardship, and by actively pursuing methods to reduce its environmental impact. To meet the Company’s public commitments, as well as the stringent laws and government regulations related to environmental protection and remediation to which its global operations are subject, the Company has well-defined policies, requirements and management systems. The Company's EH&S Management System (“EMS”) defines the “who, what, when and how” needed for the businesses to achieve the Company’s policies, requirements, performance objectives, leadership expectations and public commitments. To ensure effective utilization, the EMS is integrated into a company-wide management system for EH&S, Operations, Quality and Human Resources. It is the Company's policy to adhere to a waste management hierarchy that minimizes the impact of wastes and emissions on the environment. First, work to eliminate or minimize the generation of waste and emissions at the source through research, process design, plant operations and maintenance. Second, find ways to reuse and recycle materials. Finally, unusable or non-recyclable hazardous waste is treated before disposal to eliminate or reduce the hazardous nature and volume of the waste. Treatment may include destruction by chemical, physical, biological or thermal means. Disposal of waste materials in landfills is considered only after all other options have been thoroughly evaluated. The Company has specific requirements for waste that is transferred to non-Dow facilities, including the periodic auditing of these facilities. The Company believes third-party verification and transparent public reporting are cornerstones of world-class EH&S performance and building public trust. Numerous Dow sites in Europe, Latin America, Asia Pacific and U.S. & Canada have received third-party verification of the Company’s compliance with Responsible Care® and with outside specifications such as ISO-14001. The Company continues to be a global champion of Responsible Care® and has worked to broaden the application and impact of Responsible Care® around the world through engagement with suppliers, customers and joint venture partners. The Company’s EH&S policies helped to achieve improvements in many aspects of EH&S performance in 2019. The Company’s process safety performance was excellent in 2019 and improvements were made in injury/illness rates, and safety remains a priority. Further improvement in these areas, as well as environmental compliance, remains a top management priority, with initiatives underway to further improve performance and compliance in 2020 as the Company continues to implement the 2025 Sustainability Goals. Detailed information on Dow’s performance regarding environmental matters and goals can be found online on the Company's Science & Sustainability webpage at www.dow.com/sustainability. The website and its content are not deemed incorporated by reference into this report. Chemical Security Public and political attention continues to be placed on the protection of critical infrastructure, including the chemical industry, from security threats. Terrorist attacks, natural disasters and cyber incidents have increased concern about the security and safety of chemical production and distribution. Many, including the Company and the American Chemistry Council, have called for uniform risk-based and performance-based national standards for securing the U.S. chemical industry. The Maritime Transportation Security Act of 2002 and its regulations further set forth risk-based and performance-based standards that must be met at U.S. Coast Guard-regulated facilities. U.S. Chemical Plant Security legislation was passed in 2006 and the Department of Homeland Security is now implementing the regulations known as the Chemical Facility Anti-Terrorism Standards. The Company is complying with the requirements of the Rail Transportation Security Rule issued by the U.S. Transportation Security Administration. The Company continues to support uniform risk-based national standards for securing the chemical industry. The focus on security, emergency planning, preparedness and response is not new to the Company. A comprehensive, multi-level security plan has been maintained since 1988. This plan, which has been activated in response to significant world and national events since then, is reviewed on an annual basis. The Company continues to improve its security plans, placing emphasis on the safety of Dow communities and people by being prepared to meet risks at any level and to address both internal and external identifiable risks. The security plan includes regular vulnerability assessments, security audits, mitigation efforts and physical security upgrades designed to reduce vulnerability. The Company’s security plans also are developed to avert interruptions of normal business operations that could materially and adversely affect the Company’s results of operations, liquidity and financial condition. The Company played a key role in the development and implementation of the American Chemistry Council’s Responsible Care® Security Code ("Security Code"), which requires that all aspects of security - including facility, transportation and cyberspace - be assessed and gaps addressed. Through the global implementation of the Security Code, the Company has permanently heightened the level of security - not just in the U.S., but worldwide. The Company employs several hundred employees and contractors in its Emergency Services and Security department worldwide. In 2019, the Company established its Global Security Operations Center ("GSOC") to provide 24-hour/day, 365-day/year real-time monitoring of global risks to Dow assets and people. The GSOC employs state-of-the-art social media monitoring, threat reporting and geo-fencing capabilities to analyze global risks and report those risks facilitating decision-making and actions to prevent Dow crises. Through the implementation of the Security Code, including voluntary security enhancements and upgrades made since 2002, the Company is well-positioned to comply with U.S. chemical facility regulations and other regulatory security frameworks. The Company is currently participating with the American Chemistry Council to review and update the Security Code. The Company continues to work collaboratively across the supply chain on Responsible Care®, Supply Chain Design, Emergency Preparedness, Shipment Visibility and transportation of hazardous materials. The Company is cooperating with public and private entities to lead the implementation of advanced tank car design, and track and trace technologies. Further, the Company’s Distribution Risk Review process that has been in place for decades was expanded to address potential threats in all modes of transportation across the Company’s supply chain. To reduce vulnerabilities, the Company maintains security measures that meet or exceed regulatory and industry security standards in all areas in which they operate. The Company's initiatives relative to chemical security, emergency preparedness and response, Community Awareness and Emergency Responses and crisis management are implemented consistently at all Dow sites on a global basis. The Company participates with chemical associations globally and participates as an active member of the U.S. delegation to the G7 Global Partnership Sub-Working Group on Chemical Security. Climate Change Climate change matters for the Company are likely to be driven by changes in regulations, public policy and physical climate parameters. Regulatory Matters Regulatory matters include cap and trade schemes; increased greenhouse gas (“GHG”) limits; and taxes on GHG emissions, fuel and energy. The potential implications of each of these matters are all very similar, including increased cost of purchased energy, additional capital costs for installation or modification of GHG emitting equipment, and additional costs associated directly with GHG emissions (such as cap and trade systems or carbon taxes), which are primarily related to energy use. It is difficult to estimate the potential impact of these regulatory matters on energy prices. Reducing the Company's overall energy usage and GHG emissions through new and unfolding projects will decrease the potential impact of these regulatory matters. The Company also has a dedicated commercial group to handle energy contracts and purchases, including managing emissions trading. The Company has not experienced any material impact related to regulated GHG emissions, and continues to evaluate and monitor this area for future developments. Physical Climate Parameters Many scientific academies throughout the world have concluded that it is very likely that human activities are contributing to global warming. At this point, it is difficult to predict and assess the probability and opportunity of a global warming trend on the Company specifically. Preparedness plans are developed that detail actions needed in the event of severe weather. These measures have historically been in place and these activities and associated costs are driven by normal operational preparedness. Dow continues to study the long-term implications of changing climate parameters on water availability, plant siting issues, and impacts and opportunities for products. Dow’s Energy business and Public Affairs and Sustainability functions are tasked with developing and implementing a comprehensive strategy that addresses the potential challenges of energy security and GHG emissions on the Company. Dow continues to elevate its internal focus and external positions - to focus on the root causes of GHG emissions - including the unsustainable use of energy. The Company's energy plan provides the roadmap: • Conserve - aggressively pursue energy efficiency and conservation • Optimize - increase and diversify energy resources • Accelerate - develop cost-effective, clean, renewable and alternative energy sources • Transition - to a sustainable energy future Through corporate energy efficiency programs and focused GHG management efforts, the Company has and is continuing to reduce its GHG emissions footprint. Dow’s manufacturing intensity, measured in Btu per pound of product, has improved by more than 40 percent since 1990. As part of the 2025 Sustainability Goals, the Company will maintain GHG emissions below 2006 levels on an absolute basis for all GHGs. The Company intends to implement the recommendations of the Financial Stability Board's Task Force on Climate-related Financial Disclosures ("Task Force") over the next three years, which is aligned with the recommendations of the Task Force. Environmental Remediation The Company accrues the costs of remediation of its facilities and formerly owned facilities based on current law and regulatory requirements. The nature of such remediation can include management of soil and groundwater contamination. The accounting policies adopted to properly reflect the monetary impacts of environmental matters are discussed in Note 1 to the Consolidated Financial Statements. To assess the impact on the financial statements, environmental experts review currently available facts to evaluate the probability and scope of potential liabilities. Inherent uncertainties exist in such evaluations primarily due to unknown environmental conditions, changing governmental regulations and legal standards regarding liability, and the ability to apply remediation technologies. These liabilities are adjusted periodically as remediation efforts progress or as additional technical or legal information becomes available. The Company had an accrued liability of $948 million at December 31, 2019, related to the remediation of current or former Dow-owned sites. At December 31, 2018, the liability related to remediation was $654 million. In addition to current and former Dow-owned sites, under the federal Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") and equivalent state laws (hereafter referred to collectively as "Superfund Law"), the Company is liable for remediation of other hazardous waste sites where the Company allegedly disposed of, or arranged for the treatment or disposal of, hazardous substances. Because Superfund Law imposes joint and several liability upon each party at a site, the Company has evaluated its potential liability in light of the number of other companies that also have been named potentially responsible parties (“PRPs”) at each site, the estimated apportionment of costs among all PRPs, and the financial ability and commitment of each to pay its expected share. The Company’s remaining liability for the remediation of Superfund sites was $207 million at December 31, 2019 ($156 million at December 31, 2018). The Company has not recorded any third-party recovery related to these sites as a receivable. Information regarding environmental sites is provided below: 1. Dow-owned sites are sites currently or formerly owned by the Company. In the United States, remediation obligations are imposed by the Resource Conservation and Recovery Act or analogous state law. At December 31, 2019, 28 of these sites (32 sites at December 31, 2018) were formerly owned by Dowell Schlumberger, Inc., a group of companies in which the Company previously owned a 50 percent interest. The Company sold its interest in Dowell Schlumberger in 1992. 2. Superfund sites are sites, including sites not owned by the Company, where remediation obligations are imposed by Superfund Law. Additional information is provided below for the Company’s Midland, Michigan, manufacturing site and Midland off-site locations (collectively, the "Midland sites"), as well as a Superfund site in Wood-Ridge, New Jersey, the locations for which the Company has the largest potential environmental liabilities. In the early days of operations at the Midland manufacturing site, wastes were usually disposed of on-site, resulting in soil and groundwater contamination, which has been contained and managed on-site under a series of Resource Conservation and Recovery Act permits and regulatory agreements. The Hazardous Waste Operating License for the Midland manufacturing site, issued in 2003, and renewed and replaced in September 2015, also included provisions for the Company to conduct an investigation to determine the nature and extent of off-site contamination from historic Midland manufacturing site operations. In January 2010, the Company, the U.S. Environmental Protection Agency ("EPA") and the State of Michigan ("State") entered into an Administrative Order on Consent that requires the Company to conduct a remedial investigation, a feasibility study and a remedial design for the Tittabawassee River, the Saginaw River and the Saginaw Bay, and pay the oversight costs of the EPA and the State under the authority of CERCLA. See Note 17 to the Consolidated Financial Statements for further information relating to Midland off-site environmental matters. Rohm and Haas, a wholly owned subsidiary of the Company, is a PRP at the Wood-Ridge, New Jersey Ventron/Velsicol Superfund Site, and the adjacent Berry’s Creek Study Area ("BCSA") (collectively, the "Wood-Ridge sites"). Rohm and Haas is a successor in interest to a company that owned and operated a mercury processing facility, where wastewater and waste handling resulted in contamination of soils and adjacent creek sediments. In 2018, the Berry’s Creek Study Area Potentially Responsible Party Group (“PRP Group”), consisting of over 100 PRPs, completed a Remedial Investigation/Feasibility Study for the BCSA. During that time, the EPA concluded that an “iterative or adaptive approach” was appropriate for cleaning up the BCSA. Thus, each phase of remediation will be followed by a period of monitoring to assess its effectiveness and determine if there is a need for more work. In September 2018, the EPA signed a Record of Decision ("ROD 1") which describes the initial phase of the EPA’s plan to clean-up the BCSA. ROD 1 will remediate waterways and major tributaries in the most contaminated part of the BCSA. The PRP Group has signed agreements with the EPA to design the selected remedy. Although there is currently much uncertainty as to what will ultimately be required to remediate the BCSA and Rohm and Haas's share of these costs has yet to be determined, the range of activities that are required in the interim Record of Decision is known in general terms. At December 31, 2019, the Company had accrued liabilities totaling $368 million ($240 million at December 31, 2018) for environmental remediation at the Midland and Wood-Ridge sites. In 2019, the Company spent $32 million ($32 million in 2018) for environmental remediation at the Midland and Wood-Ridge sites. During the third quarter of 2019, the Company accrued additional liabilities totaling $447 million related to environmental remediation matters at a number of current and historical locations. The additional accrual primarily resulted from: the culmination of long-standing negotiations and discussions with regulators and agencies, including technical studies supporting higher cost estimates for final or staged remediation plans; the Company’s evaluation of the cost required to manage remediation activities at sites affected by Dow’s separation from DowDuPont and related agreements with Corteva and DuPont; and, the Company’s review of its closure strategies and obligations to monitor ongoing operations and maintenance activities. In addition, the Company recorded indemnification assets of $48 million related to Dow Silicones’ environmental matters. Net of indemnifications, the Company recognized a pretax charge of $399 million related to these environmental matters, included in “Cost of sales” in the consolidated statements of income. In total, the Company’s accrued liability for probable environmental remediation and restoration costs was $1,155 million at December 31, 2019, compared with $810 million at December 31, 2018. This is management’s best estimate of the costs for remediation and restoration with respect to environmental matters for which the Company has accrued liabilities, although it is reasonably possible that the ultimate cost with respect to these particular matters could range up to approximately one and a half times that amount. Consequently, it is reasonably possible that environmental remediation and restoration costs in excess of amounts accrued could have a material impact on the Company’s results of operations, financial condition and cash flows. It is the opinion of the Company’s management, however, that the possibility is remote that costs in excess of the range disclosed will have a material impact on the Company’s results of operations, financial condition and cash flows. The amounts charged to income on a pretax basis related to environmental remediation totaled $588 million in 2019, $176 million in 2018 and $163 million in 2017. The amounts charged to income on a pretax basis related to operating the Company's current pollution abatement facilities, excluding internal recharges, totaled $677 million in 2019, $695 million in 2018 and $566 million in 2017. Capital expenditures for environmental protection were $83 million in 2019, $55 million in 2018 and $57 million in 2017. Asbestos-Related Matters of Union Carbide Corporation Union Carbide is and has been involved in a large number of asbestos-related suits filed primarily in state courts during the past four decades. These suits principally allege personal injury resulting from exposure to asbestos-containing products and frequently seek both actual and punitive damages. The alleged claims primarily relate to products that Union Carbide sold in the past, alleged exposure to asbestos-containing products located on Union Carbide’s premises, and Union Carbide’s responsibility for asbestos suits filed against a former Union Carbide subsidiary, Amchem. In many cases, plaintiffs are unable to demonstrate that they have suffered any compensable loss as a result of such exposure, or that injuries incurred in fact resulted from exposure to Union Carbide’s products. The table below provides information regarding asbestos-related claims pending against Union Carbide and Amchem based on criteria developed by Union Carbide and its external consultants: Plaintiffs’ lawyers often sue numerous defendants in individual lawsuits or on behalf of numerous claimants. As a result, the damages alleged are not expressly identified as to Union Carbide, Amchem or any other particular defendant, even when specific damages are alleged with respect to a specific disease or injury. In fact, there are no asbestos personal injury cases in which only Union Carbide and/or Amchem are the sole named defendants. For these reasons and based upon Union Carbide’s litigation and settlement experience, Union Carbide does not consider the damages alleged against Union Carbide and Amchem to be a meaningful factor in its determination of any potential asbestos-related liability. For additional information see Part I, Item 3. Legal Proceedings and Asbestos-Related Matters of Union Carbide Corporation in Note 17 to the Consolidated Financial Statements.

<s>[INST] The separation was contemplated by the merger of equals transaction effective August 31, 2017, under the Agreement and Plan of Merger, dated as of December 11, 2015, as amended on March 31, 2017. TDCC and E. I. du Pont de Nemours and Company and its consolidated subsidiaries (“Historical DuPont”) each merged with subsidiaries of DowDuPont and, as a result, TDCC and Historical DuPont became subsidiaries of DowDuPont (the “Merger”). Subsequent to the Merger, TDCC and Historical DuPont engaged in a series of internal reorganization and realignment steps to realign their businesses into three subgroups: agriculture, materials science and specialty products. Dow Inc. was formed as a wholly owned subsidiary of DowDuPont to serve as the holding company for the materials science business. As of the effective date and time of the distribution, DowDuPont does not beneficially own any equity interest in Dow and no longer consolidates Dow and its consolidated subsidiaries into its financial results. The consolidated financial results of Dow for all periods presented reflect the distribution of TDCC’s agricultural sciences business (“AgCo”) and specialty products business (“SpecCo”) as discontinued operations, as well as reflect the receipt of Historical DuPont’s ethylene and ethylene copolymers businesses (other than its ethylene acrylic elastomers business) (“ECP”) as a common control transaction from the closing of the Merger on August 31, 2017. See Notes 3 and 4 to the Consolidated Financial Statements and Dow Inc.'s Amendment No. 4 to the Registration Statement on Form 10 filed with the U.S. Securities and Exchange Commission ("SEC") on March 8, 2019 for additional information. Throughout this Annual Report on Form 10K, unless otherwise indicated, amounts and activity are presented on a continuing operations basis. Except as otherwise indicated by the context, the terms "Union Carbide" means Union Carbide Corporation, a wholly owned subsidiary of the Company, and "Dow Silicones" means Dow Silicones Corporation (formerly known as Dow Corning Corporation, which changed its name effective as of February 1, 2018), a wholly owned subsidiary of the Company. Items Affecting Comparability of Financial Results As a result of the separation from DowDuPont, pro forma net sales and pro forma Operating EBIT are provided in this section and based on the consolidated financial statements of TDCC, adjusted to give effect to the separation from DowDuPont as if it had been consummated on January 1, 2017. Pro forma adjustments include (1) the margin impact of various manufacturing, supply and service related agreements entered into with DuPont and Corteva, Inc. ("Corteva") in connection with the separation which provide for different pricing than the historical intercompany and intracompany pricing practices of TDCC and Historical DuPont (only included for 2018 and the first three months of 2019), (2) the inclusion of ECP for the period of January 1, 2017 through August 31, 2017, (3) the removal of the amortization of ECP's inventory stepup recognized in connection with the Merger, (4) the elimination of the impact of events directly attributable to the Merger, internal reorganization and business realignment, separation, distribution and other related transactions (e.g., onetime transaction costs), and (5) the elimination of the effect of a consummated divestiture agreed to with certain regulatory agencies as a condition of approval for the Merger. These adjustments impacted the consolidated results as well as the reportable segments. See Note 27 to the Consolidated Financial Statements for a summary of the pro forma adjustments impacting segment measures for the years ended December 31, 2019, 2018 and 2017. Page About Dow Results of Operations Segment Results Packaging & Specialty Plastics Indust [/INST] Negative. </s>

Stonemor Inc.

2020-04-07

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management’s discussion and analysis presented below provides information to assist in understanding the Company’s financial condition and results of operations and should be read in conjunction with the Company’s consolidated financial statements included in Part II, Item 8. Financial Statements and Supplementary Data of this Annual Report. Certain statements contained in this Annual Report, including, but not limited to, information regarding our operating activities, the plans and objectives of our management and assumptions regarding our future performance and plans are forward-looking statements. When used in this Annual Report, the words “believes,” “anticipates,” “expects” and similar expressions are intended to identify forward-looking statements. Forward-looking statements are based on management’s expectations and estimates. These statements are neither promises nor guarantees and are made subject to certain risks and uncertainties that could cause actual results to differ materially from the results stated or implied in this Annual Report. We believe the assumptions underlying the consolidated financial statements are reasonable. Our risks and uncertainties are more particularly described in Part I, Item 1A. Risk Factors of this Annual Report. You should not place undue reliance on forward-looking statements included in this Annual Report, which speak only as of the date the statements were made. Except as required by applicable laws, we undertake no obligation to update or revise forward-looking statements, whether as a result of new information, future events or otherwise. BUSINESS OVERVIEW We are one of the leading providers of funeral and cemetery products and services in the death care industry in the United States (“U.S.”). As of December 31, 2019, we operated 321 cemeteries in 27 states and Puerto Rico, of which 291 were owned and 30 were operated under leases, operating agreements or management agreements. We also owned, operated or managed 90 funeral homes in 17 states and Puerto Rico. On December 31, 2019, we consummated the C-Corporation Conversion for the purpose of transitioning the Partnership and its affiliates from a master limited partnership structure to a corporate form. See Part II. Item 8. Financial Statements and Supplementary Data-Notes to the Consolidated Financial Statements-Note 1 General of this Annual Report for further information related to the C-Corporation Conversion. Our revenue is derived from our Cemetery Operations and Funeral Home Operations segments. Our Cemetery Operations segment principally generates revenue from sales of interment rights, cemetery merchandise, which includes markers, bases, vaults, caskets and cremation niches and our cemetery services, which include opening and closing (“O&C”) services, cremation services and fees for the installation of cemetery merchandise. Our Funeral Home Operations segment principally generates revenue from sales of funeral home merchandise, which includes caskets and other funeral related items and service revenues, which include services such as family consultation, the removal of and preparation of remains and the use of funeral home facilities for visitation and prayer services. These sales occur both at the time of death, which we refer to as at-need, and prior to the time of death, which we refer to as pre-need. Our Funeral Home Operations segment also include revenues related to the sale of term and whole life insurance on an agency basis, in which we earn a commission from the sales of these insurance policies. The pre-need sales enhance our financial position by providing a backlog of future revenue from both trust and insurance-funded pre-need funeral and cemetery sales. We believe pre-need sales add to the stability and predictability of our revenues and cash flows. Pre-need sales are typically sold on an installment plan. While revenue on the majority of pre-need funeral sales is deferred until the time of need, sales of pre-need cemetery property interment rights provide opportunities for full current revenue recognition when the property is available for use by the customer. We also earn investment income on certain payments received from customers on pre-need contracts, which are required by law to be deposited into the merchandise and service trusts. Amounts are withdrawn from the merchandise and service trusts when we fulfill the performance obligations. Earnings on these trust funds, which are specifically identifiable for each performance obligation, are also included in the total transaction price. For sales of interment rights, a portion of the cash proceeds received are required to be deposited into a perpetual care trust. While the principal balance of the perpetual care trust must remain in the trust in perpetuity, we recognize investment income on such assets as revenue, excluding realized gains and losses from the sale of trust assets. Pre-need contracts are subject to financing arrangements on an installment basis, with a contractual term not to exceed 60 months. Interest income is recognized utilizing the effective interest method. For those contracts that do not bear a market rate of interest, we impute such interest based upon the prime rate at the time of origination plus 150 basis points in order to segregate the principal and interest components of the total contract value. Our revenue depends upon the demand for funeral and cemetery services and merchandise, which can be influenced by a variety of factors, some of which are beyond our control including demographic trends, such as population growth, average age, death rates and number of deaths. Our operating results and cash flows could also be influenced by our ability to remain relevant to the customers. We provide a variety of unique product and service offerings to meet the needs of our customers’ families. The mix of services could influence operating results, as it influences the average revenue per contract. Expense management, which includes controlling salaries, merchandise costs, corporate overhead and other expense categories, could also impact operating results and cash flows. Lastly, economic conditions, legislative and regulatory changes and tax law changes, all of which are beyond our control, could impact our operating results and cash flows. For further discussion of our key operating metrics, see our Results of Operations and Liquidity and Capital Resources sections below. RECENT EVENTS The following are key events and transactions that have occurred since January 1, 2019 that were material to us and/or facilitate an understanding of our consolidated financial statements contained in Part II, Item 8. Financial Statements and Supplementary Data of this Annual Report: • COVID-19 Pandemic. See the following section “General Trends and Outlook” of Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations for discussion on the impact we have seen on our business as a result of the COVID-19 Pandemic; • Divestitures. On January 3, 2020, we consummated the Oakmont Sale with Carriage Funeral Holdings, Inc. for an aggregate cash purchase price of $33.0 million. The divested assets consisted of one cemetery, one funeral home and certain related assets. In March 2020, we entered into the Olivet Agreement with Cypress Lawn Cemetery Association to sell substantially all of the assets of the cemetery, funeral establishment and crematory commonly known as Olivet Memorial Park, Olivet Funeral and Cremation Services and Olivet Memorial Park & Crematory for a net cash purchase price of $24.3 million, subject to certain adjustments. In addition, in March 2020, we entered into the California Agreement with certain entities owned by John Yeatman and Guy Saxton to sell substantially all of our remaining California properties, consisting of five cemeteries, six funeral establishments and four crematories for a cash purchase price of $7.1 million, subject to certain closing adjustments. In January 2020, we redeemed an aggregate $30.4 million of principal on the Senior Secured Notes, primarily using the net proceeds from the Oakmont Sale. Per the Indenture, we anticipate using the first $23.7 million of net proceeds and 80% of the remaining net proceeds from the Olivet Sale along with 80% of the net proceeds from the Remaining California Sale to redeem additional portions of the outstanding Senior Secured Notes; • Amendments to Indenture and Capital Raise in 2020. On April 1, 2020, the Partnership, Cornerstone Family Services of West Virginia Subsidiary, Inc. and Wilmington Trust, National Association, as trustee, entered into the Supplemental Indenture. Pursuant to the terms of the Supplemental Indenture, several financial covenants were amended. The amendments effected by the Supplemental Indenture will become operational when we pay a $5 million consent fee to the holders of the Senior Secured Notes, of which $3.5 million will be paid in cash and $1.5 million will be paid by increasing the principal amount of the Senior Secured Notes outstanding, and satisfy other specified conditions. Concurrently with the execution of the Supplemental Indenture, we entered the Axar Commitment pursuant to which Axar committed to (a) purchase shares of our Series A Preferred Stock with an aggregate purchase price of $8.8 million on April 3, 2020, (b) exercise its basic rights in the rights offering by tendering the shares of Series A Preferred Stock so purchased for shares of Common Stock and (c) purchase any shares offered in the rights offering for which other stockholders do not exercise their rights, up to a maximum of an additional $8.2 million of such shares. We did not pay Axar any commitment, backstop or other fees in connection with the Axar Commitment. As contemplated by the Axar Commitment, on April 3, 2020, we sold an aggregate of 176 shares of our Series A Preferred Stock to the 2020 Purchasers for an aggregate purchase price of $8.8 million. Under the terms of the Supplemental Indenture and the Axar Commitment, we agreed to undertake an offering to holders of our Common Stock of transferable rights to purchase their pro rata share of shares of Common Stock with an aggregate exercise price of at least $17 million at a price of $0.73 per share. The rights offering period, during which the rights will be transferable, will be no less than 20 calendar days and no more than 45 calendar days. We agreed to use our best efforts to complete the rights offering with an expiration date no later than July 24, 2020. For further details, see Part II. Item 8. Financial Statements and Supplementary Data-Notes to the Consolidated Financial Statements-Note 26 Subsequent Events of this Annual Report; • Reduction in Workforce. On January 31, 2019, we announced a profit improvement initiative as part of our ongoing organizational review. This profit improvement initiative is intended to further integrate, streamline and optimize our operations. As part of this profit improvement initiative, during 2019 we undertook certain cost reduction initiatives, which included a reduction of approximately 200 positions of our workforce within our field operations and corporate functions in our headquarters located in Trevose, Pennsylvania; • Recapitalization Transactions in 2019. On June 27, 2019, we closed a $447.5 million recapitalization transaction, consisting of (i) the sale of an aggregate of 52,083,333 of the Partnership’s Series A Preferred Units representing limited partner interests in the Partnership at a purchase price of $1.1040 per Preferred Unit, reflecting an 8% discount to the liquidation preference of each Preferred Unit, for an aggregate purchase price of $57.5 million and (ii) a concurrent private placement of the Senior Secured Notes to certain financial institutions. The net proceeds of the Recapitalization Transactions were used to fully repay our outstanding senior notes due in June 2021 and retire the revolving credit facility due in May 2020, as well as for associated transaction expenses, cash collateralization of existing letters of credit and other needs under the former credit facility, with the balance available for general corporate purposes; • Board Reconstitution. In connection with the closing of the Recapitalization Transactions, our Board of Directors was reconstituted. Directors Martin R. Lautman, Ph.D., Leo J. Pound, Robert A Sick and Fenton R. Talbott resigned as directors and the authorized number of directors was reduced to seven. Andrew Axelrod, David Miller and Spencer Goldenberg were elected to fill the vacancies created by the resignations. The reconstituted board is comprised of Messrs. Axelrod, Miller and Goldenberg, Robert B. Hellman, Jr., Stephen Negrotti, Patricia Wellenbach and Joseph M. Redling. Mr. Axelrod serves as the chairman of the board; • Changes in Executive Management. On April 15, 2019, Garry P. Herdler became our Senior Vice President and Chief Financial Officer, replacing Mark Miller. On September 19, 2019, ₋ Jeffrey DiGiovanni became our Senior Vice President and Chief Financial Officer, replacing Garry P. Herdler. With Mr. DiGiovanni’s promotion, the roles of Chief Accounting Officer and Chief Financial Officer were combined; ₋ Jim Ford resigned from the Company, and the role of Chief Operating Officer was eliminated; and ₋ Tom Connolly became our Senior Vice President of Business Planning and Operations; • C-Corporation Conversion. On December 31, 2019, we completed the C-Corporation Conversion; and • Lease Accounting Standard. Effective January 1, 2019, we adopted the new lease accounting standard as further discussed in Part II. Item 8. Financial Statements and Supplementary Data-Notes to the Consolidated Financial Statements-Note 1 General of this Annual Report which resulted in an increase in other assets of $15.3 million and increases of $2.2 million and $13.1 million in accounts payable and accrued liabilities and other long-term liabilities, respectively, in the consolidated balance sheet. The adoption did not have a material impact on our results of operations or cash flows. GENERAL TRENDS AND OUTLOOK We expect our business to be affected by key trends in the death care industry, based upon assumptions made by us and information currently available. Death care industry factors affecting our financial position and results of operations include, but are not limited to, death rates, per capita disposable income, demographic trends in terms of number of adults aged 65 and older, cremation rates and trends and e-commerce sales. The number of deaths which is related to the age structure of the population, mortality rates, disease prevalence, natural disasters, sudden accidents, suicides and other causes drives industry revenue. With the aging of the U.S. population, the number of deaths is expected to increase over the next few years. Per the report by Max Roser titled, Future Population Growth, projected deaths per year in the U.S. are expected to increase by 12% from 2019 to 2028. Number of births and deaths per year, United States Source: Max Roser (2020) - "Future Population Growth". Published online at OurWorldInData.org. Retrieved from: 'https://ourworldindata.org/future-population-growth' [Online Resource] The growth of per capita disposable income is positively correlated with industry performance, as with higher per capita income, consumers are more likely to choose full-service traditional funerals over cremation and purchase additional expensive merchandise and services. The proportion of the population aged 65 and older is a positive indicator of demand for cemetery services, as this age segment of the population accounts for the majority of all deaths and are most likely to purchase pre-need services and merchandise. Per the report published by IBISWorld in June 2019 titled, IBISWorld Industry Report 81221: Funeral Homes in the US, individuals aged 65 and older are projected to account for 73.9% of market demand in the funeral operations industry in 2019. Per the report published by IBISWorld in April 2019 titled, IBISWorld Industry Report 81222: Cemetery Services in the US, individuals aged 55 and older are projected to account for 86.3% of market demand in the cemetery services industry in 2019. Major Market Segmentation by Age (2019) Funeral Homes Industry (U.S.) Cemetery Operations Industry (U.S.) Cremations typically cost significantly less than traditional burial services and bring in significantly less revenue and profit for cemeteries and funeral homes. The rising demand for cremations due to cost considerations, increased mobility of the population, environmental reasons, religious considerations and changing consumer preferences present a potential threat to the cemetery services and funeral homes industries. Per the National Funeral Directors Association’s 2019 Cremation & Burial Report, the cremation rate within the U.S. began to exceed the burial rate within the U.S. around the year 2015, and is expected to be over 60% by the year 2025. Rates of Burial and Cremation Source: 2019 NFDA Cremation & Burial Report Funeral homes have traditionally benefited from limited competition for industry products, such as caskets and urns; however, online retailers are beginning to encroach on this market sector by offering these products to consumers at more cost-effective prices. In addition, we are subject to fluctuations in the fair value of equity and fixed-maturity debt securities held in our trusts. These values can be negatively impacted by contractions in the credit market and overall downturns in economic activity. Our ability to make payments on our debt depends on our success at managing operations with respect to these industry trends. To the extent our underlying assumptions about or interpretations of available information prove to be incorrect, our actual results may vary materially from our expected results. COVID-19 Pandemic The outbreak of COVID-19 in Wuhan, China in December 2019 has since reached pandemic proportions, posing a significant threat to the health and economic wellbeing of our employees, customers and vendors. Currently, our operations have been deemed essential by the state and local governments in which we operate, with the exception of Puerto Rico, and we are actively working with federal, state and local government officials to ensure that we continue to satisfy their requirements for offering our essential services The operation of all of our facilities is critically dependent on the employees who staff these locations. To ensure the wellbeing of our employees and their families, we have provided all of our employees with detailed health and safety literature on COVID-19, such as the CDC’s industry-specific guidelines for working with the deceased who were and may have been infected with COVID-19. In addition, our procurement and safety teams have updated and developed new safety-oriented guidelines to support daily field operations and provided personal protection equipment to those employees whose positions necessitate them, and we have implemented work from home policies at our corporate office consistent with CDC guidance to reduce the risks of exposure to COVID-19 while still supporting the families that we serve. Our marketing and sales team has quickly responded to the sales challenges presented by the COVID-19 Pandemic by implementing virtual meeting options using a variety of web-based tools to ensure that we can continue to connect with and meet our customers’ needs in a safe, effective and productive manner. Some of our locations have also started providing live video streaming of their funeral and burial services to our customers, so that family and friends can connect virtually during their time of grief. Like most businesses world-wide, the COVID-19 Pandemic has impacted us financially; however, we cannot presently predict the scope and severity with which COVID-19 will impact our business, financial condition, results of operations and cash flows. As recently as early March 2020, we were experiencing sales growth for the first quarter of 2020, as compared to the first quarter of 2019. However, over the last two weeks, we have seen our pre-need sales activity decline as Americans practice social distancing. In addition, our pre-need customers with installment contracts could default on their installment contracts due to lost work or other financial stresses arising from the COVID-19 Pandemic. While we expect our pre-need sales to be challenged during the COVID 19 Pandemic, we believe the implementation of our virtual meeting tools is one of several key steps to mitigate this disruption. In addition, we expect that throughout this disruption our cemeteries and funeral homes will remain open and available to serve our families in all the locations in which we operate to the extent permitted by local authorities, with the exception of Puerto Rico. Business Strategies We believe the Recapitalization Transactions demonstrate both strong underlying values of our asset base as well as confidence in our ability to execute our turnaround plan. We believe the recapitalization of our balance sheet has reset our financial footing and helps position us to execute the following business strategies: • Execute on Financial Strategy. The Recapitalization Transactions have significantly extended our debt capital structure with a five-year maturity, which provides us with a meaningful liquidity improvement to execute our turnaround strategy, including the next phase of our performance improvement plans. In April 2019, we announced a turnaround strategy focused on four key goals: cash flow and liquidity, capital structure, strategic balance sheet/portfolio review, and performance improvement from cost reductions and revenue enhancement; • Implementation of New Strategic Initiatives. We view our substantial and diverse asset base as a strength, but we have prioritized the ways in which we view our assets. We believe that by tiering operating units by class and contribution, initiating a divestiture plan for select assets and prioritizing certain assets over others, we will be able to optimize results in our top tier properties and more efficiently manage our assets. From a portfolio review perspective, we continue to focus our resources on improving our “top tier” assets as we believe they possess the greatest potential for improved profitability. We are also minimizing costs and resources on our “lower-tier” assets to reduce the impact these assets have on profitability of the portfolio; and • Improve Operating Efficiencies. We believe we have identified significant expense reduction opportunities in the next phase of this operational turnaround strategy with additional “4-wall level” operational savings, identified projects and industry benchmarking. In addition, we are focused on improving performance through cost reductions and revenue enhancement and executing on other long and short-term turnaround strategies that will allow us to meet our primary objectives on a continuing basis. The next phase of cost reduction and operational performance improvement opportunities have now been identified with a focus on prioritizing identified opportunities in procurement, sourcing, product hierarchy, field labor efficiencies, shared services and outsourcing. We believe that the execution of these initiatives will result in improved profitability and cash flow across the asset base. In terms of revenue enhancements, we believe we have identified the primary drivers of our sales productivity and pre-need sales issues and, while it is in the early stages, we remain focused on improving retention of sales personnel and optimizing staffing levels across our asset base. RESULTS OF OPERATIONS We have two distinct reportable segments, Cemetery Operations and Funeral Home Operations, which are supported by corporate costs and expenses. Cemetery Operations Overview We are currently one of the largest owners and operators of cemeteries in the United States of America. As of December 31, 2019, we operated 321 cemeteries in 27 states and Puerto Rico. We own 291 of these cemeteries, and we manage or operate the remaining 30 under leases, operating agreements or management agreements. Revenues from our Cemetery Operations segment accounted for approximately 82% and 83% of our total revenues during the years ended December 31, 2019 and 2018, respectively. Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 The following table presents operating results for our Cemetery Operations segment for the years ended December 31, 2019 and 2018 (in thousands): The following table presents supplemental operating data for the years ended December 31, 2019 and 2018: ______________________________ (1) Net of cancellations. Sales of double-depth burial lots are counted as two sales. Cemetery interments revenues were $67.4 million for the year ended December 31, 2019, a decrease of $9.5 million and 12% from $76.9 million for the year ended December 31, 2018. The change was due to decreases in the pre-need sales of lots of $3.9 million, lawn crypts of $2.7 million and mausoleums of $2.6 million. These decreases were partially offset by a net increase in at-need interment revenues of $0.9 million, a decrease in cancellations of $0.9 million primarily related to the decrease in interment revenues and a net increase in various other pre-need revenues of $0.2 million. These changes were combined with a decrease of $2.3 million due to further refinement of our process for recording revenues in accordance with Accounting Standard Codification (“ASC”) 606, Revenue from Contracts with Customers (“ASC 606”). Cemetery merchandise revenues were $64.5 million for the year ended December 31, 2019, a decrease of $10.9 million and 15% from $75.4 million for the year ended December 31, 2018. The change was primarily due to a decrease in pre-need revenues from markers and bases of $7.7 million, a decline in contracts serviced that were acquired through acquisitions in prior years of $2.1 million, a net decrease in at-need merchandise revenues of $0.3 million and a net decrease in various other pre-need merchandise revenues of $0.1 million. These decreases were partially offset by a decrease in cancellations of $0.7 million primarily related to the decrease in merchandise revenues. These changes were combined with a decrease of $1.4 million due to further refinement of our process for recording revenues in accordance with ASC 606. Cemetery services revenues were $65.5 million for the year ended December 31, 2019, a decrease of $1.8 million and 3% from $67.3 million for the year ended December 31, 2018. The change was due to a decrease in at-need opening and closing revenues of $0.9 million, a decline in contracts serviced that were acquired through acquisitions in prior years of $0.5 million and a decrease in pre-need marker installations of $0.4 million. These decreases were partially offset by a net increase in various other pre-need and at-need service revenues of $0.8 million and a decrease in cancellations of $0.2 million primarily related to the decrease in service revenues. These changes were combined with a decrease of $1.0 million due to further refinement of our process for recording revenues in accordance with ASC 606. Interest income was $8.3 million for the year ended December 31, 2019, a decrease of $0.7 million and 8% from $9.0 million for the year ended December 31, 2018. The change was primarily due to a decrease in accounts receivable outstanding driven by the accelerated collection of pre-need receivables. Investment and other income was $32.2 million for the year ended December 31, 2019, a decrease of $1.1 million and 3% from $33.3 million for the year ended December 31, 2018. The change was due to a decrease in land sales of $0.5 million combined with a net decrease of $1.5 million in various other sources of other income, partially offset by an increase in investment income of $0.9 million. Cost of goods sold was $40.2 million for the year ended December 31, 2019, a decrease of $14.5 million and 26% from $54.6 million for the year ended December 31, 2018. The change was due to a decrease of $4.7 million related to lower revenue activity and a $6.9 million decrease in costs primarily related to markers, the servicing of contacts acquired through acquisition, vaults and lots. These decreases were combined with $2.9 million of vault inventory adjustments and impairments that were recorded in the first and fourth quarters of 2018, but which did not recur in 2019. Cemetery expenses were $74.3 million for the year ended December 31, 2019, a decrease of $4.4 million and 6% from $78.7 million for the year ended December 31, 2018. The change was primarily due to a decrease in payroll and related taxes of $3.6 million resulting from a reduction in force in 2019 and the implementation of a general manager operating model, gains on insurance recoveries received of $1.1 million and a decrease in real estate taxes of $1.0 million resulting from the reassessment of certain properties under management in the prior year that did not recur in the current year. Partially offsetting these decreases was an increase in repairs and maintenance of $1.0 million and a net increase in various other cemetery expenses of $0.3 million. Selling expenses were $59.3 million for the year ended December 31, 2019, a decrease of $3.2 million and 5% from $62.5 million for the year ended December 31, 2018. The change was due to a decrease in payroll and related taxes of $5.4 million, resulting primarily from a decrease in contracts written during the current year, which resulted in reduced sales incentive compensation and the elimination of an annual sales trip bonus. This was combined with a net decrease of $0.5 million in various other expenses. These decreases were partially offset by an increase in marketing and advertising expense of $2.7 million. General and administrative expenses were $44.2 million for the year ended December 31, 2019, an increase of $1.2 million and 3% from $43.1 million for the year ended December 31, 2018. The change was due to an increase in payroll and related taxes of $4.1 million primarily associated with the implementation of a general manager operating model, combined with an increase in the cost of surety bonds of $0.7 million. These increases were partially offset by decreases in non-general manager related payroll of $0.9 million resulting from a reduction in force in 2019, legal fees of $0.8 million, employee benefits of $0.4 million and a net decrease in various other expenses of $1.5 million. Depreciation and amortization expenses were $7.4 million for the year ended December 31, 2019, a decrease of $0.6 million and 8% from $8.0 million for the year ended December 31, 2018. The change was due to routine depreciation and amortization of the associated asset base. Funeral Home Operations Overview As of December 31, 2019, we owned, operated or managed 90 funeral homes located in 17 states and Puerto Rico. Revenues from Funeral Home Operations accounted for approximately 18% and 17% of our total revenues during the years ended December 31, 2019 and 2018, respectively. Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 The following table presents operating results for our Funeral Home Operations for the years ended December 31, 2019 and 2018 (in thousands): Funeral home merchandise revenues were $23.8 million for the year ended December 31, 2019, a decrease of $1.9 million and 7% from $25.7 million for the year ended December 31, 2018. The change was due to a $1.0 million decrease in revenues from pre-need contracts that matured during the current year, a $0.5 million decrease in at-need casket sales and a net decrease in various other merchandise revenues of $0.4 million. Funeral home services revenues were $27.9 million for the year ended December 31, 2019, a decrease of $0.7 million and 2% from $28.5 million for the year ended December 31, 2018. The change was due to a $0.7 million decrease related to a reduction in at-need services during the current year and a net decrease in various other funeral home service revenues of $0.3 million. Partially offsetting these decreases was increased revenue from pre-need contracts that matured during the current year of $0.3 million. Funeral home expenses were $45.7 million for the year ended December 31, 2019, a decrease of $1.6 million and 3% from $47.3 million for the year ended December 31, 2018. The change was due to savings of $1.9 million achieved with the elimination of the insurance sales group and a decrease in payroll and related costs of $0.8 million. Partially offsetting these decreases was an increase in casket costs of $0.8 million and a net increase in various other expenses of $0.3 million. Corporate Operating Results Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 Corporate Overhead The following table summarizes our corporate overhead by expense category for the years ended December 31, 2019 and 2018 (in thousands): Corporate overhead expense was $51.1 million for the year ended December 31, 2019, a decrease of $2.2 million and 4% from $53.3 million for the year ended December 31, 2018. The change was due to the following: • savings in payroll and payroll-related benefits of $2.5 million resulting primarily from a reduction in workforce in 2019; • a decrease of $2.0 million in various other expenses, primarily driven by reductions in telecom, recruiting and employee benefits provider fees; • a decrease in accounting fees of $0.9 million primarily related to nonrecurring costs incurred in 2018 associated with the implementation of ASC 606 and nonrecurring accounting-related consulting fees and internal audit fees associated with our delayed 2018 periodic filings and material weakness identified in 2018; • an increase of $0.3 million in severance and bonus expenses; • an increase in legal fees and legal settlements of $0.7 million; • an increase in stock compensation expense of $1.1 million; and • an increase of $1.1 million in other professional fees primarily resulting from financial advisory and consulting fees, partially offset by nonrecurring fees paid to an interim executive in 2018. Other Losses, Net Other losses, net were $8.1 million for the year ended December 31, 2019, a decrease of $3.4 million and 30% from $11.5 million for the year ended December 31, 2018. Other losses, net for the year ended December 31, 2019 consisted of a $2.8 million impairment of cemetery property, a $2.6 million impairment charge related to damaged and excess inventory and damaged allocated merchandise, a $2.1 million loss on the termination of a management agreement and $0.6 million related to other loss events. Other losses, net for the year ended December 31, 2018 consisted of $9.7 million of impairment charges related to damaged and excess inventory and damaged allocated merchandise and $2.8 million impairment of cemetery property, partially offset by gains of $1.0 million from the termination of a management agreement and sales of certain funeral homes and unused buildings. Interest Expense Interest expense was $48.5 million for the year ended December 31, 2019, an increase of $17.9 million and 59% from $30.6 million for the year ended December 31, 2018. The change was primarily due to the following: • an increase of $17.2 million related to a higher interest rate and principal on our Senior Secured Notes compared to the interest rate and principal under our prior revolving credit facility and senior notes; • an increase of $3.4 million due to the write-off and amortization of deferred financing fees in connection with our Recapitalization Transactions; and • a decrease of $2.7 million resulting from the payoff of the revolving credit facility in the second quarter of 2019. Loss on Debt Extinguishment Loss on debt extinguishment was $8.5 million for the year ended December 31, 2019. This related to the write-off of deferred financing fees of $6.9 million and original issue discounts of $1.6 million associated with the refinancing of the senior notes and revolving credit facilities. For the year ended December 31, 2018, there was no loss on debt extinguishment. Loss on Goodwill Impairment We recorded a loss on goodwill impairment of $24.9 million related to our Cemetery Operations reporting unit for the year ended December 31, 2019. For the year ended December 31, 2018 there was no impairment of goodwill. For further information, see Part II, Item 8. Financial Statements and Supplementary Data-Notes to the Consolidated Financial Statements-Note 9 Goodwill and Intangible Assets of this Annual Report. Income Tax Expense Income tax expense was $28.2 million for the year ended December 31, 2019 compared to a $1.8 million income tax benefit for the year ended December 31, 2018. The variance was primarily due to the change in our tax status from a partnership to a C-corporation, which resulted in us recognizing deferred tax assets and liabilities created by differences in the book versus tax basis of the Partnership’s assets and liabilities. The provision for the year ended December 31, 2019 was net of the future benefit expected to be realized upon filing a consolidated federal tax return for Stonemor Inc. and its subsidiaries. The primary book versus tax basis difference was the result of our cemetery properties that for tax purposes are depreciated over the average life of the cemeteries, which range from 100 to 300 years. The benefit for the year ended December 31, 2018 was primarily driven by changes in the Tax Act, which allowed us to use post-December 31, 2017 NOLs against long life deferred tax liabilities. Our effective tax rate differs from our statutory tax rate, primarily because our legal entity structure includes different tax filing entities that are not subject to entity level income taxes. The effective rate for 2019 is not expected to continue into future tax years, because it reflected adjustments triggered by our change in tax status from a partnership to a C-corporation on December 31, 2019. Additionally, our “ownership change” for income tax purposes that was triggered by the Recapitalization Transactions in June 2019 provided us with the opportunity to reevaluate our ability to offset our NOLs and certain other deferred tax assets against future deferred tax liabilities. LIQUIDITY AND CAPITAL RESOURCES General Our primary sources of liquidity are cash generated from operations and the remaining balance of the proceeds from the sale of the Senior Secured Notes. Our primary cash requirements, in addition to normal operating expenses, are for capital expenditures, net contributions to the merchandise and perpetual care trust funds and debt service. In general, as part of our operating strategy, we expect to fund: • working capital deficits through available cash, including the remaining balance of the proceeds from the sale of the Senior Secured Notes, cash generated from operations and proceeds from asset sales; and • expansion capital expenditures, net contributions to the merchandise and perpetual care trust funds and debt service obligations through available cash, cash generated from operations or proceeds from asset sales. Amounts contributed to the merchandise trust funds will be withdrawn at the time of the delivery of the product or service sold to which the contribution related, which will reduce the amount of additional borrowings or asset sales needed. • any maintenance capital expenditures through available cash and cash flows from operating activities. While we rely heavily on our available cash and cash flows from operating activities to execute our operational strategy and meet our financial commitments and other short-term financial needs, we cannot be certain that sufficient capital will be generated through operations or be available to us to the extent required and on acceptable terms. We have experienced negative financial trends, including use of cash in operating activities, which, when considered in the aggregate, raise substantial doubt about our ability to continue as a going concern. These negative financial trends include: • we have continued to incur net losses for the years ended December 31, 2019 and 2018 and have an accumulated deficit and negative cash flow from operating activities as of December 31, 2019, due to an increased competitive environment, increased expenses due to the consummated C-Corporation Conversion and increases in professional fees and compliance costs; and • a decline in billings coupled with the increase in professional, compliance and consulting expenses tightened our liquidity position and increased reliance on long-term financial obligations. During 2018 and 2019, we implemented (and will continue to implement) various actions to improve profitability and cash flows to fund operations. A summary of these actions is as follows: • sold an aggregate of 52,083,333 of the Partnership’s Preferred Units for an aggregate purchase price of $57.5 million and completed a private placement of $385.0 million of the Senior Secured Notes. The net proceeds of both transactions were used to fully repay the then-outstanding senior notes due in June 2021 and retire our revolving credit facility that was due in May 2020; • continue to manage recurring operating expenses and seek to limit non-recurring operating expenses; and • identify and complete sales of select assets to provide supplemental liquidity. On April 1, 2020, we entered into the Supplemental Indenture that amended three financial covenants and the premium payable upon voluntary redemption of the Senior Secured Notes in the Indenture, and we agreed to use our best efforts to effectuate an offering to holders of our Common Stock of transferable rights to purchase their pro rata share of shares of our Common Stock with an aggregate exercise price of at least $17 million at a price of $0.73 per share, as promptly as practicable with an expiration date no later than July 24, 2020 and to receive proceeds of not less than $8.2 million therefrom (in addition to the $8.8 million capital raise described next). Concurrently with the execution of the Supplemental Indenture, we entered into the Axar Commitment pursuant to which Axar committed to (a) purchase shares of our Series A Preferred Stock with an aggregate purchase price of $8.8 million on April 3, 2020, (b) exercise its basic rights in the rights offering by tendering the shares of Series A Preferred Stock so purchased for shares of our Common Stock and (c) purchase any shares offered in the rights offering for which other stockholders do not exercise their rights, up to a maximum of an additional $8.2 million of such shares. As contemplated by the Axar Commitment, on April 3, 2020, we sold an aggregate of 176 shares of our Series A Preferred Stock to the 2020 Purchasers for an aggregate purchase price of $8.8 million. There is no certainty that our actual operating performance and cash flows will not be substantially different from forecasted results, and there is no certainty we will not need amendments to the Indenture in the future. Factors that could impact the significant assumptions used by us in assessing our ability to satisfy our financial covenants include the following: • operating performance not meeting reasonably expected forecasts; • failing to generate profitable sales; • investments in our trust funds experiencing significant declines due to factors outside our control; • being unable to compete successfully with other cemeteries and funeral homes in our markets; • the number of deaths in our markets declining; and • an adverse change in the mix of funeral and cemetery revenues between burials and cremations. If our planned, implemented and not yet implemented actions are not completed or implemented and cash savings are not realized, or we fail to improve our operating performance and cash flows or we are not able to comply with the covenants under the Indenture, we may be forced to limit our business activities, limit our ability to implement further modifications to our operations or limit the effectiveness of some actions that are included in our forecasts, amend the Indenture and/or seek other sources of capital, and we may be unable to continue as a going concern. Additionally, a failure to generate additional liquidity could negatively impact our access to inventory or services that are important to the operation of our business. Our ability to meet our obligations as of December 31, 2019 and to continue as a going concern is dependent upon achieving the action plans noted above. Based on our forecasted operating performance, planned actions to improve our profitability and cash flows, the execution of the Supplemental Indenture and the Axar Commitment and the consummation of the transactions contemplated thereby, including receipt of not less than $17.0 million in proceeds from the contemplated rights offering, together with plans to file financial statements on a timely basis consistent with the debt covenants, we do not believe it is probable that we will breach the covenants under the Indenture or be unable to continue as a going concern for the next twelve-month period. As such, the consolidated financial statements for the years ended December 31, 2019 and 2018 were prepared on the basis of a going concern, which contemplates that we will be able to realize assets and discharge liabilities in the normal course of business. Accordingly, they do not give effect to adjustments, if any, that would be necessary should we be required to liquidate our assets. Cash Flows The following table summarizes our consolidated statements of cash flows by class of activities (in thousands): Significant sources and uses of cash during the Years Ended December 31, 2019 and 2018 Operating Activities Net cash used in operations was $38.0 million for the year ended December 31, 2019 compared to $26.5 million of net cash provided by operations during the year ended December 31, 2018. The $64.4 million change in operating cash flow was primarily due to the following: • Change in cash from accounts payable and accrued liabilities - $19.8 million: We aggressively managed our working capital in 2019 to maximize cash flows, while upon completion of the Recapitalization Transaction in June 2019, we made significant paydowns on our payables, which resulted in a net increase in operating cash outflows of $19.8 million in 2019. • Cash interest - $6.6 million: Our cash interest paid in 2019 increased by $6.6 million as our total debt and associated debt service costs increased under the Senior Secured Notes as compared to our prior revolving credit facility and senior notes. • Impact of early payoff - $14.1 million: In order to improve the liquidity profile of the business in 2019 and 2018, we ran an early payoff program during the fourth quarter of 2019 and throughout 2018. The early payoff program offered customers with outstanding pre-need receivable contracts the opportunity to pre-pay their outstanding balance at a 15% discount. The change in cash flows generated by each year’s early payoff program accounted for a net decrease in operating cash inflows of $14.1 million in 2019. • Merchandise trust distributions - $19.1 million: We received $2.0 million of excess income distributions from our merchandise trusts in 2019 compared to $21.1 million of excess income distributions from our merchandise trusts in 2018, which resulted in a net decrease in operating cash inflows of $19.1 million in 2019. • Sales production, non-recurring expenses and other working capital items - 4.8 million: Our cash flows in 2019 were further impacted by the continued contraction in sales production and other working capital items, partially offset by decreases in our non-recurring expenses, which resulted in a net increase in operating cash outflows of $4.8 million. Investing Activities Net cash used in investing activities for the year ended December 31, 2019 was $0.2 million as compared to $12.6 million in the comparable 2018 period. The cash used in investing activities for the year ended December 31, 2019 was primarily attributable to capital expenditures of $6.4 million, offset by proceeds from divestitures of $6.3 million, which consisted of the $5.0 million letter of intent deposit we received in connection with the Oakmont Sale and $1.3 million from the termination of one of our management agreements. Net cash used in investing activities during the year ended December 31, 2018 consisted of $12.2 million used for capital expenditures and $1.7 million used for property acquisitions, offset by proceeds from asset sales of $1.3 million. Financing Activities Net cash provided by financing activities for the year ended December 31, 2019 was $76.8 million, an increase of $79.3 million from net cash used in financing activities of $2.6 million for the year ended December 31, 2018, primarily due to net proceeds of $406.1 million and $57.5 million from the issuance of the Senior Secured Notes and the Preferred Offering, respectively, which were both related to our comprehensive recapitalization, as described in Note 10 Long-Term Debt and Note 11 Redeemable Convertible Preferred Units and Partners' Deficit of the consolidated financial statements included in Part II, Item 8. Financial Statements and Supplementary Data of this Annual Report. These investing proceeds were offset by the repayment in full of the prior senior notes and revolving credit facilities of $366.9 million, the payment of $17.4 million in financing costs related to the debt refinancing and debt amendments, principal payments of $1.4 million for our finance leases, payments of $0.8 million for employee tax withholdings on the units that vested in 2019 and a $0.3 million intercompany advance that was effectively repaid by a reduction in the units issued to GP Holdings in the C-Corporation Conversion to comply with our settlement with the SEC. Net cash used in financing activities during the year ended December 31, 2018 consisted primarily of $4.0 million of financing costs partially offset by $1.4 million of net proceeds from borrowings. Capital Expenditures The following table summarizes maintenance and expansion capital expenditures, excluding amounts paid for acquisitions, for the periods presented (in thousands): Contractual Obligations In the normal course of business, we enter into various contractual and contingent obligations that impact or could impact our liquidity. We have contractual obligations requiring future cash payments related to debt maturities, interest on debt, operating lease and finance lease agreements, liabilities to purchase merchandise related to our pre-need sales contracts and capital commitments to private credit funds. A summary of our total contractual and contingent obligations as of December 31, 2019 is presented in the table below (in thousands): (1) Represents the interest payable and par value of our financed vehicles and of our Senior Secured Notes outstanding as of December 31, 2019, exclusive of the unamortized debt discounts and unamortized deferred financing fees as of December 31, 2019 of $14.3 million and $12.9 million, respectively. This table assumes that we pay the fixed rate of 7.50% per annum in cash plus the fixed rate of 4.00% per annum payable in kind through January 30, 2022 and cash interest payments at 9.875% for all interest periods after January 30, 2022, and that current principal amounts outstanding under the Senior Secured Notes are not repaid until the maturity date of June 30, 2024. Since December 31, 2019, an aggregate of $31.3 million of principal on our Senior Secured Notes has been redeemed, primarily with the net proceeds from the Oakmont Sale. Per the Indenture, we anticipate using the first $23.7 million of net proceeds and 80% of the remaining net proceeds from the Olivet Sale along with 80% of the net proceeds from the Remaining California Sale to redeem additional portions of the outstanding Senior Secured Notes. (2) Represents the amounts due related to an agreement we entered into in 2017 to purchase cemetery land in annual installments beginning January 26, 2018 through January 26, 2025. Cypress Lawn Cemetery Association has agreed to assume the obligations under this agreement in connection with the Olivet Sale. (3) Represents the aggregate rent payments pertaining to our lease and management agreements with the Archdiocese of Philadelphia. This table assumes that we defer the rent payments, together with accrued interest compounded quarterly, that are related to the periods from June 1, 2019 through May 31, 2025. This table does not include any associated unamortized discount. For further details, see "Agreements with the Archdiocese of Philadelphia" section below. (4) Total cannot be separated into periods, because we are unable to anticipate when the merchandise and services will be delivered. This balance represents the revenues to be recognized from the total performance obligations on our customer contracts. (5) Represents unfunded capital commitments to private credit funds that are callable at any time during the lockup periods, which range from four to ten years with three potential one year extensions at the discretion of the funds’ general partners and which will be funded using existing trust assets. Not included in the above table are potential funding obligations related to our merchandise and service trusts. In certain states and provinces, we have withdrawn allowable distributable earnings including unrealized gains prior to the maturity or cancellation of the related contract. Additionally, some states have laws that either require replenishment of investment losses under certain circumstances or impose various restrictions when trust fund values drop below certain prescribed amounts. In the event that our trust investments do not recover from market declines, we may be required to deposit portions or all of these amounts into the respective trusts in some future period. As of December 31, 2019, we had unrealized losses of $4.2 million in the various trusts within these states. Agreements with the Archdiocese of Philadelphia In accordance with the lease and management agreements with the Archdiocese of Philadelphia, we have agreed to pay to the Archdiocese aggregate fixed rent of $36.0 million in the following amounts: The fixed rent for lease years 6 through 11, an aggregate of $6.0 million is deferred. If prior to May 31, 2025, the Archdiocese terminates the agreements pursuant to its terms during lease year 11 or we terminate the agreements as a result of a default by the Archdiocese, we are entitled to retain the deferred fixed rent. If the agreements are not terminated, the deferred fixed rent will become due and payable on or before June 30, 2025. Long-Term Debt and Redeemable Convertible Preferred Units Senior Secured Notes On June 27, 2019, StoneMor Partners L.P., Cornerstone Family Services of West Virginia Subsidiary, Inc. and, collectively with the Company, certain direct and indirect subsidiaries of the Company, the initial purchasers party thereto and Wilmington Trust, National Association, as trustee and as collateral agent, entered into an indenture with respect to the 9.875%/11.500% Senior Secured PIK Toggle Notes due 2024. For further detail on our Senior Secured Notes, see Note 10 Long-Term Debt of Part II, Item 8. Financial Statements and Supplementary Data of this Annual Report. Redeemable Convertible Preferred Units On June 27, 2019, funds and accounts affiliated with Axar Capital Management LP and certain other investors entered into the Series A Purchase Agreement pursuant to which the Partnership sold to such purchasers an aggregate of 52,083,333 of the Partnership’s Series A Convertible Preferred Units representing limited partner interests in the Partnership with certain rights, preferences and privileges as were set forth in the Partnership’s Third Amended and Restated Agreement of Limited Partnership dated as of June 27, 2019. The purchase price for the Preferred Units sold pursuant to the Series A Purchase Agreement was $1.1040 per Preferred Unit, reflecting an 8% discount to the liquidation preference of each Preferred Unit, for an aggregate purchase price of $57.5 million. The terms of the sale of the Preferred Units were determined based on arms-length negotiations between the Partnership and Axar. Pursuant to the Series A Purchase Agreement, the Partnership filed a registration statement on Form S-1 with the SEC to effect a $40.2 million rights offering of common units representing limited partnership interests in the Company (“Common Units”) to all holders of Common Units (other than the Purchasers, American Infrastructure Funds LP and their respective affiliates). The offering entitled each unitholder to one non-transferable subscription right for each common unit held by the unitholder on the record date for the offering. Each subscription right entitled the unitholder to purchase 1.24 common units for each common unit held by the unitholder at a purchase price of $1.20 per Common Unit (the “Rights Offering”). The Rights Offering was completed in 2019 with the sale of 3,039,380 common units for an aggregate price of $3.6 million. The proceeds from the Rights Offering were used to redeem 3,039,380 of Partnership’s outstanding Preferred Units on October 25, 2019 at a price of $1.20 per Preferred Unit. For further detail on our Preferred Units, see Note 11 Redeemable Convertible Preferred Units and Owners’ Equity of Part II, Item 8. Financial Statements and Supplementary Data of this Annual Report. Surety Bonds We have entered into arrangements with certain surety companies, whereby such companies agree to issue surety bonds on our behalf as financial assurance and/or as required by existing state and local regulations. The surety bonds are used for various business purposes; however, the majority of the surety bonds issued and outstanding have been used to support our pre-need sales activities. When selling pre-need contracts, we may post surety bonds where allowed by state law. We post the surety bonds in lieu of trusting a certain amount of funds received from the customer. If we were not able to renew or replace any such surety bond, we would be required to fund the trust only for the portion of the applicable pre-need contracts for which we have received payments from the customers, less any applicable retainage, in accordance with state law. We have provided cash collateral to secure these surety bond obligations and may be required to provide additional cash collateral in the future under certain circumstances. For the years ended December 31, 2019 and 2018, we had $92.3 million and $91.4 million, respectively, of cash receipts from sales attributable to related bond contracts. These amounts do not consider reductions associated with taxes, obtaining costs or other costs. Surety bond premiums are paid annually and the bonds are automatically renewable until maturity of the underlying pre-need contracts, unless we are given prior notice of cancellation. Except for cemetery pre-construction bonds (which are irrevocable), the surety companies generally have the right to cancel the surety bonds at any time with appropriate notice. In the event a surety company were to cancel the surety bond, we would be required to obtain replacement surety assurance from another surety company or fund a trust for an amount generally less than the posted bond amount. We do not expect that we will be required to fund material future amounts related to these surety bonds due to a lack of surety capacity or surety company non-performance. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The preparation of our consolidated financial statements and related notes included within Part II, Item 8. Financial Statements and Supplementary Data of this Annual Report in conformity with general accepted accounting principles (“GAAP”) requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses and disclosure of contingent assets and liabilities that arose during the reporting period and through the date our financial statements are filed with the SEC. Although we base our estimates on historical experience and various other assumptions we believe to be reasonable, actual results may differ from these estimates. A critical accounting estimate or policy is one that requires a high level of subjective judgement by management and could have a material impact on our financial position, results of operations or cash flows if actual results vary significantly from our estimates. Revenue Recognition We recognize revenue in an amount that reflects the consideration to which we expect to be entitled for the transfer of goods and services to our customers. We account for individual products and services separately as distinct performance obligations. Our performance obligations include the delivery of funeral and cemetery merchandise and services and cemetery property interment rights. Revenue is measured based on the consideration specified in a contract with a customer and is net of any sales incentives and amounts collected on behalf of third parties. The consideration (including any discounts) is allocated among separate products and services in a package based on their relative stand-alone selling prices. The stand-alone selling price is determined by management based upon local market conditions and reasonable ranges for both merchandise and services, which is the best estimate of the stand-alone price. For items that are not sold separately (e.g., second interment rights), we estimate stand-alone selling prices using the best estimate of market value, using inputs such as average selling price and list price broken down by each geographic location. Additionally, we consider typical sales promotions that could impact the stand-alone selling price estimates. Pursuant to state law, all or a portion of the proceeds from funeral and cemetery merchandise or services sold on a pre-need basis may be required to be paid into trust funds. We defer investment earnings related to these merchandise and service trusts until the associated merchandise is delivered or services are performed. A portion of the proceeds from the sale of cemetery property interment rights is required by state law to be paid by us into perpetual care trust funds to maintain the cemetery. The portion of these proceeds are not recognized as revenue. Investment earnings from these trusts are distributed to us regularly and recognized in current cemetery revenue. Inaccuracies in our records of the timing of physical delivery of our merchandise and services can have a material impact on our financial position, results of operations or cash flows. Deferred Revenues Revenues from the sale of services and merchandise, as well as any investment income from the merchandise trusts, are deferred until such time as the services are performed or the merchandise is delivered. In addition to amounts deferred on new contracts, investment income and unrealized gains and losses on our merchandise trusts are recognized as deferred revenues. Deferred revenues also include deferred revenues from pre-need sales that we acquired through our various acquisitions, and we provide a profit margin for these deferred revenues to account for the projected future costs of delivering products and providing services on these acquired pre-need contracts. Inaccuracies in our records of the timing of physical delivery of our merchandise and services can have a material impact on our financial position, results of operations or cash flows. For further details on our deferred revenues, see Part II, Item 8. Financial Statements and Supplementary Data - Note 1 General and Note 13 Deferred Revenues and Costs. Loss Contract Analysis We perform an analysis annually to determine whether our pre-need contracts are in a loss position, which would necessitate a charge to earnings. For this analysis, we add the sales prices of the underlying contracts and net realized earnings, then subtract net unrealized losses to derive the net amount of estimated proceeds for contracts as of the balance sheet date. We consider unrealized gains and losses based on current market prices quoted for the investments, and we do not include future expected returns on the investments in our analysis. We compare our estimated proceeds to the estimated direct costs to deliver our contracts, which consist primarily of funeral and cemetery merchandise costs along with salaries, supplies and equipment related to the delivery of a pre-need contract. If a deficiency were to exist, we would record a charge to earnings and a corresponding liability for the expected loss on delivery of those contracts from our backlog. Inaccuracies in the judgements made in determining the net amount of estimated proceeds and estimated direct costs can have a material impact our financial position, results of operations or cash flows. Allowance for Doubtful Accounts Accounts receivable is presented net of an allowance for doubtful accounts. The allowance for doubtful accounts is determined by applying a cancellation rate to amounts included in accounts receivable. The cancellation rate is based upon a five year average rate by each specific location. Inaccuracies in the judgements made in determining the cancelation rate can have a material impact on our financial position, results of operations or cash flows. For further details on our allowance for doubtful accounts, see Part II, Item 8. Financial Statements and Supplementary Data - Note 1 General and Note 4 Accounts Receivable, Net of Allowance. Other-Than-Temporary Impairment of Trust Assets Assets held in our merchandise trusts are carried at fair value. Any change in unrealized gains and losses is reflected in the carrying value of the assets and is recognized as deferred revenue. Any and all investment income streams, including interest, dividends or gains and losses from the sale of trust assets, are offset against deferred revenue until such time that we deliver the underlying merchandise. Investment income generated from our merchandise trust is included in "Cemetery investment and other revenues". Pursuant to state law, a portion of the proceeds from the sale of cemetery property is required to be paid into perpetual care trusts. All principal must remain in this trust in perpetuity while interest and dividends may be released and used to defray cemetery maintenance costs, which are expensed as incurred. Assets in our perpetual care trusts are carried at fair value. Any change in unrealized gains and losses is reflected in the carrying value of the assets and is offset against perpetual care trust corpus. We evaluate whether or not the assets in our merchandise and perpetual care trusts have an other-than-temporary impairment on a security-by-security basis. We determine whether or not the impairment of a fixed maturity debt security is other-than-temporary by evaluating each of the following: • Whether it is our intent to sell the security. If there is intent to sell, the impairment is considered to be other-than-temporary. • If there is no intent to sell, we evaluate whether it is not more likely than not we will be required to sell the debt security before its anticipated recovery. If we determine that it is more likely than not that we will be required to sell an impaired investment before its anticipated recovery, the impairment is considered to be other-than-temporary. We further evaluate whether or not all assets in the trusts have other-than-temporary impairments based upon a number of criteria including the severity of the impairment, length of time a security has been in a loss position, changes in market conditions and concerns related to the specific issuer. If an impairment is considered to be other-than-temporary, the cost basis of the security is adjusted downward to its fair value. For assets held in the perpetual care trusts, any reduction in the cost basis due to an other-than-temporary impairment is offset with an equal and opposite reduction in the perpetual care trust corpus and has no impact on earnings. For assets held in the merchandise trusts, any reduction in the cost basis due to an other-than-temporary impairment is recorded in deferred revenue. Inaccuracies in the judgements made in assessing our intent to sell and severity of impairment and in analyzing the changes in market conditions and concerns related to an asset’s issuer can have a material impact on our financial position, results of operations or cash flows. For further details on our other-than-temporary impairment of our trust assets, see Part II, Item 8. Financial Statements and Supplementary Data - Note 1 General, Note 7 Merchandise Trusts and Note 8 Perpetual Care Trusts. Asset Acquisitions Asset acquisitions are measured based on their cost to us, including transaction costs incurred by us. An asset acquisition’s cost or the consideration transferred by us is assumed to be equal to the fair value of the net assets acquired. If the consideration transferred is cash, measurement is based on the amount of cash we paid to the seller, as well as transaction costs incurred by us. Consideration given in the form of nonmonetary assets, liabilities incurred or equity interests issued is measured based on either the cost to us or the fair value of the assets or net assets acquired, whichever is more clearly evident. The cost of an asset acquisition is allocated to the assets acquired based on their estimated relative fair values. Goodwill is not recognized in an asset acquisition. Inaccuracies made in the judgements made in determining the fair value of the nonmonetary assets acquired can have a material impact on our financial position, results of operations or cash flows. Valuation of long-lived assets We assess our long-lived assets, such as definite-lived intangible assets and property and equipment, for impairment whenever events or circumstances indicate that the carrying amount of an asset may not be recoverable. We assess our goodwill and indefinite-lived assets for impairment annually, as of October 1st, or whenever events or circumstances indicate that the carrying amount of goodwill or the indefinite-lived assets may not be recoverable. If the carrying value of an asset exceeds its fair value, we record an impairment charge that reduces our earnings. We apply the discounted cash flow method (the “DCF method”) to determine the fair value of our goodwill, utilizing a number of factors, such as actual operating results, future business plans and forecasted cash flows, economic projections, volatility of earnings, changes in senior management, market data, terminal values and discount rates. These factors used to determine the fair value of our goodwill are highly subjective and very sensitive to changes in the underlying assumptions, such as • a prolonged downturn in the business environment in which the reporting unit operates; • underperformance of the reporting unit performance compared to our forecasts; • volatility in equity and debt markets resulting in higher discount rates; and • unexpected regulatory changes. We apply various valuation techniques, such as the income approach or sales comparison approach, to determine the fair values of our long-lived assets. In evaluating our long-lived assets for recoverability, we consider current market conditions and our intent with respect to holding or disposing of the assets. The factors used in our evaluations for recoverability and the inputs we use in applying the valuation technique we select are highly subjective and very sensitive to changes in the underlying assumptions. Changes in economic and operating conditions or our intent with regard to our long-lived assets that occurs subsequent to our impairment analyses could impact these assumptions and result in future impairments of our long-lived assets. Inaccuracies made in the judgements discussed above in determining the fair value of goodwill, indefinite-lived assets and long-lived assets can have a material impact on our financial position, results of operations or cash flows For further details on our intangible assets see Part II, Item 8. Financial Statements and Supplementary Data - Note 1 General. Income Taxes Effective December 31, 2019, in connection with the C-Corporation Conversion, we are subject to both federal and state income taxes. We record deferred tax assets and liabilities to recognize temporary differences between the bases of assets and liabilities in our tax and GAAP balance sheets and for federal and state NOL carryforwards and alternative minimum tax credits. We record a valuation allowance against our deferred tax assets, if we deem that it is more likely than not that some portion or all of the recorded deferred tax assets will not be realizable in future periods. In evaluating our ability to recover our deferred tax assets, we consider all available positive and negative evidence, including our past operating results, recent cumulative losses and our forecast of future taxable income. In determining future taxable income, we make assumptions regarding the amount of taxable income, the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies. These assumptions require us to make significant judgments about our forecasts of our future taxable income and are consistent with the plans and estimates we use to manage our business. Any reduction in estimated future taxable income may require us to record an additional valuation allowance against our deferred tax assets. An increase in the valuation allowance would result in additional income tax expense in the period and could have a significant impact on our future earnings. On December 22, 2017, the Tax Cuts and Jobs Act of 2017 (the "Tax Act") was signed into law. The Tax Act made broad and complex changes to the U.S. tax code by, among other things, (i) reducing the federal corporate income tax rate, (ii) creating a new limitation on deductible interest expense, (iii) creating bonus depreciation that will allow for full expensing on qualified property and (iv) imposing limitations on deductibility of certain executive compensation. We evaluated the provisions of the Tax Act and determined the primary impact of the Tax Act was the reduction in corporate tax rate from 35% to 21%, which required us to remeasure our deferred tax assets and liabilities in our consolidated financial statements for the year ended December 31, 2017. Subsequently, in February 2018, the SEC staff issued Staff Accounting Bulletin No. 118 ("SAB 118") to address the application of 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 Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting for the income tax effects of certain elements of the Tax Act. In accordance with SAB 118, we recognized the provisional tax impacts related to the remeasurement of our deferred tax assets and liabilities in our consolidated financial statements for the year ended December 31, 2017. Upon completion of our analysis of the Tax Act in 2018, we noted there were no material adjustments. As of December 31, 2019, we had federal and state NOL carryforwards of approximately $423.0 million and $542.0 million, respectively, a portion of which expires annually. We believe the Recapitalization Transactions caused an “ownership change for income tax purposes under the applicable provisions of the Internal Revenue Code of 1986, as amended, which may significantly limit our ability to use such federal NOL carryforwards to offset future taxable income. The C-Corporation Conversion did not impact our ability to use existing NOLs. For further details on our income taxes, see Part II, Item 8. Financial Statements and Supplementary Data - Note 1 General and Note 12 Income Taxes. Contingencies We are party to various legal proceedings in the ordinary course of our business, as well as class and collective actions under the Exchange Act and for related state law claims that certain of our officers and directors breached their fiduciary duty to the Partnership and its unitholders. We accrue for contingencies when the occurrence of a material loss is probable and can be reasonably estimated, based on our best estimate of the expected liability. The accuracy of the estimates used to determine probability and amount of a potential future liability is impacted by, among other things, the complexity of the issues and the amount of due diligence we have been able to perform. Differences between the actual settlement costs, final judgments or fines and our estimates could have a material impact on our financial position, results of operations or cash flows. For further details on our contingencies, see Part II, Item 8. Financial Statements and Supplementary Data-Note 15 Commitments and Contingencies. Insurance loss reserves We purchase comprehensive general liability, professional liability, automobile liability and workers’ compensation insurance coverages structured with high deductibles. This high-deductible insurance program means we are primarily self-insured for claims and associated costs and losses covered by these policies. Historical insurance industry experience indicates a high degree of inherent variability in assessing the ultimate amount of losses associated with casualty insurance claims. This is especially true with respect to liability and workers’ compensation exposures due to the extended period of time that transpires between when the claim might occur and the full settlement of such claim, which is often many years. We continually evaluate loss estimates associated with claims and losses related to these insurance coverages falling within the deductible of each coverage. We analyze and adjust our insurance loss reserve, using assumptions based on factors such as claim settlement patterns, claim development trends, claim frequency and severity patterns, inflationary trends and data reasonableness that impact our analysis and determination of the “best estimate” of the projected ultimate claim losses. Differences between actual insurance loss settlements and our insurance loss reserves could have a material impact on our financial position, results of operations or cash flows. Recent Accounting Pronouncements and Accounting Changes For discussion of recent accounting pronouncements and accounting changes, see Part II, Item 8. Financial Statements and Supplementary Data-Note 1 General.

<s>[INST] Management’s discussion and analysis presented below provides information to assist in understanding the Company’s financial condition and results of operations and should be read in conjunction with the Company’s consolidated financial statements included in Part II, Item 8. Financial Statements and Supplementary Data of this Annual Report. Certain statements contained in this Annual Report, including, but not limited to, information regarding our operating activities, the plans and objectives of our management and assumptions regarding our future performance and plans are forwardlooking statements. When used in this Annual Report, the words “believes,” “anticipates,” “expects” and similar expressions are intended to identify forwardlooking statements. Forwardlooking statements are based on management’s expectations and estimates. These statements are neither promises nor guarantees and are made subject to certain risks and uncertainties that could cause actual results to differ materially from the results stated or implied in this Annual Report. We believe the assumptions underlying the consolidated financial statements are reasonable. Our risks and uncertainties are more particularly described in Part I, Item 1A. Risk Factors of this Annual Report. You should not place undue reliance on forwardlooking statements included in this Annual Report, which speak only as of the date the statements were made. Except as required by applicable laws, we undertake no obligation to update or revise forwardlooking statements, whether as a result of new information, future events or otherwise. BUSINESS OVERVIEW We are one of the leading providers of funeral and cemetery products and services in the death care industry in the United States (“U.S.”). As of December 31, 2019, we operated 321 cemeteries in 27 states and Puerto Rico, of which 291 were owned and 30 were operated under leases, operating agreements or management agreements. We also owned, operated or managed 90 funeral homes in 17 states and Puerto Rico. On December 31, 2019, we consummated the CCorporation Conversion for the purpose of transitioning the Partnership and its affiliates from a master limited partnership structure to a corporate form. See Part II. Item 8. Financial Statements and Supplementary DataNotes to the Consolidated Financial StatementsNote 1 General of this Annual Report for further information related to the CCorporation Conversion. Our revenue is derived from our Cemetery Operations and Funeral Home Operations segments. Our Cemetery Operations segment principally generates revenue from sales of interment rights, cemetery merchandise, which includes markers, bases, vaults, caskets and cremation niches and our cemetery services, which include opening and closing (“O&C”) services, cremation services and fees for the installation of cemetery merchandise. Our Funeral Home Operations segment principally generates revenue from sales of funeral home merchandise, which includes caskets and other funeral related items and service revenues, which include services such as family consultation, the removal of and preparation of remains and the use of funeral home facilities for visitation and prayer services. These sales occur both at the time of death, which we refer to as atneed, and prior to the time of death, which we refer to as preneed. Our Funeral Home Operations segment also include revenues related to the sale of term and whole life insurance on an agency basis, in which we earn a commission from the sales of these insurance policies. The preneed sales enhance our financial position by providing a backlog of future revenue from both trust and insurancefunded preneed funeral and cemetery sales. We believe preneed sales add to the stability and predictability of our revenues and cash flows. Preneed sales are typically sold on an installment plan. While revenue on the majority of preneed funeral sales is deferred until the time of need, sales of preneed cemetery property interment rights provide opportunities for full current revenue recognition when the property is available for use by the customer. We also earn investment income on certain payments received from customers on preneed contracts, which are required by law to be deposited into the merchandise and service trusts. Amounts are withdrawn from the merchandise and service trusts when we fulfill the performance obligations. Earnings on these trust funds, which are specifically identifiable for each performance obligation, [/INST] Negative. </s>

Software Acquisition Group Inc.

2020-03-20

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 formed under the laws of the State of Delaware on May 9, 2019 for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or other similar Business Combination with one or more businesses. We have not selected any specific Business Combination target and we have not, nor has anyone on our behalf, initiated any substantive discussions, directly or indirectly, with any Business Combination target. We intend to effectuate our Business Combination using cash from the proceeds of the Initial Public Offering and the sale of the Private Warrants, 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 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 are incurring 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 May 9, 2019 (inception) through 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 after the Initial Public Offering. 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. For the period from May 9, 2019 (inception) through December 31, 2019, we had net income of $7,341, which consists of interest income on marketable securities held in the Trust Account of $219,910, offset by operating costs of $210,617 and a provision for income taxes of $1,952. Liquidity and Capital Resources On November 22, 2019, we consummated the Initial Public Offering of 14,950,000 units, which includes the full exercise by the underwriters of their over-allotment option in the amount of 1,950,000 units,hed at a price of $10.00 per Unit, generating gross proceeds of $149,500,000. Simultaneously with the closing of the Initial Public Offering, we consummated the sale of 4,740,000 Private Placement Warrants to our Sponsor at a price of $1.00 per Private Placement Warrants, generating gross proceeds of $4,740,000. Following the Initial Public Offering and the sale of the Private Placement Warrants, a total of $149,500,000 was placed in the Trust Account. We incurred $8,745,223 in transaction costs, consisting of $2,990,000 of underwriting fees, $5,232,500 of deferred underwriting fees and $522,723 of other offering costs. For the period from May 9, 2019 (inception) through December 31, 2019, cash used in operating activities was $158,869. Net income of $7,341 was offset by interest earned on marketable securities held in the Trust Account of $219,910. Changes in operating assets and liabilities provided $53,700 of cash from operating activities. As of December 31, 2019, we had marketable securities held in the Trust Account of $149,719,910 (including approximately $220,000 of interest income earned from investments in a money market fund that invests primarily in U.S. treasury bills with a maturity of 180 days or less). Interest income on the balance in the Trust Account may be used by us to pay taxes. Through December 31, 2019, we have not withdrawn any interest earned on the Trust Account. 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 income taxes payable and 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. As of December 31, 2019, we had $1,093,408 of cash held outside of 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 certain of our officers and directors or their affiliates 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 warrants identical to the Private Placement Warrants, at a price of $1.00 per warrant 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 did not have any off-balance sheet arrangements as of December 31, 2019. 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 $10,000 for office space, utilities and secretarial and administrative support to the Company. We began incurring these fees on November 19, 2019 and will continue to incur these fees monthly until the earlier of the completion of the Business Combination and the Company’s liquidation. The underwriters are entitled to deferred fee of three and half percent (3.50%) of the gross proceeds of the Initial Public Offering, or $5,232,500. The deferred fee will become payable to the underwriter 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 identified the following critical accounting policies: 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. Net loss per common share We apply the two-class method in calculating earnings per share. Common stock subject to possible redemption which is not currently redeemable and is not redeemable at fair value, has been excluded from the calculation of basic net loss per common 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 standards Management does not believe that any recently issued, but not yet effective, accounting pronouncements, 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 formed under the laws of the State of Delaware on May 9, 2019 for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or other similar Business Combination with one or more businesses. We have not selected any specific Business Combination target and we have not, nor has anyone on our behalf, initiated any substantive discussions, directly or indirectly, with any Business Combination target. We intend to effectuate our Business Combination using cash from the proceeds of the Initial Public Offering and the sale of the Private Warrants, 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 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 [/INST] Positive. </s>

Sprout Social, Inc.

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 of our financial condition and results of operations together with “Selected Consolidated Financial and Other Data” and our audited consolidated financial statements and related notes included elsewhere in this Annual Report. This discussion 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 factors, including those set forth under “Risk Factors” and in other parts of this Annual Report. Overview Sprout Social is a powerful, centralized platform that provides the critical business layer to unlock the massive commercial value of social media. Currently, more than 23,000 customers across 100 countries rely on our platform to reach larger audiences, create stronger relationships with their customers and make better business decisions. Introduced in 2011, our cloud software brings together social messaging, data and workflows in a unified system of record, intelligence and action. Operating across major social media networks, including Twitter, Facebook, Instagram, Pinterest, LinkedIn, Google and YouTube, we provide organizations with a centralized platform to effectively manage their social media efforts across stakeholders and business functions. Virtually every aspect of business has been impacted by social media, from marketing, sales and public relations to customer service, product and strategy, creating a need for an entirely new category of software. We offer our customers a centralized, secure and powerful platform to manage this broad, complex channel effectively across their organization. Since our founding, we have achieved several key milestones: • 2010 - Founded Company, launched V1 beta and Lightbank became an investor; • 2011 - Launched our Sprout platform, surpassed 1,000 customers and NEA became an investor; • 2013 - Reached 100 employees; • 2015 - Surpassed 15,000 customers; • 2016 - Reached 250 employees and Goldman Sachs became an investor; • 2017 - Completed first business acquisition and awarded Glassdoor’s “Top Places to Work” and “Highest Rated CEO”; • 2018 - Surpassed 20,000 customers, opened EMEA office, reached 500 employees, launched first add-on module (Listening), Future Fund became an investor and awarded Glassdoor’s “Top Places to Work” and “Highest Rated CEO”; and • 2019 - Completed our IPO resulting in $134.3 million of net proceeds, surpassed $100 million in total ARR and awarded Glassdoor’s “Highest Rated CEO”. We generate revenue primarily from subscriptions to our social media management platform under a software-as-a-service model. Our subscriptions can range from monthly to one-year or multi-year arrangements and are generally non-cancellable during the contractual subscription term. Subscription revenue is recognized ratably over the contract terms beginning on the date the product is made available to customers, which typically begins on the commencement date of each contract. We also generate revenue from professional services related to our platform provided to certain customers, which is recognized at the time these services are provided to the customer. This revenue has historically represented less than 1% of our revenue and is expected to be immaterial for the foreseeable future. Our tiered subscription-based model allows our customers to choose among three core plans to meet their needs. Each plan is licensed on a per user per month basis at prices dependent on the level of features offered. Additional product modules, which offer increased functionality depending on a customer’s needs, can be purchased by the customer on a per user per month basis. We generated revenue of $102.7 million and $78.8 million during the years ended December 31, 2019 and 2018, respectively, representing growth of 30%. Excluding the impact of the 2017 acquisition of Simply Measured, Inc., or Simply Measured, our organic growth rate in 2019 was 44%. This organic growth rate excludes the impact of revenue generated from legacy Simply Measured products as well as revenue from the transition of legacy customers to our platform up to an amount equal to such customers’ prior spend on legacy Simply Measured products. This organic growth rate includes all incremental revenue generated above such prior spend from the sale of additional or higher-priced products and users and profiles to legacy customers of Simply Measured. In 2019, software subscriptions contributed 99% of our revenue. We generated net losses of $46.8 million and $20.9 million during the years ended December 31, 2019 and 2018, respectively, which included stock-based compensation expense of $25.3 million during the year ended December 31, 2019, primarily as a result of the vesting of RSUs in connection with our IPO in December 2019. We expect to continue investing in the growth of our business and, as a result, generate net losses for the foreseeable future. Key Factors Affecting Our Performance Acquiring new customers We are focused on continuing to organically grow our customer base by increasing demand for our platform and penetrating our addressable market. We have invested, and expect to continue to invest, heavily in expanding our sales force and marketing efforts to acquire new customers. Currently, we have more than 23,000 customers. We calculate the lifetime value of our customers and associated customer acquisition costs for a particular year by comparing (i) gross profit from net new organic ARR for the year divided by one minus the estimated subscription renewal rate to (ii) total sales and marketing expense incurred in the preceding year. On this basis, we estimate that for each of 2019 and 2018, the calculated lifetime value of our customers has exceeded six times the associated cost of acquiring them. This calculation assumes the actual subscription renewal rate for the period will remain consistent in future years. While we believe this assumption is reasonable based on our historic data and experience, subscription renewal rates may vary year-to-year, and the lifetime value of our customers may decline or fluctuate between periods. Moreover, our sales and marketing expense reflects the amortization of sales commissions, which are deferred and amortized over a three-year period in accordance with GAAP. If all sales commissions incurred in the year were expensed and not amortized, the result would not have a material impact on the lifetime value of our customers. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Key Business Metrics-Organic ARR” for more information on how we define and calculate organic ARR. Expanding within our current customer base We believe that there is a substantial and largely untapped opportunity for organic growth within our existing customer base. Customers often begin by purchasing a small number of user subscriptions and then expand over time, increasing the number of users or social profiles, as well as purchasing additional product modules. Customers may then expand use-cases between various departments to drive collaboration across their organizations. Our sales and customer success efforts include encouraging organizations to expand use-cases to more fully realize the value from the broader adoption of our platform throughout an organization. We will continue to invest in enhancing awareness of our brand, creating additional uses for our products and developing more products, features and functionality of existing products, which we believe are vital to achieving increased adoption of our platform. We have a history of attracting new customers and we have recently increased our focus on expanding their use of our platform over time. We use dollar-based net retention rate to evaluate the long-term value of our customer relationships, because we believe this metric reflects our ability to retain and expand subscription revenue generated from our existing customers. Our dollar-based net retention rate for the years ended December 31, 2019 and 2018 was 110% and 106%, respectively. Our dollar-based net retention rate excluding our SMB customers for the years ended December 31, 2019 and 2018 was 120% and 115%, respectively. We calculate dollar-based net retention rate by dividing the organic ARR from our customers as of December 31st in the reported year by the organic ARR from those same customers as of December 31st in the previous year. This calculation is net of upsells, contraction, cancellation or expansion during the period but excludes organic ARR from new customers. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Key Business Metrics-Organic ARR” for more information on how we define and calculate organic ARR. Sustaining product and technology innovation Our success is dependent on our ability to sustain product and technology innovation and maintain the competitive advantage of our proprietary technology. We continue to invest resources to enhance the capabilities of our platform by introducing new products, features and functionality of existing products. International expansion We see international expansion as a meaningful opportunity to grow our platform. Revenue generated from non-U.S. customers during the year ended December 31, 2019 was approximately 29% of our total revenue. We have built local teams in Ireland, Canada, the United Kingdom, Singapore, India and Australia to support our growth internationally. We believe global demand for our platform and offerings will continue to increase as awareness of our platform in international markets grows. We plan to continue adding to our local sales, customer support and customer success teams in select international markets over time. Key Business Metrics We review the following key business metrics to evaluate our business, measure our performance, identify trends, formulate financial projections and make strategic decisions. Number of customers We define a customer as a unique account, multiple accounts containing a common non-personal email domain, or multiple accounts governed by a single agreement. Number of customers excludes customers exclusively using legacy products obtained through the acquisition of Simply Measured. We believe that the number of customers using our platform is an indicator not only of our market penetration, but also of our potential for future growth as our customers often expand their adoption of our platform over time based on an increased awareness of the value of our platform and products. Total ARR Total ARR is ARR from all of our products. We define ARR as the annualized revenue run-rate of subscription agreements from all customers as of the last date of the specified period. Total ARR includes the impact of recurring revenue generated from legacy Simply Measured products, which a small number of legacy Simply Measured customers have continued to access. These customers may continue to do so for a limited period in the future as we continue to transition those customers to other Sprout products. We believe total ARR is an indicator of the scale of our entire platform while mitigating fluctuations due to seasonality and contract term. Organic ARR Organic ARR is ARR excluding the impact of recurring revenue generated from legacy Simply Measured products. We believe organic ARR is an indicator of the scale and visibility of our core platform while mitigating fluctuations due to seasonality and contract term. Number of customers contributing more than $10,000 in ARR We view the number of customers that contribute more than $10,000 in ARR as a measure of our ability to scale with our customers and attract larger organizations. We believe this represents potential for future growth, including expanding within our current customer base. Over time, larger customers have constituted a greater share of our revenue. We define customers contributing more than $10,000 in ARR as those on a paid subscription plan that had more than $10,000 in ARR as of a period end. Components of our Results of Operations Revenue Subscription We generate revenue primarily from subscriptions to our social media management platform under a software-as-a-service model. Our subscriptions can range from monthly to one-year or multi-year arrangements and are generally non-cancellable during the contractual subscription term. Subscription revenue is recognized ratably over the contract terms beginning on the date our product is made available to customers, which typically begins on the commencement date of each contract. Our customers do not have the right to take possession of the online software solution. We also generate a small portion of our subscription revenue from third-party resellers. Professional Services We sell professional services consisting of, but not limited to, implementation fees, specialized training, one-time reporting services and recurring periodic reporting services. Professional services revenue is recognized at the time these services are provided to the customer. This revenue has historically represented less than 1% of our revenue and is expected to be immaterial for the foreseeable future. Cost of Revenue Subscription Cost of revenue primarily consists of expenses related to hosting our platform and providing support to our customers. These expenses are comprised of fees paid to data providers, hosted data center costs and personnel costs directly associated with cloud infrastructure, customer success and customer support, including salaries, benefits, bonuses and allocated overhead. These costs also include depreciation expense and amortization expense related to acquired developed technologies. Overhead associated with facilities and information technology is allocated to cost of revenue and operating expenses based on headcount. Although we expect our cost of revenue to increase in absolute dollars as our business and revenue grows, we expect our cost of revenue to decrease as a percentage of our revenue over time. Professional Services and Other Cost of professional services primarily consists of expenses related to our professional services organization and are comprised of personnel costs, including salaries, benefits, bonuses and allocated overhead. Gross Profit and Gross Margin Gross margin is calculated as gross profit as a percentage of total revenue. Our gross margin may fluctuate from period to period based on revenue earned, the timing and amount of investments made to expand our hosting capacity, our customer support and professional services teams and in hiring additional personnel, and the impact of acquisitions. We expect our gross profit and gross margin to increase as our business grows over time. Operating Expenses Research and Development Research and development expenses primarily consist of personnel costs, including salaries, benefits and allocated overhead. Research and development expenses also include depreciation expense and other expenses associated with product development. We plan to increase the dollar amount of our investment in research and development for the foreseeable future as we focus on developing new features and enhancements to our plan offerings. However, we expect our research and development expenses to decrease as a percentage of our revenue over time. Sales and Marketing Sales and marketing expenses primarily consist of personnel costs directly associated with our sales and marketing department, online advertising expenses, as well as allocated overhead, including depreciation expense and amortization related to acquired developed technologies. Sales force commissions and bonuses are considered incremental costs of obtaining a contract with a customer. Sales commissions are earned and recorded at contract commencement for both new customer contracts and expansion of contracts with existing customers. Sales commissions are deferred and amortized on a straight-line basis over a period of benefit of three years. We plan to increase the dollar amount of our investment in sales and marketing for the foreseeable future, primarily for increased headcount for our sales department. General and Administrative General and administrative expenses primarily consist of personnel expenses associated with our finance, legal, human resources and other administrative employees. Our general and administrative expenses also include professional fees for external legal, accounting and other consulting services, depreciation and amortization expense, as well as allocated overhead. We expect to increase the size of our general and administrative functions to support the growth of our business. We also recognized certain non-recurring professional fees and other expenses as part of our transition to becoming a public company and expect to continue to incur additional expenses as a result of operating as a public company, including costs to comply with rules and regulations applicable to companies listed on a U.S. securities exchange, costs related to compliance and reporting obligations pursuant to the rules and regulations of the SEC, investor relations and professional services. We expect the dollar amount of our general and administrative expenses to increase for the foreseeable future. However, we expect our general and administrative expenses to decrease as a percentage of revenue over time. Interest Income (Expense), Net Interest income (expense), net consists primarily of interest expenses on outstanding line of credit balances and is offset by interest income earned on our cash balances. Other Income Other income consists of sublease rental income from our Seattle, Washington and San Francisco, California offices. Income Tax Provision The income tax provision consists of current and deferred taxes for our U.S. and foreign jurisdictions. We have historically reported a taxable loss in our most significant jurisdiction, the U.S., and have a full valuation allowance against our deferred tax assets. We expect this trend to continue for the foreseeable future. Results of Operations The following tables set forth information comparing the components of our results of operations in dollars and as a percentage of total revenue for the periods presented. _______________ (1) Includes stock-based compensation expense as follows: Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 Revenue The increase in subscription revenue was primarily driven by revenue from new customers and expansion within existing customers. The total number of customers grew from 21,135 as of December 31, 2018 to 23,693 as of December 31, 2019. The increase in new customers was primarily driven by our growing sales force capacity to meet market demand. Expansion within existing customers was driven by our ability to increase the number of users, social profiles and products purchased by customers. This is in part attributable to the expansion of use-cases across various functions within our existing customers’ organizations. Cost of Revenue and Gross Margin The increase in cost of subscription revenue for the year ended December 31, 2019 compared to the year ended December 31, 2018 was primarily due to the following: Fees paid to our data providers increased due to revenue growth. Personnel costs increased primarily as a result of a 63% increase in headcount as we continue to grow our customer support and customer success teams to support our customer growth. The increase in stock-based compensation was due to the initial expense related to employee RSUs vesting as a result of the completion of our IPO on December 17, 2019. Operating Expenses Research and Development The increase in research and development expense for the year ended December 31, 2019 compared to the year ended December 31, 2018 was primarily due to the following: The increase in stock-based compensation was due to the initial expense related to employee RSUs vesting as a result of the completion of our IPO on December 17, 2019. Sales and Marketing The increase in sales and marketing expense for the year ended December 31, 2019 compared to the year ended December 31, 2018 was primarily due to the following: Personnel costs increased primarily as a result of a 31% increase in headcount as we continue to expand our sales teams to grow our customer base, as well as additional sales commission expense due to the year over year sales growth, which increased the amortization of contract acquisition costs. The increase in stock-based compensation was due to the initial expense related to employee RSUs vesting as a result of the completion of our IPO on December 17, 2019. General and Administrative The increase in general and administrative expense for the year ended December 31, 2019 compared to the year ended December 31, 2018 was primarily due to the following: Stock-based compensation expense increased $9.4 million as the result of restricted stock award and restricted stock unit grants to our President and Chief Executive Officer that immediately vested in June and December 2019, respectively. The remaining increase in stock-based compensation was due to the initial expense related to employee RSUs vesting as a result of the completion of our IPO on December 17, 2019. Personnel costs increased primarily as a result of a 72% increase in headcount as we continue to grow our business. Bad debt expense increased due to higher accounts receivable balances and the attrition of customers acquired in the Simply Measured acquisition. Rent expense increased due to renting additional office space. Interest Income (Expense), Net The increase in net interest income was driven by interest earned on cash deposits, as well as a decrease in interest expense related to line of credit borrowings. Other Income The increase in other income is due to sublease rental income from our Seattle, Washington and San Francisco, California offices. Income Tax Expense _________________ (1) Calculated metric is not meaningful. The increase in income tax expense is due to the provision related to foreign income taxes. Comparison of the year ended December 31, 2018 to the year ended December 31, 2017 We have elected not to include a discussion of our results of operations for 2018 compared to 2017 in this report in reliance upon Instruction 1 to Item 303 of Regulation S-K. This information is contained in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Registration Statement on Form S-1 (File No. 333-234316) filed with the SEC on October 25, 2019, as amended on December 2, 2019 and December 6, 2019. Non-GAAP Financial Measures In addition to our results determined in accordance with U.S. generally accepted accounting principles, or GAAP, we believe the following non-GAAP measures are useful in evaluating our operating performance. We use the below non-GAAP financial information, collectively, to evaluate our ongoing operations and for internal planning and forecasting purposes. We believe that non-GAAP financial information, when taken collectively, may be helpful to investors because it provides consistency and comparability with past financial performance by excluding certain items that may not be indicative of our business, operating results or future outlook. However, non-GAAP financial information is presented for supplemental informational purposes only, has limitations as an analytical tool and should not be considered in isolation or as a substitute for financial information presented in accordance with GAAP. In addition, other companies, including companies in our industry, may calculate non-GAAP financial measures differently or may use other measures to evaluate their performance, all of which could reduce the usefulness of our non-GAAP financial measures as tools for comparison. Investors are encouraged to review the related GAAP financial measures and the reconciliation of these non-GAAP financial measures to their most directly comparable GAAP financial measures, and not to rely on any single financial measure to evaluate our business. Non-GAAP Operating Loss We define non-GAAP operating loss as GAAP loss from operations, excluding stock-based compensation expense. We believe non-GAAP operating loss provides our management and investors consistency and comparability with our past financial performance and facilitates period-to-period comparisons of operations, as this non-GAAP financial measure eliminates the effect of stock-based compensation, which is often unrelated to overall operating performance, particularly given the impact of stock-based compensation expense recognized in December 2019 upon the completion of the IPO. Non-GAAP Net Loss We define non-GAAP net loss as GAAP net loss and comprehensive loss, excluding stock-based compensation expense. We believe non-GAAP net loss provides our management and investors consistency and comparability with our past financial performance and facilitates period-to-period comparisons of operations, as this non-GAAP financial measure eliminates the effect of stock-based compensation, which is often unrelated to overall operating performance, particularly given the impact of stock-based compensation expense recognized in December 2019 upon the completion of the IPO. Non-GAAP Net Loss per Share We define non-GAAP net loss per share as GAAP net loss per share attributable to common shareholders, basic and diluted, excluding stock-based compensation expense. We believe non-GAAP net loss per share provides our management and investors consistency and comparability with our past financial performance and facilitates period-to-period comparisons of operations, as this non-GAAP financial measure eliminates the effect of stock-based compensation, which is often unrelated to overall operating performance, particularly given the impact of stock-based compensation expense recognized in December 2019 upon the completion of the IPO. Free Cash Flow Free cash flow is a non-GAAP financial measure that we define as net cash used in operating activities less purchases of property and equipment. We believe that free cash flow is a useful indicator of liquidity that provides information to management and investors about the amount of cash used in our core operations that, after the purchases of property and equipment, is not available to be used for strategic initiatives. For example, if free cash flow is negative, we may need to access cash reserves or other sources of capital to invest in strategic initiatives. One limitation of free cash flow is that it does not reflect our future contractual obligations. Additionally, free cash flow does not represent the total increase or decrease in our cash balance for a given period. Quarterly Results of Operations The following tables present selected unaudited quarterly statements of operations data for each of the eight fiscal quarters ended December 31, 2019, as well as the percentage of total revenue that each line item represents for each quarter for Sprout Social, Inc. and its subsidiaries. The information for each of these quarters has been prepared on a basis substantially consistent with our audited consolidated financial statements included elsewhere in this Annual Report 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. This data should be read in conjunction with our audited consolidated financial statements and related notes included elsewhere in this Annual Report. These quarterly results are not necessarily indicative of our future results of operations to be expected for any future period. _________________ (1) Includes stock-based compensation expense as follows: Quarterly Revenue, Cost of Revenue and Gross Profit Trends Our revenue increased sequentially for all periods presented primarily due to increased subscription revenue from new customers and expansion within existing customers. Total cost of revenue increased sequentially for all periods presented, consistent with our revenue growth, in order to support our overall growth. Gross profit generally increased sequentially in each of the quarters presented, primarily driven by an increase in revenue. Our gross profit margins were generally consistent for all periods presented. During the fourth quarter of 2019, our total cost of revenue and gross profit margins were impacted by stock-based compensation that was due to the initial expense related to employee RSUs vesting as a result of the completion of our IPO on December 17, 2019. Quarterly Operating Expenses Trends Total operating expenses generally increased sequentially for all periods presented due primarily to increases in headcount and other related personnel costs to support our growth. We plan to continue our investment in research and development for the foreseeable future as we focus on developing new features and enhancements to our product offerings. We also plan to continue our investment in sales and marketing for the foreseeable future and incur additional costs for increased headcount for our sales department. During the second quarter of 2019, we experienced a significant increase in general and administrative expenses due to $5.3 million of stock-based compensation expense as the result of a restricted stock award to our President and Chief Executive Officer that immediately vested in June 2019. During the fourth quarter of 2019, we experienced a significant one-time increase in operating expenses from stock-based compensation that was due to the initial expense related to employee RSUs vesting as a result of the completion of our IPO on December 17, 2019. We expect to continue to expand our general and administrative functions to support the growth of our business and future operations as a public company, a trend that we expect to continue for the foreseeable future. Liquidity and Capital Resources As of December 31, 2019, our principal sources of liquidity were cash of $135.3 million and net accounts receivable of $11.1 million. We have generated losses from operations and negative cash flows from operations, as evidenced by our accumulated deficit and statement of cash flows. We expect to continue to incur operating losses and negative operating cash flows for the foreseeable future due to the investments in our business we intend to make as described above. Prior to our IPO in December 2019, we financed our operations primarily through private issuance of equity securities and line of credit borrowings. In our IPO, we received net proceeds of $134.3 million after deducting underwriting discounts and commissions of $10.5 million and offering expenses of $5.2 million. See Notes 1, 7 and 8 to our audited consolidated financial statements for more information regarding these transactions. Our principal uses of cash in recent periods have been to fund operations and invest in capital expenditures. We believe our existing cash will be sufficient to meet our operating and capital needs for at least the next 12 months. Our future capital requirements will depend on many factors, including our subscription growth rate, subscription renewal activity, billing frequency, the timing and extent of spending to support our research and development efforts, the expansion of sales and marketing activities, the introduction of new and enhanced product offerings, and the continuing market acceptance of our product. In the future, we may enter into arrangements to acquire or invest in complementary businesses, products and technologies, including 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 or generate cash flows necessary to expand our operations, our business, results of operations and financial condition could be adversely affected. SVB Credit Facility In December 2017, we entered into a Loan and Security Agreement with Silicon Valley Bank, or SVB, which comprised a $15.0 million line of credit, or the Revolver, and a $5.0 million incremental revolving line commitment, or the Incremental Revolver, and, together with the Revolver, the SVB Credit Facility. In November 2019, we amended the SVB Credit Facility to increase the Revolver (including the exercise of the Incremental Revolver, as amended) to $40.0 million and amend, among others terms, levels for the minimum adjusted EBITDA and minimum liquidity covenants, the advance rate and the interest rate. The November 2019 amendment includes a “streamline period”, or Streamline Period, concept, which occurs when we maintain, for every consecutive day in the immediately preceding fiscal quarter, the sum of (i) unrestricted cash at SVB plus (ii) unused availability under the Revolver in an amount equal to or greater than $75.0 million (the Streamline Balance). Any Streamline Period terminates on the earlier of the occurrence of an event of default and failure to maintain the Streamline Balance. The minimum adjusted EBITDA and minimum liquidity covenants do not apply during any Streamline Period. As of December 31, 2019, we did not have any outstanding principal balance under the SVB Credit Facility. In connection with the November 2019 amendment, the Revolver now has a floating interest rate equal to the greater of (i) 4.75% and (ii) (x) at any time when the Streamline Period is not in effect, one and one-half of one percent (1.50%) above the prime rate and (y) at any time when the Streamline Period is in effect, the prime rate, which interest is payable monthly. The SVB Credit Facility matures on January 31, 2021 and is extendable to January 31, 2022 following the occurrence of a qualified public offering (as defined therein) completed December 17, 2019. The SVB Credit Facility contains customary negative covenants that limit our ability to, or require mandatory prepayment in the event that we, among other things, incur additional indebtedness or liens, merge with other companies or consummate certain changes of control, acquire other companies, engage in new lines of business, add new offices or business locations, make certain investments, pay dividends, transfer or dispose of certain assets, liquidate or dissolve and enter into various specified transactions. The SVB Credit Facility also contains affirmative covenants, including certain financial covenants such as minimum adjusted EBITDA and minimum liquidity covenants and financial reporting requirements. With limited exceptions, our obligations under the SVB Credit Facility are secured by all of our property other than intellectual property (which is subject to a negative pledge). As of December 31, 2019, we were in compliance with the covenants in the SVB Credit Facility. The following table summarizes our cash flows for the periods presented: Operating Activities Our largest source of operating cash is cash collections from our customers for subscription services. Our primary uses of cash from operating activities are for personnel costs across the sales and marketing and research and development departments and hosting costs. Historically, we have generated negative cash flows from operating activities. Net cash used in operating activities during the year ended December 31, 2019 was $14.4 million, which resulted from a net loss of $46.8 million adjusted for non-cash charges of $37.9 million and net cash outflow of $5.5 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of $25.3 million of stock-based compensation expense, $4.3 million of depreciation and intangible asset amortization expense, $4.8 million for amortization of deferred contract acquisition costs, which were primarily commissions, $2.2 million for bad debt expense and $1.1 million of amortization of right-of-use, or ROU, operating lease assets. The net cash outflow from changes in operating assets and liabilities was primarily the result of a $8.2 million increase in deferred commissions due to the addition of new customers and expansion of the business, a $2.8 million increase in gross accounts receivable, a $2.7 million increase in prepaid expenses and a $1.6 million decrease in operating lease liabilities. These outflows were offset by a $8.2 million increase in deferred revenue. Net cash used in operating activities during the year ended December 31, 2018 was $17.2 million, which resulted from a net loss of $20.9 million adjusted for non-cash charges of $7.8 million and net cash outflow of $4.1 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of $4.0 million of depreciation and intangible asset amortization expense and $2.8 million for amortization of deferred contract acquisition costs, which were primarily commissions. The net cash outflow from changes in operating assets and liabilities was the result of a $7.0 million increase in deferred commissions due to the addition of new customers and expansion of the business, a $4.9 million increase in accounts receivable due to the growth of our business and a $1.2 million increase in prepaid expenses and other assets. These outflows were offset by a $7.2 million increase in deferred revenue and a $1.8 million net increase in accounts payable, accrued expenses and accrued wages and payroll due to growth in our business and higher headcount. Investing Activities Net cash used in investing activities for the year ended December 31, 2019 was $0.8 million, which was primarily due to purchases of computer equipment and hardware. Net cash used in investing activities for the year ended December 31, 2018 was $2.1 million, which was primarily due to leasehold improvements of our Chicago office. Financing Activities Net cash provided by financing activities for the year ended December 31, 2019 was $124.3 million, which was the result of $139.5 million of net proceeds from our IPO, offset by $9.9 million in payments related to the employee withholding taxes as a result of the net settlement of stock-based awards and $5.2 million in payments of deferred costs associated with our IPO. Net cash provided by financing activities for the year ended December 31, 2018 was $37.2 million, which was primarily driven by the net proceeds of $40.3 million from the issuance of the Series D preferred stock, offset by net cash payments for borrowings on the line of credit of $3.0 million. Contractual Obligations The following table summarizes our non-cancellable contractual obligations as of December 31, 2019. _________________ (1) Consists of minimum guaranteed purchase commitments for data and services. Off-Balance Sheet Arrangements As of December 31, 2019, we did not have any relationships with any entities or financial partnerships, such as structured finance or special purpose entities, that would have been established for the purpose of facilitating off-balance sheet arrangements or other purposes. Recent Accounting Pronouncements Refer to section titled “Recently Adopted Accounting Pronouncements” in Note 1 of the notes to our audited consolidated financial statements for more information. Critical Accounting Policies and Estimates Our audited consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these audited consolidated financial statements in conformity with GAAP requires management to make estimates, judgments 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 and the reported amounts of revenue and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates and assumptions. Our actual results may differ from these estimates. We believe that of our significant accounting policies, which are described in Note 1 to our audited consolidated financial statements, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our audited consolidated financial condition and results of operations. Revenue Recognition We generate revenue from subscriptions to our social media management platform under a software-as-a-service model. Our subscriptions can range from monthly to one-year or multi-year arrangements and are generally non-cancellable during the contractual subscription term. Our customers do not have the right to take possession of the online software solution. We adopted Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 606, Revenue from Contracts with Customers (Topic 606), effective January 1, 2018, utilizing the full retrospective method of adoption. As such, the consolidated financial statements present revenue in accordance with Topic 606 for the periods presented. We commence revenue recognition when control of these products is transferred to customers in an amount that reflects the consideration we expect to be entitled to in exchange for such products. We determine revenue recognition through the following steps: • identify the contract with a customer; • identify the performance obligations in a contract; • determination of the transaction price; • allocate the transaction price to the performance obligations identified in the contract; and • recognize revenue when (or as) performance obligations are satisfied. We have determined that subscriptions for our online software products are a distinct performance obligation, because the online software product is fully functional once a customer has access. In addition, we sell additional professional services, which are considered a distinct performance obligation, as they are sold separately, and the customer can benefit from the services to make better use of the online product purchased. For contracts containing multiple performance obligations, the transaction price is allocated to each performance obligation based on the relative standalone selling price, or SSP, of the services provided to the customer. We determine the SSP based upon the prices at which we separately sell subscription and various professional services, and based on our overall pricing objectives, taking into consideration market conditions, the value of our contracts, the types of offerings sold, customer demographics and other factors. Subscription revenue is recognized ratably over the contract terms beginning on the date our product is made available to customers, which typically begins on the commencement date of each contract. Our subscription service arrangements are generally non-cancellable during the contractual subscription term and do not provide for refunds of subscription fees. Professional services revenue is recognized at the time these services are provided to the customer and represent less than 1% of our revenue for the periods presented and is expected to be immaterial for the foreseeable future. Deferred Revenue Deferred revenue is recorded upon establishment of unconditional right to payment under non-cancellable contracts for subscription and professional services before transferring the related product or service to a customer. Deferred revenue is recognized to revenue over time as products and professional services are delivered. We generally invoice customers in monthly, quarterly, semi-annual and annual installments. The deferred revenue balance is influenced by several factors, including the compounding effects of renewals, invoice duration, timing and size. As of December 31, 2019, including amounts already invoiced and amounts contracted but not yet invoiced, $42.1 million of revenue is expected to be recognized from remaining performance obligations, of which 91% is expected to be recognized in the next 12 months, with the remainder expected to be recognized the following year. Deferred Sales Commissions Sales force commissions are considered incremental costs of obtaining a contract with a customer. Sales commissions earned for initial contracts and for expansion of contracts with existing customers are deferred and amortized on a straight-line basis over a period of benefit of three years. We determined the three-year period by taking into consideration the products sold, expected customer life, expected contract renewals, technology life cycle and other factors. Goodwill Goodwill consists of the excess purchase price over the fair value of net assets acquired in purchase business combinations. We conduct a test for the impairment of goodwill on at least an annual basis as of October 1st or sooner if indicators of impairment arise. We first assess qualitative factors to determine whether it is more likely than not that goodwill is impaired. As part of the qualitative assessment, we evaluate factors including macroeconomic conditions, industry and market considerations, cost factors and overall financial performance of its reporting units. While the most recent October 1st assessment indicated no impairment, assumptions used in the qualitative assessment are highly sensitive to changes. If we conclude that it is more likely than not that a reporting unit is impaired or if we elect not to perform the optional qualitative assessment, a quantitative assessment is performed. For the quantitative assessment, the fair value of each reporting unit is compared with the carrying amounts of net assets, including goodwill, related to each reporting unit. We recognize an impairment charge for the amount, if any, by which the carrying amount of a reporting unit exceeds the fair value of the reporting unit. Stock-Based Compensation We recognize compensation expense for equity awards based on the grant-date fair value on a straight-line basis over the remaining requisite service period for the award. Restricted Stock Units At the end of 2015, we began issuing restricted stock units to certain of our employees. The general terms of the restricted stock units required both a service and performance condition to be satisfied prior to vesting. The service condition is satisfied upon the participant’s completion of a required period of continuous service from the vesting start date. The performance condition was satisfied upon the consummation of our IPO, which resulted in recognition of stock-based compensation expense in the fourth quarter of 2019 for awards that had vested prior to December 31, 2019. In 2019, we issued restricted stock units to certain employees that require a service condition to be satisfied prior to vesting, but that do not require a liquidity event condition to be satisfied prior to vesting. Pursuant to his employment agreement, our President and CEO is eligible to receive awards of fully vested restricted stock units with respect to shares of our Class B common stock under our Class B Plan, covering up to 1.0% of our fully diluted common equity determined as of the date of our IPO, or 483,663 shares, following the consummation of our IPO, depending on the valuation of the Company in connection with our IPO and the achievement of market capitalization thresholds thereafter, which we refer to as the Howard IPO Award. The initial grant under the Howard IPO Award was based on the valuation of the Company (calculated based on the closing price of the Company’s Class A common stock on its first trading day on The Nasdaq Capital Market on December 13, 2019) and calculated as follows: (i) a valuation between $750,000,000 and $999,999,999, would result in an initial grant under the Howard IPO Award equal to 0.5% of our outstanding fully diluted common equity; (ii) a valuation at least $1,000,000,000 but less than $2,000,000,000, would result in an initial grant under the Howard IPO Award equal to 0.75% of our fully diluted common equity; and (iii) a valuation at least $2,000,000,000, would result in an initial grant under the Howard IPO Award equal to 1.0% of our outstanding fully diluted common equity. No initial grant under the Howard IPO Award would be made as a result of our IPO if the valuation of the Company calculated as described above was below $750,000,000. The initial Howard IPO Award resulted in a grant equal to 0.5% of our fully diluted common equity, or 241,831 shares on December 17, 2019. The initial Howard IPO Award had not yet settled as of December 31, 2019. If during the twenty-four month period immediately following the effectiveness of our IPO, the Company achieves a “market cap threshold” (calculated based on the 30-day average of the product of the closing price per share of our Class A common stock on a trading day and the number of shares outstanding on such trading day using the treasury stock method) of $1,000,000,000 or greater, Mr. Howard is eligible to receive RSU awards under our Class B Plan equal to: (i) 0.25% of our fully diluted common equity as of the date of our IPO, or 120,916 shares, upon the Company’s achievement of a market cap threshold of $1,000,000,000; and (ii) 0.25% of our fully diluted common equity as of the date of our IPO, or 120,916 shares, upon the Company’s achievement of a market cap threshold of $2,000,000,000, in each case, to the extent the applicable market cap threshold value was not previously achieved in connection with any previous grant made under the Howard IPO Award, and subject to Mr. Howard’s continued service to the Company through each applicable award date. All such RSUs granted pursuant to the Howard IPO Award will be fully vested and the maximum number of Class B common stock issuable upon settlement of such RSUs will not exceed 1.0% of our fully diluted common equity (as described above). In connection with RSUs granted to Mr. Howard pursuant to the Howard IPO Award that immediately vested in December 2019, we recognized $4.1 million of stock-based compensation expense in the fourth quarter of 2019. We anticipate recognizing additional compensation expense for similar grants upon the achievement of certain company valuation and market capitalization thresholds (as described above). Because the maximum company valuation was not achieved at the end of the first trading day of our Class A common stock following our IPO, Mr. Howard will remain eligible to receive additional grants up to the maximum award contemplated by the Howard IPO Award if certain market capitalization thresholds are achieved during the first twenty-four months following the completion of our IPO (as described above). We expect that the remaining compensation expense to be recognized in connection with the Howard IPO Award will be $2.0 million. Common Stock Valuations Prior to the consummation of our IPO our common stock was not publicly traded. As such, we were required to estimate the fair value of our common stock. Our board of directors considered numerous objective and subjective factors to determine the fair value of our common stock as awards were approved, including utilizing third-party valuations to assist with the determination of the estimated fair-market value and common stock price. Given the absence of a public trading market for our common stock, the valuations of common stock were determined in accordance with the guidance provided by the American Institute of Certified Public Accountants Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, and our board of directors exercised reasonable judgment and considered numerous and subjective factors to determine the best estimate of fair value of our common stock, including the following factors: • contemporaneous valuations performed by independent third-party specialists; • the prices, rights, preferences and privileges of our redeemable convertible preferred stock relative to those of our common stock; • the prices of common or preferred stock sold to third-party investors by us and in secondary transactions or repurchased by us in arms-length transactions; • lack of marketability of our common stock; • our actual operating and financial performance; • current business conditions and projections; • our stage of development; • likelihood of achieving a liquidity event, such as an initial public offering or a merger or acquisition of our company given prevailing market conditions; • the market performance of comparable publicly traded companies; and • the U.S. and global capital market conditions. In valuing our common stock, our board of directors determined the equity value of our business using various valuation methods including combinations of income and market approaches with input from management. The income approach estimates value based on the expectation of future cash flows that a company will generate. These future cash flows were discounted to their present values using a discount rate derived from an analysis of the cost of capital of comparable publicly traded companies in our industry or similar business operations as of each valuation date and adjusted to reflect the risks inherent in our cash flows. For each valuation, the equity value determined by the income and market approaches was then allocated to the common stock. The Option Pricing Method was selected as the principal equity allocation method. When we had completed or were expecting to complete a preferred equity financing, the terms and pricing of the financing round were included in the analysis used to estimate our value and the value of our common stock. Application of these approaches involves the use of estimates, judgments and assumptions that are highly complex and subjective, such as those regarding our expected future revenue, expenses, and future cash flows, discount rates, market multiples, the selection of comparable companies, and the probability of possible future events. Changes in any or all of these estimates and assumptions or the relationships between those assumptions affect our valuations as of each valuation date and may have a material impact on the valuation of our common stock. For valuations after the completion of the IPO, our board of directors will determine the fair value of each share of underlying common stock based on the closing price of our common stock as reported on the date of grant. Future expense amounts for any particular period could be affected by changes in our assumptions or market conditions. JOBS Act Accounting Election We are an “emerging growth company” as defined in the JOBS Act. 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 use this exemption from new or revised accounting standards and, therefore, we will not be subject to the same new or revised accounting standards as other public companies that have not made this election. While we have elected to use this extended transition period, to date we have not delayed the adoption of any applicable accounting standards.

<s>[INST] Overview Sprout Social is a powerful, centralized platform that provides the critical business layer to unlock the massive commercial value of social media. Currently, more than 23,000 customers across 100 countries rely on our platform to reach larger audiences, create stronger relationships with their customers and make better business decisions. Introduced in 2011, our cloud software brings together social messaging, data and workflows in a unified system of record, intelligence and action. Operating across major social media networks, including Twitter, Facebook, Instagram, Pinterest, LinkedIn, Google and YouTube, we provide organizations with a centralized platform to effectively manage their social media efforts across stakeholders and business functions. Virtually every aspect of business has been impacted by social media, from marketing, sales and public relations to customer service, product and strategy, creating a need for an entirely new category of software. We offer our customers a centralized, secure and powerful platform to manage this broad, complex channel effectively across their organization. Since our founding, we have achieved several key milestones: 2010 Founded Company, launched V1 beta and Lightbank became an investor; 2011 Launched our Sprout platform, surpassed 1,000 customers and NEA became an investor; 2013 Reached 100 employees; 2015 Surpassed 15,000 customers; 2016 Reached 250 employees and Goldman Sachs became an investor; 2017 Completed first business acquisition and awarded Glassdoor’s “Top Places to Work” and “Highest Rated CEO”; 2018 Surpassed 20,000 customers, opened EMEA office, reached 500 employees, launched first addon module (Listening), Future Fund became an investor and awarded Glassdoor’s “Top Places to Work” and “Highest Rated CEO”; and 2019 Completed our IPO resulting in $134.3 million of net proceeds, surpassed $100 million in total ARR and awarded Glassdoor’s “Highest Rated CEO”. We generate revenue primarily from subscriptions to our social media management platform under a softwareasaservice model. Our subscriptions can range from monthly to oneyear or multiyear arrangements and are generally noncancellable during the contractual subscription term. Subscription revenue is recognized ratably over the contract terms beginning on the date the product is made available to customers, which typically begins on the commencement date of each contract. We also generate revenue from professional services related to our platform provided to certain customers, which is recognized at the time these services are provided to the customer. This revenue has historically represented less than 1% of our revenue and is expected to be immaterial for the foreseeable future. Our tiered subscriptionbased model allows our customers to choose among three core plans to meet their needs. Each plan is licensed on a per user per month basis at prices dependent on the level of features offered. Additional product modules, which offer increased functionality depending on a customer’s needs, can be purchased by the customer on a per user per month basis. We generated revenue of $102.7 million and $78.8 million during the years ended December 31, 2019 and 2018, respectively, representing growth of 30%. Excluding the impact of the 2017 acquisition of Simply Measured, Inc., or Simply Measured, our organic growth rate in 2019 was 44%. This organic growth rate excludes the impact of revenue generated from legacy Simply Measured products as well as revenue from the transition of legacy customers to our platform up to an amount equal to such customers’ prior spend on legacy Simply Measured products. This organic growth rate includes all incremental revenue generated above such prior spend from the sale of additional or higherpriced products and users and profiles to legacy customers of Simply Measured. In 2019, software subscriptions contributed 99% of our revenue. We generated net losses of $46.8 million and $20.9 million during the years ended December 31, 2019 and 2018, respectively, which included stockbased compensation expense of $25.3 million during the year ended December 3 [/INST] Negative. </s>

Pivotal Software, Inc.

2019-03-29

2019-02-01

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 section titled “Selected Consolidated Financial Data” and our Consolidated Financial Statements and accompanying notes included elsewhere in this annual filing. This discussion contains forward-looking statements that involve risks and uncertainties; our future results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below and those discussed in the section titled “Risk Factors” included elsewhere in this Annual Report. Our fiscal year is the 52- or 53-week period ending on the Friday nearest to January 31. Overview We provide a leading cloud-native platform that makes software development and IT operations a strategic advantage for our customers. Our cloud-native platform, Pivotal Cloud Foundry (“PCF”), accelerates and streamlines software development by reducing the complexity of building, deploying and operating new cloud-native applications and modernizing legacy applications. This enables our customers’ development and IT operations teams to spend more time writing code, waste less time on mundane tasks and focus on activities that drive business value - building and deploying great software. PCF customers can accelerate their adoption of a modern software development process and their business success using our platform through our complementary strategic services, Pivotal Labs (“Labs”). Enterprises across industries have adopted our platform to build, deploy and operate software, including enterprises in the automotive and transportation, industrial and business services, financial services, healthcare and insurance, technology and media, consumer and communications and government sectors. Our offering, which includes PCF and Labs, enables organizations to build cloud-native software and compete in today’s business environment. • PCF accelerates and streamlines software development by reducing the complexity of building, deploying and operating modern applications. PCF integrates an expansive set of critical, modern software technologies delivered continuously to provide a turnkey cloud-native platform. PCF combines leading open-source software with our robust proprietary software to meet the exacting enterprise-grade requirements of large organizations, including the ability to operate and manage software across private and public cloud environments, such as Amazon Web Services, Microsoft Azure, Google Cloud Platform, VMware vSphere and OpenStack. PCF is sold on a subscription basis. • Labs software development experts deliver strategic services that transfer the expertise for enterprises to accelerate their cloud-native transformation by implementing modern agile development practices. With Labs, we help customers co-develop new applications and transform existing ones while accelerating software development, streamlining IT operations and ultimately driving self-sustaining business transformation. We generate a substantial and increasing portion of our revenue from the sale of PCF subscriptions generated from sales of products to handle customers’ differing workloads and needs, including Pivotal Application Service (“PAS”), Pivotal Container Service (“PKS”) and products accessed in our Marketplace. We generate subscription revenue primarily from the sale of time-based subscriptions. Subscriptions are offered typically for one- to three-year terms, and we recognize revenue from our subscriptions ratably over the subscription term. We expect that over time subscription revenue will become a larger percentage of our total revenue as customers continue to adopt and expand their PCF subscriptions and as our systems integrator (“SI”) partner relationships ramp to directly deliver Labs-like services to our customers. We offer strategic services including Labs, implementation and other services. Labs involves co-development and application transformation services. We offer implementation services to enable our customers to configure, deploy, test, launch and operate PCF. Part of our strategy to scale our subscription revenue is to rely, in part, on SI partners to deliver co-development, application transformation and implementation services to our customers. We intend to grow our services revenue at a slower rate than our subscription revenue as customers are enabled on our platform and increasingly use our partner ecosystem for their services needs. Our strategic services are typically priced on a time and materials basis with revenue recognized upon the delivery of the services. We remain focused on attracting new subscription customers, retaining our customers and expanding their usage of our platform, and leveraging strategic services, delivered by us and our partners, to accelerate our customers’ pace of innovation and use of PCF. This focus has resulted in rapid growth of our subscription revenue and significant total revenue growth in recent periods. To realize this rapid growth, we have made and expect to continue to make substantial investments across our business. Specifically, we have increased our total employee base over time, and we intend to continue to invest in our business to take advantage of our market opportunity and to expand our sales capacity and further improve sales productivity to drive additional revenue and grow our global customer base. Additionally, we continue to invest in the development and expansion of our partner ecosystem to supplement our sales and services resources and increase our reach in our target markets. We also expect to continue to make significant investments in research and development to expand our product and engineering teams to further develop our platform. We expect to incur increased general and administrative expenses to support our growth and operations. Key Metrics We regularly review the following key metrics to measure performance, identify trends, formulate financial projections and monitor our business. While we believe that these metrics are useful in evaluating our business, other companies may not use similar metrics or may not calculate similarly-titled metrics in a consistent manner. Subscription Customers We believe that the number of our subscription customers is an important indicator of the growth of our business, our increased customer footprint and the market acceptance of our platform. We define the number of subscription customers as the organizations that have a subscription contract for our software resulting in at least $50,000 of annual revenue in that period. While we may enter into subscription agreements with multiple parties inside a larger organization, we count a customer as an addition to our subscription customers only if it represents a unique global ultimate parent. In the case of the U.S. government, we count U.S. government departments and major agencies as unique subscription customers. We view our total number of subscription customers as reflective of the number of sources of revenue to us and our growth and potential for future growth. We had 377, 319 and 275 subscription customers as of February 1, 2019, February 2, 2018 and February 3, 2017, respectively. We expect growth in subscription customers to continue as we deliver enhancements to our products and remain focused on increasing our subscription customer count. Our total number of subscription customers and the net additions in any period may continue to fluctuate as a result of several factors, including the focus of our sales force, customer satisfaction with the functionality, features, performance or pricing of our offering, consolidation of our customer base and other factors, a number of which are beyond our control. Dollar-Based Net Expansion Rate We believe that the dollar-based net expansion rate is an important measure of our business because it is an indicator of our subscription customers’ expanded use of and demand for our platform and our ability to grow revenue and profitability. Our dollar-based net expansion rate compares our subscription revenue from a common group of customers across comparable periods. We calculate our dollar-based net expansion rate for all periods on a trailing four-quarter basis. To do so, we calculate our dollar-based net expansion rate as of each quarter end by starting with the subscription revenue from customers as of the prior year’s same quarter (the “Prior Period Subscription Revenue”). We then calculate subscription revenue from these same customers as of the current quarter end (the “Current Period Subscription Revenue”). Finally, to assess net expansion level for common groups of customers over time, we divide the aggregate Current Period Subscription Revenue for the trailing four quarters by the aggregate Prior Period Subscription Revenue for the trailing four quarters, resulting in our dollar-based expansion rate. We expect our dollar-based net expansion rate to remain a significant indicator of our business momentum and results of operations as existing customers realize the benefits of our software and expand their PCF subscriptions. Our dollar-based net expansion rate has fluctuated and we expect it to continue to fluctuate and trend downward over time as we scale our business and as a result of several factors, including the size of the transactions, the timing and terms of the deals and our customers’ satisfaction with our offering. Our dollar-based net expansion rate was approximately 149% for the year ended February 1, 2019, 158% for the year ended February 2, 2018 and 163% for the year ended February 3, 2017. Components of Results of Operations Revenue Subscription Subscription revenue is primarily derived from sales of PCF subscriptions. Our customers subscribe to use our software platform for a variety of workloads, such as applications, containers or other microservices. Subscriptions are offered typically for one- to three-year terms, and we recognize revenue from our subscriptions ratably over the subscriptions’ term. We generally bill our customers annually in advance, although for our multi-year contracts, some customers pay the full contract amount in advance. To a lesser extent, we generate revenue from certain historical software products sold on a perpetual license basis. Perpetual license revenue represented less than 2% of our total revenue in fiscal 2019, fiscal 2018 and fiscal 2017. We expect the percentage of perpetual license revenue to continue to decline as a percentage of total revenue. We generally recognize revenue from our perpetual licenses upon delivery, assuming all the other revenue recognition criteria are satisfied. Services Services revenue is primarily derived from Labs, as well as implementation and other professional services. To a decreasing extent, services revenue also includes revenue from maintenance and support associated with the perpetual licenses described above. Our services revenue may continue to fluctuate; any services revenue growth is expected to be modest both in absolute dollars and relative to subscription revenue. Cost of Revenue Subscription Cost of subscription revenue consists primarily of personnel and related costs, consisting of salaries, benefits, bonuses and stock-based compensation (“personnel costs”) directly associated with our customer support and allocated overhead costs. Additionally, cost of subscription revenue includes intangible asset and other asset amortization expense and certain third-party expenses such as cloud infrastructure costs and software and support fees. We expect our cost of subscription revenue to increase in absolute dollar amounts as we invest in our business. Services Cost of services revenue consists primarily of personnel costs directly associated with delivery of Labs, implementation and other professional services, costs of third-party contractors and allocated overhead costs. We expect our cost of services revenue to increase in absolute dollar amounts as we invest in our business. As a percentage of revenue, we expect it may vary quarter to quarter due to the seasonality of projects and timing of engagements. Operating Expenses Sales and Marketing Sales and marketing expenses consist primarily of personnel costs as well as commissions. Other sales and marketing costs include travel and entertainment, promotional events (such as our SpringOne Platform Conference) and allocated overhead costs. We expect our sales and marketing expenses will increase in absolute dollar amounts as we hire additional sales and marketing personnel, increase our marketing activities and build brand awareness. Research and Development Research and development expenses consist primarily of personnel costs, cloud infrastructure costs related to our research and development efforts and allocated overhead costs. We expect our research and development expenses will increase in absolute dollar amounts as we expand our research and development team to develop new products and product enhancements. General and Administrative General and administrative expenses consist primarily of personnel costs and allocated overhead costs for our administrative, legal, information technology, human resources, finance and accounting employees and executives. Our general and administrative expenses also include professional fees, audit fees, tax services and legal fees, as well as insurance and other corporate expenses. We expect our general and administrative expenses will increase in absolute dollar amounts as we also expect to increase the size of our general and administrative function to support the growth of our business. We also anticipate that we will incur additional costs for employees and third-party consulting services as we continue to operate as a public company. Other Income (Expense), Net Other income (expense), net primarily consists of gains and losses from transactions denominated in a currency other than the functional currency and interest income earned on money market funds. Provision for (Benefit from) Income Taxes Provision for (benefit from) income taxes consists primarily of income taxes related to foreign and state jurisdictions in which we conduct business. We maintain a full valuation allowance on our federal, state, and certain foreign deferred tax assets as we have concluded that it is not more likely than not that the deferred assets will be utilized. Results of Operations Comparison of Fiscal 2019, Fiscal 2018 and Fiscal 2017 Revenue Total revenue increased by $148.1 million, or 29%, to $657.5 million in fiscal 2019 from $509.4 million in fiscal 2018. Subscription revenue increased by $141.8 million, or 55%, to $400.9 million in fiscal 2019 from $259.0 million in fiscal 2018. The increase in subscription revenue was primarily due to increased sales to existing subscription customers and the addition of 58 new subscription customers in fiscal 2019. Services revenue increased by $6.2 million, or 2%, to $256.6 million in fiscal 2019 from $250.4 million in fiscal 2018. The increase in services revenue was driven by growth in subscription customers requiring services. Total revenue increased by $93.2 million, or 22%, to $509.4 million in fiscal 2018 from $416.3 million in fiscal 2017. Subscription revenue increased by $109.0 million, or 73%, to $259.0 million in fiscal 2018 from $150.0 million in fiscal 2017. The increase in subscription revenue was primarily due to increased sales to existing subscription customers and the remaining increase was due to sales to 44 new subscription customers. Services revenue decreased by $15.9 million, or 6%, to $250.4 million in fiscal 2018 from $266.3 million in fiscal 2017. The decrease in services revenue primarily reflects the decline of maintenance and support contracts associated with certain historical software products sold on a perpetual license basis. Excluding the impact from this maintenance and support services, in total services were relatively flat in fiscal 2018 compared to fiscal 2017. Revenue from maintenance and support contracts associated with historical software products sold on a perpetual license basis represented less than 4%, 5% and 10% of total revenue in fiscal 2019, 2018 and fiscal 2017, respectively, and is expected to represent a decreasing amount of revenue in future years. Cost of Revenue Total cost of revenue increased by $12.3 million, or 5%, to $240.7 million in fiscal 2019 from $228.4 million in fiscal 2018. Cost of subscription revenue increased by $1.7 million, or 5%, to $32.1 million in fiscal 2019 from $30.5 million in fiscal 2018, due to higher personnel related costs, offset by a decrease in intangible asset amortization. Cost of services revenue increased by $10.7 million, or 5%, to $208.6 million in fiscal 2019 from $197.9 million in fiscal 2018. The increase in cost of services revenue was higher due to growth in personnel costs of $11.5 million, offset by lower third party spend. Subscription gross margin increased to 92% in fiscal 2019 from 88% in fiscal 2018 due to economies of scale as our subscription revenues increased. Services gross margin decreased to 19% in fiscal 2019 from 21% in fiscal 2018 driven by growth in services personnel costs. Total cost of revenue decreased by $6.0 million, or 3%, to $228.4 million in fiscal 2018 from $234.3 million in fiscal 2017. Cost of subscription revenue remained relatively flat, decreasing by $0.8 million, or 2%, to $30.5 million in fiscal 2018 from $31.3 million in fiscal 2017. Cost of services revenue decreased by $5.2 million, or 3%, to $197.9 million in fiscal 2018 from $203.1 million in fiscal 2017. The decrease in cost of services revenue was primarily due to a decrease of $4.8 million in personnel costs consistent with the decrease in services revenue. Subscription gross margin increased to 88% in fiscal 2018 from 79% in fiscal 2017 due to economies of scale as our subscription revenues increased. Services gross margin decreased to 21% in fiscal 2018 from 24% in fiscal 2017 driven by growth in services personnel costs. Operating Expenses Sales and Marketing Sales and marketing expense increased by $65.2 million, or 29%, to $286.4 million in fiscal 2019 from $221.2 million in fiscal 2018. The increase in sales and marketing expense was primarily due to an increase of $65.3 million in personnel costs and commissions. Sales and marketing expense increased by $26.9 million, or 14%, to $221.2 million in fiscal 2018 from $194.3 million in fiscal 2017. The increase in sales and marketing expense was primarily due to an increase of $28.3 million in personnel costs and commissions, partially offset by lower amounts in other areas. Research and Development Research and development expense increased by $35.5 million, or 22%, to $196.4 million in fiscal 2019 from $160.9 million in fiscal 2018. The increase in research and development expense was primarily due to an increase of $36.7 million in personnel costs as we continued to increase our research and development efforts, offset by $1.8 million of lower cloud infrastructure and related spend. Research and development expense increased by $8.8 million, or 6%, to $160.9 million in fiscal 2018 from $152.1 million in fiscal 2017. The increase in research and development expense was primarily due to an increase of $5.7 million in cloud infrastructure costs and $2.5 million in personnel costs as we continued to increase our research and development efforts. General and Administrative General and administrative expense increased by $13.6 million, or 20%, to $80.8 million in fiscal 2019 from $67.2 million in fiscal 2018. The increase in general and administrative expense was primarily due to an increase of $12.2 million in support personnel costs and a $1.5 million non-cash write-off of certain intangible assets. General and administrative expense increased by $5.2 million, or 8%, to $67.2 million in fiscal 2018 from $62.0 million in fiscal 2017. The increase in general and administrative expense was primarily due to an increase of $5.4 million in personnel costs, partially offset by lower amounts in other areas. Other Income (Expense), Net Other income (expense), net increased by $3.3 million, or 156%, to other income of $5.5 million in fiscal 2019 from other income of $2.1 million in fiscal 2018. Other income (expense), net generated in fiscal 2019 was primarily due to a gain on sale of an investment of approximately $3.2 million and interest earned on money market investments of $8.4 million, offset by foreign currency losses in our international operations.The other income generated in fiscal 2018 was primarily due to foreign currency gains in our foreign operations related to the appreciation of the British Pound. Other income (expense), net changed by $5.9 million, or 157%, to other income of $2.1 million in fiscal 2018 from other expense of $3.7 million in fiscal 2017. The other income generated in fiscal 2018 was primarily due to foreign currency gains in our foreign operations related to the appreciation of the British Pound. Provision for (Benefit from) Income Taxes In fiscal 2019, we recorded a tax expense of $0.6 million primarily due to foreign taxes in our profitable jurisdictions. The fiscal 2018 income tax benefit of $2.6 million was primarily due to the release of a valuation allowance of $7.4 million under the provisions of the Tax Cuts and Jobs Act (the “TCJA” or “Tax Reform”) partially offset by foreign taxes recorded in our profitable jurisdictions. The tax provision recorded in fiscal 2017 of $2.6 million was primarily due to the net tax expense of the federal valuation allowance and foreign taxes due in profitable jurisdictions. See Note 2 and Note 9 to our consolidated financial statements included elsewhere in this filing for more information. Quarterly Results of Operations Data The following tables set forth selected unaudited consolidated quarterly statements of operations data for each of the eight fiscal quarters ended February 1, 2019, as well as the percentage of revenue that each line item represents for each quarter. 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. 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 results are not necessarily indicative of our results of operations to be expected for any future period. Quarterly Revenue Trends Our quarterly subscription revenue increased sequentially in each of the periods presented due primarily to the expansion of our existing customer subscription footprint and in part due to an increase in the number of new customers. Our services revenue has fluctuated period to period due in part to seasonality in the delivery of services and the timing of services engagements. Quarterly Cost of Revenue and Gross Margin Trends Our quarterly gross margin has generally increased due to increasing subscription revenue and related economies of scale. Quarterly Operating Expense Trends Total costs and expenses generally increased sequentially for the fiscal quarters presented, primarily due to the addition of personnel in connection with the expansion of our business. Sales and expenses can fluctuate from quarter to quarter due to hiring activity and marketing events. Sales and marketing expenses generally grew over the periods as we hired additional personnel and amortized more commission expense associated with our multi-year subscription agreements. During fiscal 2018, the majority of our user conference and sales kick-off costs were reflected in sales and marketing expenses in the third and fourth quarters, respectively. During fiscal 2019, the majority of our user conference costs was reflected in sales and marketing expenses in the second quarter. Research and development generally grew over the periods presented, primarily due to incremental hiring activity. General and administrative costs fluctuated period to period as a result of investments to support the growth of our business. Quarterly Income Tax Trends The quarterly tax provisions for fiscal 2018 and fiscal 2019 were primarily driven by foreign taxes due in profitable jurisdictions. The quarterly expense fluctuated primarily due to variability in our services profitability in total and among tax jurisdictions with differing tax rates. The benefit recorded in the fourth quarter of 2018 was primarily due to a $7.4 million release of valuation allowance due to Tax Reform. Non-GAAP Financial Measures In addition to our results determined in accordance with GAAP, we believe the following non-GAAP information is useful in evaluating our operating results. We use the following non-GAAP financial information, collectively, to evaluate our ongoing operations and for internal planning and forecasting purposes. We believe that non-GAAP financial information may be helpful to investors because it provides consistency and comparability with past financial performance, and assists in comparisons with other companies, some of which use similar non-GAAP financial information to supplement their GAAP results. The non-GAAP financial information is presented for supplemental informational purposes only, and should not be considered a substitute for financial information presented in accordance with GAAP, and may be different from similarly-titled non-GAAP measures used by other companies. A reconciliation is provided below for each non-GAAP financial measure to the most directly comparable financial measure stated in accordance with GAAP. Investors are encouraged to review the GAAP financial measures together with such reconciliations. Non-GAAP Gross Profit and Non-GAAP Gross Margin We define non-GAAP gross profit and non-GAAP gross margin as GAAP gross profit and GAAP gross margin, adjusted for stock-based compensation expense and amortization of acquired intangibles. Non-GAAP Operating Loss We define non-GAAP operating loss and non-GAAP operating margin as GAAP operating profit and GAAP operating margin, adjusted for stock-based compensation expense and amortization of acquired intangibles. Liquidity and Capital Resources Overview To date, our principal sources of liquidity have been the net proceeds we received through the sale of our common stock in our IPO, private sales of equity securities, payments received from customers using our platform and services and borrowings under our line of credit. Following the completion of our IPO, we received aggregate proceeds of $544.4 million, net of underwriters’ discounts and commissions and offering costs paid. As of February 1, 2019, we had cash and cash equivalents totaling $701.7 million, which we intend to use for working capital, operating expenses, and capital expenditures. We may also use a portion of this to acquire complementary businesses, products, services, or technologies. Our cash equivalents are comprised primarily of money market funds. We believe that our existing cash, cash equivalents, and investments will be sufficient to satisfy our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. Our future capital requirements will depend on many factors, including our rate of revenue growth, billing terms of our subscription contracts, timing of collection of accounts receivable, the rate of expansion of our workforce, the timing and extent of our expansion into new markets, the timing of introductions of new functionality and enhancements to our platform and the continuing market acceptance of our platform, as well as general economic and market conditions. We may need to raise additional capital or incur indebtedness to continue to fund our operations in the future or to fund our needs for other strategic initiatives, such as acquisitions. We also foresee entering into lease and other related facilities obligations to support any future growth in our headcount. In September 2017, we entered into a credit agreement and a related security agreement with Silicon Valley Bank, as administrative agent, and other banks named therein that provide for a senior secured revolving credit facility in an aggregate principal amount not to exceed $100.0 million (the “Revolving Facility”). We may also request from time to time, subject to certain conditions, increases in the commitments under the Revolving Facility in an aggregate amount of up to $50.0 million on the same maturity, pricing and other terms applicable to the then-existing commitments under the Revolving Facility. There can be no assurance that such increases will be available. Borrowings under the Revolving Facility are secured by our tangible assets. Our borrowing capacity under the Revolving Facility is based on our subscription revenue. The Revolving Facility contains customary representations, warranties and covenants, including financial covenants relating to our operating performance and liquidity. The Revolving Facility has a maturity date of September 8, 2020. We had no amounts outstanding under the Revolving Facility as of February 1, 2019. Cash Flows Operating Activities Net cash used in operating activities was $5.4 million, $116.5 million and $166.4 million during fiscal 2019, fiscal 2018 and fiscal 2017, respectively. Cash used in operating activities in fiscal 2019 was primarily due to our net loss of $141.9 million, adjusted for non cash items of $87.4 million. We also had a favorable increase in cash provided by working capital of $49.2 million, which was primarily driven by accounts receivable collections. Cash used in operating activities in fiscal 2018 was primarily due to our net loss of $163.5 million, adjusted for non cash items of $45.7 million. We also had a favorable increase in cash provided by working capital of $1.3 million, which was primarily driven by reductions in the net payable due to Dell as described in Note 14 of our consolidated financial statements. Cash used in operating activities in fiscal 2017 was due to our net loss of $232.9 million adjusted for non cash items of $56.9 million. We had a favorable increase in cash provided by working capital of $9.6 million, which was primarily driven by reductions in the net payable due to Dell as described in Note 14 of our consolidated financial statements. In fiscal 2017, $400.0 million of the net payable due to Dell was settled through the issuance of preferred stock in connection with our Series C-1 financing, with the remainder of the net payable due to Dell balance settled on a cash basis. Investing Activities Net cash used in investing activities was $6.2 million, $12.9 million and $28.9 million for fiscal 2019, fiscal 2018 and fiscal 2017, respectively. Cash used in investing activities primarily consisted of capital expenditures for property, plant and equipment of $9.4 million, $12.9 million and $19.5 million for fiscal 2019, fiscal 2018 and fiscal 2017, respectively, to support facility infrastructure. Our capital expenditures related to the investments in new and upgraded back office systems, including enterprise resource planning and human capital management systems, to facilitate our growth. In fiscal 2019 we recorded a gain on sale of investment, that generated $3.2 million of cash. Financing Activities Net cash provided by financing activities was $639.5 million, $71.4 million and $258.3 million for fiscal 2019, fiscal 2018 and fiscal 2017, respectively. Cash provided by financing activities in fiscal 2019 primarily consisted of proceeds from our initial public offering of $544.4 million, net of issuance costs paid. $44.3 million relates to payments received from Dell under our tax sharing agreement. We also received proceeds from issuance of common stock as part of our employee stock programs totaling $70.8 million. We drew down an additional $15.0 million from our revolving line of credit during the beginning of the fiscal year and we subsequently repaid the full outstanding balance of $35.0 million, within the first half of the fiscal year. Cash provided by financing activities in fiscal 2018 primarily consisted of $36.1 million paid to us by Dell under the tax sharing agreement, in addition to $18.8 million of borrowings from the Revolving Facility, net of debt issuance costs. Cash provided by financing activities in fiscal 2017 were primarily due to the $252.5 million in net cash proceeds from the issuance of our Series C and C-1 convertible preferred stock. Commitments and Contractual Obligations The following table summarizes our commitments to settle contractual obligations as of February 1, 2019. ____________________________________________________________________________________________________ (1) Represents minimum operating lease payments under operating leases for office facilities, excluding potential lease renewals. The amounts in the table are net of expected sublease income. (2) Represents future minimum payments under non-cancelable purchase commitments. For those agreements with variable terms, we do not estimate what the total obligation may be beyond any minimum quantities and/or pricing. (3) Represents future minimum re-payments on any draw-downs of our revolving credit facility. We have no outstanding commitments at the end of February 1, 2019. The commitment amounts in the table above are associated with contracts that are enforceable and legally binding and that specify all significant terms, including fixed or minimum services to be used, fixed, minimum or variable price provisions, and the approximate timing of the actions under the contracts. The table does not include obligations under agreements that we can cancel without a significant penalty. For more information about operating leases and purchase obligations, see Note 15 to our consolidated financial statements included elsewhere in this annual filing. Off-Balance Sheet Arrangements As of February 1, 2019, we were not subject to any obligations pursuant to any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K, or any relationships with unconsolidated entities or financial partnerships, including entities sometimes referred to as structured finance or special purpose entities, that were established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes, that have or are reasonably likely to have a material effect on our financial condition, results of operations or liquidity. Seasonality We have seasonal and end-of-quarter and end of fiscal year concentration of our sales, which impacts our ability to plan and manage cash flows and margins. Our sales vary by season with the fourth quarter typically being our strongest sales quarter, and the first quarter typically being our largest collections and operating cash flow quarter. Within each quarter, most sales occur in the last month of that quarter. In addition, the invoicing of sales may or may not occur before the end of the current fiscal quarter as a result of our 4-4-5 Fiscal Year. This arises if the last day of a fiscal quarter is not the same date as the last day of the same fiscal quarter from the prior year. This can shift our deferred revenue and billings from one period to another. Lastly, we also experience variability in quarterly cash flow as some customers choose to prepay us upfront for the full amount of their contract value. See “Risk Factors- Our sales cycles can be long, unpredictable and vary seasonally, which can cause significant variation in the number and size of transactions that close in a particular quarter.” Critical Accounting Policies and 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 accounting principles generally accepted in the United States of America (“GAAP”). The preparation of these consolidated 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 consolidated financial statements, as well as the reported revenues and expenses during the reporting periods. These items are monitored and analyzed by us for changes in facts and circumstances, and material changes in these estimates could occur in the future. 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. Changes in estimates are reflected in reported results for the period in which they become known. Actual results may differ from these estimates under different assumptions or conditions and such differences could be material. While our significant accounting policies are more fully described in Note 2 in the notes to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K, we believe that the following accounting policies are critical to the process of making significant judgments and estimates in the preparation of our audited consolidated financial statements. Revenue Recognition In accordance with ASC 606, revenue is recognized when a customer obtains control of promised services, consisting of subscriptions of our software platform, professional services and historical software products sold on a perpetual license basis. The amount of revenue recognized reflects the consideration that we expect to be entitled to receive in exchange for these services. We apply the following five steps to recognize revenue: 1) Identify the contract with a customer. We consider the terms and conditions of our contracts to identify contracts under ASC 606. We consider that we have a contract with a customer when the contract is approved, we can identify each party’s rights regarding the services to be transferred, we can identify the payment terms for the services, we have determined the customer has the ability and intent to pay and the contract has commercial substance. We use judgment in determining the customer’s ability and intent to pay, which is based upon factors including the customer’s historical payment experience or, for new customers, credit and financial information pertaining to the customers. 2) Identify the performance obligations in the contract. Performance obligations in our contracts are identified based on the services that will be transferred to the customer that are both capable of being distinct, whereby the customer can benefit from the service either on its own or together with other resources that are readily available from third parties or from us, and are distinct in the context of the contract, whereby the transfer of the services is separately identifiable from other promises in the contract. Our performance obligations consist of (i) subscriptions consisting of (a) licenses, (b) post contract support (“PCS”), which includes real-time support and online access to documentation, technical resources and discussion forums, and (c) rights to continued delivery of unspecified upgrades, major releases and patches, (ii) professional services and (iii) other software offerings consisting of licenses and maintenance. 3) Determine the transaction price. We determine transaction price based on the consideration to which we expect to be entitled in exchange for transferring services to the customer. In determining the transaction price, any variable consideration would be considered, to the extent applicable, if, in our judgment, it is probable that a significant future reversal of cumulative revenue under the contract will not occur. None of our contracts contain a significant financing component. 4) Allocate the transaction price to performance obligations in the contract. If the contract contains a single performance obligation, the entire transaction price is allocated to that performance obligation. Contracts that contain multiple performance obligations require an allocation of the transaction price to each performance obligation based on a relative standalone selling price (“SSP”). The transaction price in our subscription offering is allocated to the performance obligations that are rendered over time. 5) Recognize revenue when or as we satisfy a performance obligation. Revenue is recognized at the time the related performance obligation is satisfied by transferring the promised services to a customer. We recognize revenue when we transfer control of the services to our customers for an amount that reflects the consideration that we expect to receive in exchange for those services. All revenue is generated from contracts with customers. For subscription arrangements, we also provide PCS and continuous unspecified upgrades, major releases and patches over the course of the subscription term, and services are therefore delivered over the life of the contract. Subscription We generate revenue from subscription sales of our software platform. The subscription offering provides customers with a term-based license to our platform, which includes, among other items, open-source software, support, security updates, enhancements, upgrades and compatibility to certified systems, all of which are offered on an if and when available basis. The fixed consideration related to subscription revenue is recognized ratably over the contract term beginning on the date that our platform is made available to the customer. The typical subscription term is one to three years. Our contracts are non-cancelable over the contract term. Customers have the right to terminate their contracts generally only if we breach the contract and we fail to remedy the breach in accordance with the contractual terms. Subscription revenue also includes certain historical software products that are sold on a perpetual license basis. Software revenue is recognized when the product is delivered to the customer. The risk of loss transfers and acceptance of the software license occurs when the license is made available for download. Services Services revenue is primarily derived from our Labs offering, as well as implementation and other professional services. To a lesser extent, services revenue also includes revenue from maintenance and support from perpetual licenses associated with our legacy data and application products. Labs, implementation and other services revenue are provided on a time and materials basis and recognized over time as services are delivered. Maintenance revenue related to legacy software licenses is recognized ratably over the term as the obligation to the customer is fulfilled. Contracts with Multiple Performance Obligations Most of our contracts with customers contain multiple promised services consisting of (i) our subscriptions and (ii) our services that are distinct and accounted for separately. The transaction price is allocated to the separate performance obligations on a relative SSP basis. We determine SSP based on our overall pricing and discounting objectives, taking into consideration the geographical region of the customer, type of offering, and value of contracts for the type of subscription and services sold. Variable Consideration Revenue from sales is recorded at the net sales price, which is the transaction price, and includes estimates of variable consideration. The amount of variable consideration that is included in the transaction price is constrained, and is included in the net sales price only to the extent that it is probable that a significant reversal in the amount of the cumulative revenue will not occur when the uncertainty is resolved. We provide support to our customers on an ongoing basis throughout the subscription term. Fees paid for support are non-refundable. Customers must deploy the then-current major release of our software to receive support. We do not offer refunds, rebates or credits to our customers in the normal course of business. The impact of other forms of variable consideration has not been material in the periods presented. Sales through Agency Arrangements with Strategic Partners We have separate agency arrangements with Dell and VMware, where Dell and Vmware invoice our customers and collect invoiced amounts on our behalf. We bear the collectability risk if customers default on payments. Deferred Revenue Contract liabilities consist of deferred revenue and include payments received in advance of performance under the contract. Such amounts are recognized as revenue over the contractual period. We receive payments from customers based upon contractual billing schedules; accounts receivable are recorded when the right to consideration becomes unconditional. We generally bill our customers annually in advance, although for our multi-year contracts, some customers prefer to pay the full multi-year contract amount in advance. Payment terms on invoiced amounts are typically 30 to 90 days. Contract assets include amounts related to our contractual right to consideration for both completed and partially completed performance obligations that may not have been invoiced; such amounts have been insignificant to date. Costs to Obtain and Fulfill a Contract We capitalize sales commissions and agency fees that are incremental to the acquisition of all contracts with customers. These costs are recorded as deferred sales commissions on the consolidated balance sheets. We determine whether costs should be deferred based on our sales compensation plans and agency agreements when the costs are in fact incremental and would not have occurred absent the customer contract. The deferred commission amounts are recoverable through the future revenue streams under the non-cancelable customer contracts. In fiscal 2019, commissions paid upon the acquisition of a new subscription customer, or the expansion of an existing subscription customer, are amortized over an estimated period of benefit which has been determined to be the expected customer life. Commissions paid for renewals of existing subscription customer contracts are amortized over the term of the contracts. In fiscal 2018 and prior, commissions paid upon the acquisition of an initial subscription contract and any subsequent renewals were amortized over an estimated period of benefit which was determined to be the contract term. A longer amortization period was not applied as the commission rates paid on initial and renewal sales were commensurate. Commissions paid for services contracts are amortized over the expected service delivery periods of the services. Amortization is recognized on a straight-line basis and included in sales and marketing expense in the consolidated statements of operations. We periodically review these deferred costs to determine whether events or changes in circumstances have occurred that could impact the period of benefit of these deferred sales commissions. There were no material impairment losses for deferred sales commissions for fiscal 2019, fiscal 2018 and fiscal 2017. Intangible Assets and Goodwill Intangible assets include developed technology, trademarks and trade names, customer relationships and customer lists and non-competition agreements. Intangible assets include those intangible assets contributed by Dell and VMware upon our formation that are not yet fully amortized as of February 1, 2019 and February 2, 2018, as well as intangible assets from our acquisitions of businesses. Intangible assets are amortized based on either the pattern in which the economic benefits of the intangible assets are estimated to be realized or on a straight-line basis, which approximates the economic benefit pattern. Finite-lived intangible assets are reviewed for impairment when events or changes indicate the carrying amount of an asset may not be recoverable. Recoverability of these assets is measured by comparison of their carrying amount to future undiscounted cash flows to be generated. If impairment is indicated based on a comparison of the assets’ carrying values and the undiscounted cash flows, the impairment loss is measured as the amount by which the carrying amount of the assets exceeds the fair value of the assets. Goodwill includes goodwill generated by our acquisitions of businesses as well as goodwill related to our formation. In conjunction with our formation, Dell and VMware contributed approximately $635 million of goodwill that represented the carrying values of the underlying contributed businesses that continue to operate as of fiscal 2019. Goodwill is not amortized and is carried at its historical cost. Goodwill is tested for impairment on an annual basis in the fourth fiscal quarter, or sooner if an indicator of impairment occurs. To determine whether goodwill is impaired, we perform either a qualitative or quantitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. For the qualitative analysis, we assess certain factors to determine if there is an indication of an impairment. For the quantitative analysis, we compare the fair value of our reporting units to their carrying values. If the estimated fair value exceeds book value, goodwill is considered not to be impaired and no additional steps are necessary. However, if the fair value of the reporting unit is less than book value, we record an impairment charge for the difference. We have determined the fair value of our reporting units by using an income based approach. Significant assumptions in our analysis include estimates for forecast revenue and earnings, terminal growth rates, weighted average cost of capital, changes in net working capital and taxes. There were no impairment charges in the fiscal periods presented. Stock-Based Compensation Our stock-based compensation includes awards related to Pivotal stock and awards previously granted by EMC Corporation ("EMC") and VMware to certain employees who transferred to Pivotal at our formation and during subsequent years. These Pivotal employees have been allowed to retain and vest in their historical EMC or VMware awards, in each case, so long as they remain employed by Pivotal and such awards are outstanding. Awards granted by EMC are no longer outstanding as the vesting of these awards was automatically accelerated on the last trading day prior to the effective date of Dell's acquisition of EMC. Compensation expense related to stock-based transactions is measured and recognized in the financial statements based on fair value. In general, the fair value of each option award is estimated on the grant date using the Black-Scholes option-pricing model and a single option award approach. This model requires that at the date of grant we determine the fair value of the underlying common stock, the expected term of the award, the expected volatility, risk-free interest rates and expected dividend yield. The stock-based compensation expense, net of forfeitures, is recognized using a straight-line basis over the requisite service periods of the awards, which is generally four years. We estimated a forfeiture rate, based on an analysis of actual historical forfeitures, to calculate stock-based compensation expense. Recently Issued Accounting Pronouncements Information about recently issued accounting pronouncements is presented in Note 2 to our consolidated financial statements included elsewhere in this Annual report. JOBS Act Accounting Election 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. We have chosen to opt out of this provision and, as a result, we will comply with new or revised accounting standards as required when they are adopted. This decision to opt out of the extended transition period under the JOBS Act is irrevocable.

<s>[INST] Overview We provide a leading cloudnative platform that makes software development and IT operations a strategic advantage for our customers. Our cloudnative platform, Pivotal Cloud Foundry (“PCF”), accelerates and streamlines software development by reducing the complexity of building, deploying and operating new cloudnative applications and modernizing legacy applications. This enables our customers’ development and IT operations teams to spend more time writing code, waste less time on mundane tasks and focus on activities that drive business value building and deploying great software. PCF customers can accelerate their adoption of a modern software development process and their business success using our platform through our complementary strategic services, Pivotal Labs (“Labs”). Enterprises across industries have adopted our platform to build, deploy and operate software, including enterprises in the automotive and transportation, industrial and business services, financial services, healthcare and insurance, technology and media, consumer and communications and government sectors. Our offering, which includes PCF and Labs, enables organizations to build cloudnative software and compete in today’s business environment. PCF accelerates and streamlines software development by reducing the complexity of building, deploying and operating modern applications. PCF integrates an expansive set of critical, modern software technologies delivered continuously to provide a turnkey cloudnative platform. PCF combines leading opensource software with our robust proprietary software to meet the exacting enterprisegrade requirements of large organizations, including the ability to operate and manage software across private and public cloud environments, such as Amazon Web Services, Microsoft Azure, Google Cloud Platform, VMware vSphere and OpenStack. PCF is sold on a subscription basis. Labs software development experts deliver strategic services that transfer the expertise for enterprises to accelerate their cloudnative transformation by implementing modern agile development practices. With Labs, we help customers codevelop new applications and transform existing ones while accelerating software development, streamlining IT operations and ultimately driving selfsustaining business transformation. We generate a substantial and increasing portion of our revenue from the sale of PCF subscriptions generated from sales of products to handle customers’ differing workloads and needs, including Pivotal Application Service (“PAS”), Pivotal Container Service (“PKS”) and products accessed in our Marketplace. We generate subscription revenue primarily from the sale of timebased subscriptions. Subscriptions are offered typically for one to threeyear terms, and we recognize revenue from our subscriptions ratably over the subscription term. We expect that over time subscription revenue will become a larger percentage of our total revenue as customers continue to adopt and expand their PCF subscriptions and as our systems integrator (“SI”) partner relationships ramp to directly deliver Labslike services to our customers. We offer strategic services including Labs, implementation and other services. Labs involves codevelopment and application transformation services. We offer implementation services to enable our customers to configure, deploy, test, launch and operate PCF. Part of our strategy to scale our subscription revenue is to rely, in part, on SI partners to deliver codevelopment, application transformation and implementation services to our customers. We intend to grow our services revenue at a slower rate than our subscription revenue as customers are enabled on our platform and increasingly use our partner ecosystem for their services needs. Our strategic services are typically priced on a time and materials basis with revenue recognized upon the delivery of the services. We remain focused on attracting new subscription customers, retaining our customers and expanding their usage of our platform, and leveraging strategic services, delivered by us and our partners, to accelerate our customers’ pace of innovation and use of PCF. This focus has resulted in rapid growth of our subscription revenue and significant total revenue growth in recent periods. To realize this rapid growth, we have made and expect to continue to make substantial investments across our business. Specifically, we have increased our total employee base over time, and we intend to continue to invest in our business to take advantage of our market opportunity and to expand our sales capacity and further improve sales productivity to drive additional revenue and grow our global customer base. Additionally, we continue to invest in the development and expansion of our partner ecosystem to supplement our sales and services resources and increase our reach in our target markets. We also expect to continue to make significant investments in research and development to expand our product and engineering teams to further develop our platform. We expect to incur increased general and administrative expenses to support our growth and operations. Key Metrics We regularly review the following key metrics to measure performance, identify trends, formulate financial pro [/INST] Negative. </s>

Professional Holding Corp.

2020-03-30

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Our discussion and analysis of earnings and related financial data are presented herein to assist investors in understanding the financial condition of our Company at December 31, 2019 and 2018, and the results of operations for the years ended December 31, 2019 and 2018. This discussion should be read in conjunction with the Consolidated Financial Statements and related footnotes of our Company presented in Item 8. Financial Statements and Supplementary Data. In addition to historical information, this discussion contains forward-looking statements that involve risks, uncertainties and assumptions that could cause actutal results to differ materially from management’s expectations. Factors that could cause such differences include, but are nto limited to, those described in the section titled “Cautionary Note Regarding Forward-Looking Information”. Overview Our principal business is lending to and accepting deposits from small to medium sized businesses, the owners and operators of these businesses, as well as other professionals, entrepreneurs and high net worth individuals. We generate the majority of our revenue from interest earned on loans, investments and other interest earning assets, such as federal funds sold and interest earning deposits with other institutions; loan and deposit fees and service charges; and fees relating to the sale of mortgage loans, swap referrals and SBA loan originations. We incur interest expense on deposits and other borrowed funds, as well as operating expenses, such as salaries and employee benefits and occupancy expenses. 2019 Highlights Highlights of our performance and financial condition as of and for the year ended December 31, 2019 and other key events that occurred during 2019 are provided below. Results of Operations · Net income of $2.3 million, which represented an increase of $230 thousand, or 10.9%, compared to the same period in 2018. · Net interest income of $28.0 million, which represented an increase of $6.1 million, or 28.0%, compared to the same period in 2018. This increase was primarily due to loan growth and slightly increased yields on loans, partially offset by an increase in total deposits, as well as increased rates paid on deposit products. · Provision for loan losses was $0.9 million, which represented a decrease of approximately $288 thousand, or 25.0%, compared to the same period in 2018. · Noninterest income totaled $2.8 million, which represented an increase of $0.9 million, or 49.8%, compared to the same period in 2018. This increase was primarily due to increased swap referral fees. · Noninterest expense of $27.0 million, which represented an increase of $7.1 million, or 35.9%, compared to the same period in 2018. This increase was primarily due to increased employee headcount, opening additional bank locations and opening our Digital Innovation Center. Financial Condition · Total assets increased to $1.1 billion, which represented an increase of $323.5 million, or 44.3%, compared to December 31, 2018. This increase was largely attributable to net loan growth of $183.7 million. · Net loans increased to $785.2 million, an increase of $183.7 million, or 30.5%, compared to December 31, 2018. We experienced growth across all loan categories, with the largest growth experienced in commercial real estate, residential real estate, and commercial. · Nonperforming assets totaled $2.3 million, which includes three loans being classified as nonperforming and no loans accruing loans over 90 days past due. There were no nonperforming assets or loans accruing over 90 days past due as of December 31, 2018. · As of December 31, 2019, we were well-capitalized, with a total risk-based capital ratio of 12.3%, a tier 1 risk-based capital ratio of 11.3%, a common equity tier 1 capital ratio of 11.3%, and a leverage ratio of 7.8%. As of December 31, 2019, all of our regulatory capital ratios exceeded the thresholds to be well-capitalized under the applicable bank regulatory requirements. Other Highlights · In January 2019, we hired a private banking team from a large South Florida-based bank to establish our Doral, FL loan production office, which opened in July 2019. · In May 2019, we converted our Boca Raton, FL loan production office into a full-service branch and we opened our fifth branch in Miami, FL (Dadeland). · In May 2019, we hired the former president of a South Florida-based community bank and a banking team from a large national bank to establish our Wellington, FL loan production office, which opened in July 2019. · In August 2019, we entered into a merger agreement to acquire Marquis Bancorp, Inc. and its wholly owned subsidiary, Marquis Bank, for shares of our Class A Common Stock. · In October 2019, we opened our Digital Innovation Center in Cleveland, OH. · In February 2020, we announced the closing of our initial public offering of 3,565,000 shares of Class A Common Stock, which included an additional 465,000 shares in connection with the exercise in full of the underwriters’ option to purchase additional shares · In March 2020, we closed our merger with MBI and its wholly owned subsidiary, Marquis Bank. The Merger On March 26, 2020, we closed our merger with MBI and its wholly owned subsidiary, Marquis Bank, headquartered in Coral Gables, Florida. The acquisition of Marquis Bank added three branches to our Miami-Dade MSA footprint making us the 12th largest independent community bank based in Florida and the fourth largest independent community bank based in South Florida. Each share of MBI common stock outstanding was converted into 1.2048 shares of our Class A Common Stock, with cash paid in lieu of any fractional shares. At the closing of the merger we issued approximately 4,227,816 shares of our Class A Common Stock. No MBI shareholders exercised appraisal rights. In addition, all stock options of MBI granted and outstanding on the closing date of the merger were converted into an option to purchase shares of our Class A Common Stock based on the exchange ratio. Upon completion of the merger, the pro forma combined institution had approximately $1.7 billion in total assets, excluding purchase accounting adjustments, total net loans of $1.3 billion and total deposits of $1.4 billion as of December 31, 2019, excluding purchase accounting adjustments. Rationale for the Merger. We believe our acquisition of MBI will support our business model and allow us to expand our presence in our existing market. MBI’s operations will enhance our existing operations and enable us to add lenders and banking services in our existing market. We expect that our high-end service, technology platform and wide range of products and services will allow us to enhance relationships with MBI’s existing clients, as well as expanding our platform for generating new relationships. We believe a number of factors will position us for significant improvements in growth and earnings within MBI’s franchise by: · enabling us to achieve operational efficiencies and potential cost savings through consolidating and integrating MBI’s operations into our existing operations; · enhancing our ability to grow organically through offering our products and services to former MBI clients; · the senior management and staff of MBI will add important skills to the combined organization; · the combined institution will benefit from increased credit portfolio diversity and increased lending capacity; · provides an attractive opportunity to expand our market presence in Miami-Dade and Broward counties, which is within our existing market footprint; · our expectation that an “in-market” acquisition will result in greater client retention and smoother integration; · the merger is expected to accelerate our growth strategy and profitability targets; and · the complementary fit of MBI’s business with ours, which our management believes will enable the combined institution to deliver improved services to clients to achieve stronger financial performance and enhance shareholder value. As a result of the merger, we believe that we will be able to efficiently integrate MBI’s operations, expand its business opportunities and enhance our profitability. We believe that other opportunities for strategic acquisitions exist in the State of Florida, both within and without our current market. Results of Operations for the Years Ended December 31, 2019, 2018, and 2017 Net Income The following table sets forth the principal components of net income for the periods indicated. Year ended December 31, 2019 compared to year ended December 31, 2018 Net income for the year ended December 31, 2019 was $2.3 million, an increase of $230 thousand, or 10.9%, from net income for the year ended December 31, 2018 of $2.1 million. Interest income increased $11.5 million while interest expense increased $5.3 million, resulting in a net interest income increase of $6.1 million for the year ended December 31, 2019 compared to the same period in the prior year. The increase in our interest income was primarily due to growth and increased yield in our loan portfolio. Provision for loan losses decreased by $288 thousand for the year ended December 31, 2019 compared to the same period in the prior year due to the reclassification of unfunded provision reserves. Noninterest income increased $0.9 million and noninterest expense increased $7.1 million for the year ended December 31, 2019 compared to the same period in the prior year. The increase in noninterest expense for the year ended December 31, 2019 compared to the same period in the prior year was primarily a result of increased employee headcount, opening additional banking locations and opening our Digital Innovation Center in Cleveland, Ohio. Year ended December 31, 2018 compared to year ended December 31, 2017 Net income for the year ended December 31, 2018 was $2.1 million, an increase of $0.3 million, or 16.1%, from net income for the year ended December 31, 2017 of $1.8 million. This increase was due to an increase in interest income primarily related to growth in our loan portfolio and rising interest rates, which improved loan yields. This increase in interest income was partially offset by a $3.0 million increase in interest expense due to deposit growth and increased rates paid on our deposit products, as well as a $6.7 million increase in noninterest expense related to increased employee headcount, an increase in banking locations and additional salary and benefits expense in preparation to open our Digital Innovation Center. The $0.1 million increase in noninterest income was primarily due to increased mortgage banking revenues and increased account fees and service charges, partially offset by a reduction in SBA origination fees and other fees and charges. Income tax expense decreased $1.2 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 due to the enactment of the Tax Act in December 2017, which reduced the corporate income tax rate. We also recognized a one-time charge in 2017 of approximately $0.7 million as a result of the revaluation of our deferred tax asset due to the change in the corporate tax rate. Net Interest Income and Net Interest Margin Analysis We analyze our ability to maximize income generated from interest earning assets and control the interest expenses of our liabilities, measured as net interest income, through our net interest margin and net interest spread. Net interest income is the difference between the interest and fees earned on interest earning assets, such as loans and securities, and the interest expense paid on interest bearing liabilities, such as deposits and borrowings, which are used to fund those assets. Net interest margin is a ratio calculated as annualized net interest income divided by average interest earning assets for the same period. Net interest spread is the difference between average interest rates earned on interest earning assets and average interest 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 in the volume and types of interest earning assets, interest bearing and noninterest-bearing liabilities and shareholders’ equity, are usually the largest drivers of periodic changes in net interest income, net interest margin and net interest spread. Fluctuations in market interest rates are driven by many factors, including governmental monetary policies, inflation, deflation, macroeconomic developments, changes in unemployment rates, 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, the economic and competitive conditions in the Miami-Dade MSA, as well as developments affecting the real estate, technology, government services, hospitality and tourism and financial services sectors within the Miami-Dade MSA. Our ability to respond to changes in these factors by using effective asset-liability management techniques is critical to maintaining the stability of our net interest income and net interest margin as our primary sources of earnings. The following table shows the average outstanding balance of each principal category of our assets, liabilities and shareholders’ equity, together with the average yields on our assets and the average costs of our liabilities for the periods indicated. Such yields and costs are calculated by dividing the annualized income or expense by the average daily balances of the corresponding assets or liabilities for the same period. (1) Includes nonaccrual loans. (2) Net interest spread is the difference between interest rates earned on interest earning assets and interest rates paid on interest-bearing liabilities. (3) Net interest margin is a ratio of net interest income to average interest earning assets for the same period. (4) Interest income on loans includes loan fees of $568, $568, and $434 for the years ended December 31, 2019, 2018, and 2017, respectively. The following table presents information regarding the dollar amount of changes in interest income and interest expense for the periods indicated for each major component of interest earning assets and interest-bearing liabilities and distinguishes between the changes attributable to changes in volume and changes attributable to changes in interest rates. For purposes of this table, changes attributable to both rate and volume that cannot be segregated have been proportionately allocated to both volume and rate. Year ended December 31, 2019 compared to year ended December 31, 2018 Net interest income increased by $6.1 million to $28.0 million for the year ended December 31, 2019 compared to the December 31, 2018. Our total interest income was impacted by an increase in interest earning assets, primarily due to organic growth in our loan portfolio, and three market rate increases between December 31, 2018 and December 31, 2019 due to increases in the federal funds target interest rate by the Federal Reserve. Average total interest earning assets were $839.0 million for the year ended December 31, 2019 compared with $609.5 million for the year ended December 31, 2018. The annualized yield on those interest earning assets increased 12 basis points from 4.55% for the year ended December 31, 2018 to 4.67% for the year ended December 31, 2019. However, due to the recent reduction in the federal funds target interest rate by the Federal Reserve in the second half of 2019, our yield on interest earning assets declined during the last quarter of 2019, which was partially offset by lower interest expense on our interest-bearing deposits. The increase in the average balance of interest earning assets was driven almost entirely by organic growth in our loan portfolio of $183.7 million, representing an increase of 30.5%, to $785.2 million for the year ended December 31, 2019 compared to $601.5 million for the year ended December 31, 2018. Average interest-bearing liabilities increased by $178.0 million, or 39.5%, from $450.3 million for the year ended December 31, 2018 to $628.3 million for the year ended December 31, 2019. The increase was primarily due to a $229.5 million increase in the average balance of interest-bearing deposits, or 37.7%. The increase in the average balance of interest-bearing deposits was primarily due to increases in certificates of deposit and money market accounts for the year ended December 31, 2019 compared to the year ended December 31, 2018, and, to a lesser extent, negotiable order of withdrawal accounts, or NOW accounts. The annualized average interest rate paid on average interest-bearing liabilities increased to 1.78% for the year ended December 31, 2019 compared to 1.30% for the year ended December 31, 2018, while the annualized average interest rate paid on interest-bearing deposits increased 50 basis points to 1.73% and the annualized average interest rate paid on borrowed funds increased by 20 basis points to 2.31%. The increases in annualized average interest rates primarily reflected an increase in market interest rates due to increases in the federal funds target interest rate during the first half of 2019, partially offset by rate cuts during the last half of 2019. For the year ended December 31, 2019, our average other noninterest-bearing liabilities increased $12.6 million, or 326.1%, to $16.5 million from $3.9 million during the year ended December 31, 2018. Average noninterest-bearing deposits also increased $37.3 million, or 29.2%, from $127.7 million to $165.0 million for the same periods. For the year ended December 31, 2019, our annual net interest margin was 3.34% and net interest spread was 2.90%. For the year ended December 31, 2018, annual net interest margin was 3.60% and net interest spread was 3.25%. Our net interest margin was adversely affected by 0.26% during the year ended December 31, 2019, compared to the same period in 2018 because rates paid on our interest-bearing deposits, our primary funding source, increased faster than loan yields, which were adversely impacted due to falling yields on 10-year treasury notes, as well as increasing competitive pricing pressures in the loan market. As a result of the recent reduction in the federal funds target interest rate as well as continued declines in the 10-year treasury yield, average rates earned on interest earning assets and average rates paid on our interest-bearing deposits both generally declined during the last half of 2019 compared to the first half of 2019. Correspondingly new loans were priced at lower yields in comparison to previously held loans which led to numerous loan payoffs at year end 2019. Year ended December 31, 2018 compared to year ended December 31, 2017 Net interest income increased by $5.9 million to $21.9 million, or 37.1%, for the year ended December 31, 2018. Our total interest income was positively impacted by an increase in interest earning assets and a slowly rising interest rate environment in 2018. Average total interest earning assets were $609.5 million in 2018 compared with $434.2 million in 2017, an increase of 40.4%. The yield on interest earning assets increased by 21 basis points from 4.34% in 2017 to 4.55% in 2018. The increase in the average balance of interest earning assets was driven primarily by organic growth in our loan portfolio. All loan categories increased in 2018, except construction and development, resulting in an increase in the average balance of the loan portfolio of $139.8 million, or 36.8%, to $520.1 million for 2018 compared to $380.3 million for 2017 categories (see “Financial Condition - Loan Portfolio” in this section for further details about the changes in our loan portfolio). Average interest-bearing liabilities increased by $139.2 million from $311.0 million for the year ended December 31, 2017 to $450.3 million for the year ended December 31, 2018. The increase was due to an increase in the average balance of interest-bearing deposits of $122.0 million, or 41.6%, and an increase in the average balance of borrowed funds of $17.2 million, or 98.6%. The increase in the average balance of interest-bearing deposits was primarily due to increases in other time deposits and money market accounts for the period ended December 31, 2018 compared to December 31, 2017, and, to a lesser extent, certificates of deposit and NOW accounts. We also experienced growth in our average noninterest-bearing deposits of $36.4 million, or 39.9%. The increase in the average balance of borrowed funds was primarily caused by an increase in Federal Home Loan Bank, or FHLB, advances. The average rate paid on interest-bearing liabilities increased to 1.30% for 2018 compared to 0.92% for 2017 as the average rate paid on interest-bearing deposits and borrowed funds increased by 33 basis points and 77 basis points, respectively, during the same period. These increases reflected an increase in market interest rates in 2018. In 2018, our net interest margin was 3.60% and net interest spread was 3.25%. In 2017, net interest margin was 3.68% and net interest spread was 3.42%. These decreases in 2018 compared to 2017 were primarily due to increasing rates paid on our deposit products outpacing increases in loan yields in 2018. Provision for Loan Losses The provision for loan losses is a charge to income in order to bring our allowance for loan losses to a level deemed appropriate by management. For a description of the factors taken into account by our management in determining the allowance for loan losses see “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Allowance for Loan Losses.” Year ended December 31, 2019 compared to year ended December 31, 2018 Our provision for loan losses amounted to $0.86 million for 2019 and $1.15 million for 2018. The decrease from 2018 to 2019 was due to the reclassification of allowance to our unfunded commitments reserve which were not considered to be material. Our allowance for loan losses as a percentage of total loans was 0.83% and 0.94% for the years ended December 31, 2019 and 2018, respectively. The decrease was primarily the result of extraordinary loan growth and to a lesser extent, a reduction in the historical peer loss rate during the year. We did not record any net charge-offs for the years ended December 31, 2019 or December 31, 2018. Year ended December 31, 2018 compared to year ended December 31, 2017 Our provision for loan losses amounted to $1.2 million for 2018 and $1.0 million for 2017. The increase from 2017 to 2018 was primarily a result of the growth of our loan portfolio. The allowance for loan losses as a percentage of total loans was 0.94% and 0.96% for the years ended December 31, 2018 and 2017, respectively. Noninterest Income Our primary sources of recurring noninterest income are service charges on deposit accounts, mortgage banking revenue, swap referral fees, origination fees for Small Business Administration, or SBA loans, and other fees and charges. Noninterest income does not include loan origination fees to the extent they exceed the direct loan origination costs, which are generally recognized over the life of the related loan as an adjustment to yield using the interest method. The following table presents the major categories of noninterest income for the periods indicated. Year ended December 31, 2019 compared to year ended December 31, 2018 Noninterest income for 2019 was $2.8 million, a $0.9 million or 49.8% increase compared to noninterest income of $1.9 million for 2018. The increase in 2019 was primarily due to an increase in swap referral fees, of $0.7 million, or 337.0%, compared to $211 thousand for the year ended December 31, 2018. The increase in swap referral fees were generated from a few large loans and it is uncertain if we will continue to sustain such increases in the future. We also experienced a slight increase in mortgage banking revenues, primarily due to loan growth. The increases were partially offset by a decrease in SBA loan origination fees of $0.2 million, or 74.4%, during the 2019 period compared to the 2018 period, which was primarily due to a decrease in loan demand during 2019 compared to 2018. Year ended December 31, 2018 compared to year ended December 31, 2017 Noninterest income for 2018 was $1.9 million, a $0.1 million, or 5%, increase compared to noninterest income of $1.8 million for 2017. The increase in 2018 was primarily due to increases in mortgage banking revenue and deposit account service charges, which increased $0.2 million, or 1061% (due to 2018 being the first full year of our mortgage banking business), and $0.1 million, or 45.9%, respectively, partially offset by a $0.3 million, or 52.3%, decrease in SBA loan origination fees. The increase in deposit account service charges was due to deposit growth and the increase in mortgage banking revenue was due to the ramping up of our mortgage banking business in 2018 compared to 2017. Noninterest Expense Generally, noninterest expense is composed of all employee expenses and costs associated with operating our facilities, obtaining and retaining client relationships and providing banking services. The largest component of noninterest expense is salaries and employee benefits. Noninterest expense also includes operational expenses, such as occupancy and equipment expenses, professional fees, data processing expenses, advertising expenses, loan processing expenses and other general and administrative expenses, including FDIC assessments, communications, travel, meals, training, supplies and postage. The following table presents the major categories of noninterest expense for the periods indicated. Year ended December 31, 2019 compared to year ended December 31, 2018 Noninterest expense amounted to $27.0 million in 2019, an increase of $7.1 million, or 35.9%, compared to $19.9 million for the year ended December 31, 2018. The increase was primarily due to an increase in salaries and benefits, from increased employee headcount and, to a lesser extent, increases in occupancy and equipment expense and professional services expense due to costs related to building the infrastructure of a publicly traded company. Noninterest expense was also impacted by additional expenses in connection with our proposed acquisition of MBI and the offering. Year ended December 31, 2018 compared to year ended December 31, 2017 Noninterest expense amounted to $19.9 million in 2018, an increase of $6.7 million, or 51.3%, compared to $13.1 million for 2017. The increase in 2018 was primarily due to an increase in salary and benefits expense due to the increase in employee headcount (due to team lift-outs from other banks) and to a lesser extent increases in occupancy and equipment expense and professional services expense, which were primarily related to the increase in our branch and loan production office locations. We also experienced an increase of other noninterest expense of approximately $0.8 million, or 43.9%, which includes FDIC assessments (which increased due to deposit growth) and information technology expenses. Income Tax Expense The amount of income tax expense we incur is influenced by the amounts of our pre-tax income, and other nondeductible expenses. Deferred tax assets and liabilities are reflected at current income tax rates in effect for the period in which the deferred tax assets and liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, such as the Tax Act, deferred tax assets and liabilities are adjusted through the provision for income taxes. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Year ended December 31, 2019 compared to year ended December 31, 2018 Income tax expense was $0.7 million for 2019 and 2018. Our effective tax rates for 2019 and 2018 were 21.9% and 24.1%, respectively. Year ended December 31, 2018 compared to year ended December 31, 2017 Income tax expense was $0.7 million for 2018 and $1.8 million for 2017. Total income tax expense decreased $1.1 million in 2018 primarily as a result of the Tax Act, which included a number of changes to existing U.S. tax laws that impact us, most notably a reduction of the U.S. corporate income tax rate to 21% for tax years beginning after December 31, 2017. Also, as a result of the Tax Act, we recognized a one-time charge of approximately $0.7 million in 2017 as a result of the revaluation of our deferred tax asset, which also increased our tax expense in 2017. Our effective tax rates for 2018 and 2017 were 24.1% and 50.4%, respectively. Financial Condition For the year ended December 31, 2019, our total assets increased $323.5 million, or 44.3%, to approximately $1.1 billion. Net loans and interest-bearing deposits at other financial institutions increased due to our decision to maintain our excess liquidity in assets with a greater level of liquidity, such as deposits with other banks and fed funds sold, as opposed to investing our excess liquidity in less liquid investment securities, despite the prospect of slightly higher yields. This strategy provided us with greater liquidity to fund our growing loan pipeline. Shareholders’ equity decreased $0.4 million, or 0.5%, to $79.3 million at December 31, 2019 compared to December 31, 2018, primarily due to our repurchase of 225,000 shares of Class A Common Stock for an aggregate purchase price of $3.9 million, partially offset by net income for the year of $2.3 million. For the year ended December 31, 2018, our total assets increased by $182.6 million, or 33.4%, from $547.0 million at December 31, 2017 to $729.6 million at December 31, 2018. Increases in net loans, interest-bearing deposits at other financial institutions, and federal funds sold were supported by increases in both noninterest-bearing and interest-bearing deposits, as well as FHLB advances. Shareholders’ equity increased $22.1 million, or 38.4%, to $79.7 million at December 31, 2018 compared to the prior year-end primarily due to proceeds from the closing of our 2018 private offering of approximately $20.0 million and net income for the year of $2.1 million. Interest-Bearing Deposits at Other Financial Institutions Cash that is not immediately needed to fund loans by the Bank is invested in liquid assets that also earn interest, including deposits with other financial institutions. For the year ended December 31, 2019, interest-bearing deposits at other financial institutions increased $96.2 million, or 176.8%, to $150.6 million from $54.4 million at December 31, 2018. The increase was primarily due to our desire to maintain our excess liquidity in more liquid assets due to our significant loan growth and a continued robust demand for loans. Interest-bearing deposits at other financial institutions increased from $11.8 million at December 31, 2017 to $54.4 million at December 31, 2018, or 360.0%, primarily as a result of closing a $20.0 million private offering of our common stock on December 18, 2018 and our preference to maintain excess liquidity in more liquid assets to fund our loan growth. As we continue to grow, so do our liquidity needs. Investment Securities We use our securities portfolio to provide a secondary source of liquidity, achieve additional interest income through higher yields on funds invested (compared to other options, such as interest-bearing deposits at other banks or fed funds sold), manage interest rate risk, and meet both collateral and regulatory capital requirements. Securities may be classified as either trading, held-to-maturity or available-for-sale. Trading securities (if any) are held principally for resale and recorded at their fair value with changes in fair value included in income. Held-to-maturity securities are those which the Corporation has the positive intent and ability to hold to maturity and are reported at amortized cost. Equity securities are carried at fair value, with changes in fair value reported in net income. Equity securities without readily determinable fair values are carried at cost, minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment. Available-for-sale securities consist of securities not classified as trading securities nor as held-to maturity securities. Unrealized holding gains and losses on available-for-sale securities are excluded from income and reported in comprehensive income or loss. Gains and losses on the sale of available-for-sale securities are recorded on the trade date and are determined using the specific-identification method. Premiums and discounts on securities available for sale are recognized in interest income using the interest method over the period to maturity. Our investment portfolio increased by $8.8 million, or 42.5%, from $20.8 million at December 31, 2018, to $29.6 million at December 31, 2019 primarily due to the investment of a portion of the proceeds from our 2018 private offering into securities available for sale, although substantially more of these proceeds were invested in more liquid assets to provide more liquidity to fund our loan growth. To supplement interest income earned on our loan portfolio, we invest in high quality mortgage-backed securities, government agency bonds, corporate bonds and equity securities (including mutual funds). Our investment portfolio decreased by $6.2 million, or 23.0%, from $27.0 million at December 31, 2017, to $20.8 million at December 31, 2018. The primary reason for the decrease was due to our preference for more liquid assets to support our loan growth, as mentioned above. The following tables summarize the contractual maturities and weighted-average yields of investment securities as of December 31, 2019 and the amortized cost and carrying value of those securities as of the indicated dates. Loan Portfolio Our primary source of income is derived from interest earned on loans. Our loan portfolio consists of loans secured by real estate as well as commercial business loans, construction and development and other consumer loans. Our loan clients primarily consist of small to medium sized businesses, the owners and operators of these businesses as well as other professionals, entrepreneurs and high net worth individuals. Our owner-occupied and investment commercial real estate loans, residential construction loans and commercial business loans provide us with higher risk-adjusted returns, shorter maturities and more sensitivity to interest rate fluctuations, and are complemented by our relatively lower risk residential real estate loans to individuals. Our lending activities are principally directed to our market area consisting of the Miami-Dade MSA. The following table summarizes and provides additional information about certain segments of our loan portfolio as of the dates indicated. Commercial Real Estate Loans. We originate both owner-occupied and non-owner-occupied commercial real estate loans. These loans may be more adversely affected by conditions in the real estate markets or in the general economy. Commercial real estate loans that are secured by owner-occupied commercial real estate and primarily collateralized by operating cash flows are also included in this category of loans. As of December 31, 2019, we had $112.6 million of owner-occupied commercial real estate loans and $158.4 million of investment commercial real estate loans, representing 41.6% and 58.4%, respectively, of our commercial real estate portfolio. As of December 31, 2019, the average loan balance of loans in our commercial real estate loan portfolio was approximately $1.0 million for owner-occupied and $2.4 million for non-owner-occupied. Commercial real estate loan terms are generally extended for 10 years or less and amortize generally over 25 years or less. Terms of 15 years are permitted where the loan is fully amortized over the term of the loan. The maximum loan to value is generally, 80% of the market value or purchase price, but may be as high as 90% for SBA 504 owner-occupied loans. Our credit policy also usually requires a minimum debt service coverage ratio of 1.20x. As of December 31, 2019, our weighted-average loan-to-value ratios for owner-occupied and non-owner-occupied commercial real estate were 52.4% and 52.3%, respectively and debt service coverage ratios were 2.37x and 1.70x, respectively. The interest rates on our commercial real estate loans have initial fixed rate terms that adjust typically at five years and we routinely charge an origination fee for our services. We generally require personal guarantees from the principal owners of the business, supported by a review of the principal owners’ personal financial statements and global debt service obligations. All commercial real estate loans with an outstanding balance of $500,000 or more are reviewed at least annually. The properties securing the portfolio are located primarily throughout our market and are generally diverse in terms of type. This diversity helps reduce the exposure to adverse economic events that affect any single industry. Construction and Development Loans. The majority of our construction loans are offered within the Miami-Dade MSA to builders primarily for the construction of single-family homes and condominium and townhouse conversions or renovations and, to a lesser extent, to individuals. Our construction loans typically have terms of 12 to 18 months with the goal of transitioning the borrowers to permanent financing or re-underwriting and selling into the secondary market. According to our credit policy, the loan to value ratio may not exceed the lesser of 80% of the appraised value, as established by an independent appraisal, or 85% of costs for residential construction and 90% of costs for SBA 504 loans. As of December 31, 2019, our weighted average loan-to-value ratio on our construction, vacant land, and land development loans were 55.3%, 44.3% and 24.2%, respectively. All construction and development loans require an interest reserve account, which is sufficient to pay the loan through completion of the project. We conduct semi-annual stress testing of our construction loan portfolio and closely monitor underlying real estate conditions as well as our borrowers’ trends of sales valuations as compared to underwriting valuations as part of our ongoing risk management efforts. We also closely monitor our borrowers’ progress in construction buildout and strictly enforce our original underwriting guidelines for construction milestones and completion timelines. As of December 31, 2019, non-owner occupied commercial real estate loans of $158.4 million represented 117.7% of total risk-based capital and total construction and land development loans of $41.5 million represented 43.3% of total risk-based capital. Residential Real Estate Loans. We offer one-to-four family mortgage loans primarily on owner-occupied primary residences and, to a lesser extent, investor-owned residences, which make up approximately 20% of our residential loan portfolio. Our residential loans also include home equity lines of credit, which totaled approximately $24.1 million, or approximately 7.0% of our residential loan portfolio as of December 31, 2019. The average loan balance of closed-end residential loans in our residential portfolio was approximately $750,570 as of December 31, 2019. Our one-to-four family residential loans have a relatively small balance spread between many individual borrowers compared to our other loan categories. Our owner-occupied residential real estate loans usually have fixed rates for five or seven years and adjust on an annual basis after the initial term based on a typical maturity of 30 years. Upon the implementation of rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act, the origination, closing and servicing of the traditional residential loan products became much more complex, which led to increased cost of compliance and training. As a result, many banks exited the business, which created an opportunity for the banks that remained in the space. While the use of technology, and other related origination strategies have allowed non-bank originators to gain significant market share over the last several years, traditional banks that made investments in personnel and technology to comply with the new requirements have typically experienced loan growth. Unlike many of our competitors, we have been able to effectively compete in the residential loan market, while simultaneously doing the same in the commercial loan market which has enabled us to establish a broader and deeper relationship with our borrowers. Additionally, by offering a full line of residential loan products, the owners of the many small to medium sized businesses that we lend to use us, instead of a competitor, for financing a personal residence. This greater bandwidth to the same market has been a significant contributor to our growth and market share in South Florida. The following chart shows our residential real estate portfolio by loan type and the weighted average loan-to-value ratio for each loan type. Commercial Loans. In addition to our other loan products, we provide general commercial loans, including commercial lines of credit, working capital loans, term loans, equipment financing, letters of credit and other loan products, primarily in our market, and underwritten based on each borrower’s ability to service debt from income. These loans are primarily made based on the identified cash flows of the borrower, as determined based on a review of the client’s financial statements, and secondarily, on the underlying collateral provided by the borrower. The average loan balance of the loans in our commercial loan portfolio was $544,021 as of December 31, 2019. For commercial loans over $500,000, a global cash flow analysis is generally required, which forms the basis for the credit approval, “Global cash flow” is defined as a cash flow calculation which includes all income sources of all principals in the transaction as well as all debt payments, including the debt service associated with the proposed transaction. In general, a minimum 1.20x debt service coverage is preferred, but in no event may the debt service coverage ratio be less than 1.00x. As of December 31, 2019, the debt service coverage ratio for our commercial loan portfolio was approximately 3.2x, excluding approximately 6.9% of the commercial loan portfolio that is cash secured. Most commercial business loans are secured by a lien on general business assets including, among other things, available real estate, accounts receivable, promissory notes, inventory and equipment, and we generally obtain a personal guaranty from the borrower or other principal. The following chart shows our commercial loan portfolio by industry segment as of December 31, 2019. Consumer and Other Loans. We offer consumer, or retail credit, to individuals for household, family, or other personal expenditures. Generally, these are either in the form of closed-end/installment credit loans or open-end/revolving credit loans. Occasionally, we will make unsecured consumer loans to highly qualified clients in amounts up to $250,000 with up to three-year repayment terms. The following chart illustrates our gross loans net of unearned income and weighted average loan-to-value ratio for our collateralized loan portfolio as of the end of the months indicated. The repayment of loans is a source of additional liquidity for us. The following table details maturities and sensitivity to interest rate changes for our loan portfolio at December 31, 2019. Nonperforming Assets Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on nonaccrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on nonaccrual status regardless of whether or not such loans are considered past due. In general, we place loans on nonaccrual status when they become 90 days past due. We also place loans on nonaccrual status if they are less than 90 days past due if the collection of principal or interest is in doubt. When interest accrual is discontinued, all unpaid accrued interest is reversed from income. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are, in management’s opinion, reasonably assured. Any loan which the Bank deems to be uncollectible, in whole or in part, is charged off to the extent of the anticipated loss. Loans that are past due for 180 days or more are charged off unless the loan is well secured and in the process of collection. We currently have no loans that are 90 days or greater past due as of December 31, 2019. We believe our disciplined lending approach and focused management of nonperforming assets has resulted in sound asset quality and timely resolution of problem assets. We have several procedures in place to assist us in maintaining the overall quality of our loan portfolio, such as annual reviews of the underlying financial performance of all commercial loans in excess of $500,000. We also engage in annual stress testing of the loan portfolio, and proactive collection and timely disposition of past due loans. Our bankers follow established underwriting guidelines, and we also monitor our delinquency levels for any negative trends. As a result, we have, in recent years, experienced a relatively low level of nonperforming assets. We had nonperforming assets of $2.3 million as of December 31, 2019, or 0.22% of total assets, and we did not have any nonperforming assets as of December 31, 2018, 2017, 2016 or 2015. Occasionally, loans that we make will be impacted due to the occurrence of unforeseen events, which was a primary factor in the recent increase in our nonperforming assets relative to our historically low, near-zero levels. However, we believe that our low loan-to-value loan portfolio is well positioned to withstand these types of discrete events as they occur from time. There can be no assurance, however, that our loan portfolio will not become subject to increasing pressures from deteriorating borrower credit due to general economic conditions. Credit Quality Indicators We strive to manage and control credit risk in our loan portfolio by adhering to well-defined underwriting criteria and account administration standards established by our management team and approved by our Board. We employ a dedicated Chief Risk Officer and have established a Risk Committee at the Bank level which oversees, among other things, risks associated with our lending activities and enterprise risk management. Our written loan policies document underwriting standards, approval levels, exposure limits and other limits or standards that our management team and Board deem appropriate for an institution of our size and character. Loan portfolio diversification at the obligor, product and geographic levels are actively managed to mitigate concentration risk, to the extent possible. In addition, credit risk management includes an independent credit review process that assesses compliance with policies, risk rating standards and other critical credit information. In addition, we adhere to sound credit principles and evaluate our clients’ borrowing needs and capacity to repay, in conjunction with their character and financial history. Our management team and Board place significant emphasis on balancing a healthy risk profile and sustainable growth. Specifically, our approach to lending seeks to balance the risks necessary to achieve our strategic goals while ensuring that our risks are appropriately managed and remain within our defined limits. We believe that our credit culture is a key factor in our relatively low levels of nonperforming loans and nonperforming assets compared to other institutions within our market. We categorize loans into risk categories based on relevant information about the ability of borrowers to service their debt including: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. Generally, all credits greater than $500,000, other than residential real estate loans, are reviewed no less than annually to monitor and adjust, if necessary, the credit risk profile. Loans classified as “substandard” or “special mention” are reviewed quarterly for further evaluation to determine if they are appropriately classified and whether there is any impairment. Beyond the annual review, all loans are graded at initial issuance. In addition, during the renewal process of any loan, as well as if a loan becomes past due, we will determine the appropriate loan grade. Loans excluded from the review process above are generally classified as “pass” credits until: (a) they become past due; (b) management becomes aware of deterioration in the credit worthiness of the borrower; or (c) the client contacts us for a modification. In these circumstances, the loan is specifically evaluated for potential reclassification to special mention, substandard, doubtful, or even a charged-off status. We use the following definitions for risk ratings: Pass. A Pass loan’s primary source of loan repayment is satisfactory, with secondary sources very likely to be realized if necessary. The pass category includes the following: · Riskless: Loans that are fully secured by liquid, properly margined collateral (listed stock, bonds, or other securities; savings accounts; certificates of deposit; loans or that portion thereof which are guaranteed by the U.S. Government or agencies backed by the “full faith and credit” thereof; loans secured by properly executed letters of credit from prime financial institutions). · High Quality Risk: Loans to recognized national companies and well-seasoned companies that enjoy ready access to capital markets or to a range of financing alternatives. Borrower’s public debt offerings are accorded highest ratings by recognized rating agencies, e.g., Moody’s or Standard & Poor’s. Companies display sound financial conditions and consistent superior income performance. The borrower’s trends and those of the industry to which it belongs are positive. · Satisfactory Risk: Loans to borrowers, reasonably well established, that display satisfactory financial conditions, operating results and excellent future potential. Capacity to service debt is amply demonstrated. Current financial strength, while financially adequate, may be deficient in a number of respects. Normal comfort levels are achieved through a closely monitored collateral position and/or the strength of outside guarantors. · Moderate Risk: Loans to borrowers who are in non-compliance with periodic reporting requirements of the loan agreement, and any other credit file documentation deficiencies, which do not otherwise affect the borrower’s credit risk profile. This may include borrowers who fail to supply updated financial information that supports the adequacy of the primary source of repayment to service the Bank’s debt and prevents bank management to evaluate the borrower’s current debt service capacity. Existing loans will include those with consistent track records of timely loan payments, no material adverse changes to underlying collateral, and no material adverse changes to guarantor(s) financial capacity, evidenced by public record searches. Special mention. A Special Mention loan has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in the deterioration of the repayment prospects for the asset or our credit position at some future date. Special Mention loans are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification. Substandard. A Substandard loan is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardizes the liquidation of the debt. They are characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected. Doubtful. A loan classified Doubtful has all the weaknesses inherent in one classified Substandard with the added characteristics that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Loss. A loan classified Loss is considered uncollectible and of such little value that continuance as a bankable asset is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be affected in the future. Based on the most recent analysis performed, the risk category of loans by class of loans is as follows: Allowance for Loan Losses We believe that we maintain our allowance for loan losses at a level sufficient to provide for probable incurred credit losses inherent in the loan portfolio as of the balance sheet date. Credit losses arise from the borrowers’ inability or unwillingness to repay, and from other risks inherent in the lending process including collateral risk, operations risk, concentration risk, and economic risk. We consider all of these risks of lending when assessing the adequacy of our allowance. The allowance for loan losses is established through a provision charged to expense. Loans are charged-off against the allowance when losses are probable and reasonably quantifiable. Our allowance for loan losses is based on management’s judgment of overall credit quality, which is a significant estimate based on a detailed analysis of the loan portfolio. Our allowance can and will change based on revisions to our assessment of our loan portfolio’s overall credit quality and other risk factors both internal and external to us. We evaluate the adequacy of the allowance for loan losses on a quarterly basis. The allowance consists of two components. The first component consists of those amounts reserved for impaired loans. A loan is deemed impaired when, based on current information and events, it is probable that the Bank will not be able to collect all amounts due (principal and interest), according to the contractual terms of the loan agreement. Loans are monitored for potential impairment through our ongoing loan review procedures and portfolio analysis. Classified loans and past due loans over a specific dollar amount, and all troubled debt restructurings are individually evaluated for impairment. The approach for assigning reserves for the impaired loans is determined by the dollar amount of the loan and loan type. Impairment measurement for loans over a specific dollar are determined on an individual loan basis with the amount reserved dependent on whether repayment of the loan is dependent on the liquidation of collateral or from some other source of repayment. If repayment is dependent on the sale of collateral, the reserve is equivalent to the recorded investment in the loan less the fair value of the collateral after estimated sales expenses. If repayment is not dependent on the sale of collateral, the reserve is equivalent to the recorded investment in the loan less the estimated cash flows discounted using the loan’s effective interest rate. The discounted value of the cash flows is based on the anticipated timing of the receipt of cash payments from the borrower. The reserve allocations for individually measured impaired loans are sensitive to the extent market conditions or the actual timing of cash receipts change. Impairment reserves for smaller-balance loans under a specific dollar amount are assigned on a pooled basis utilizing loss factors for impaired loans of a similar nature. The second component is a general reserve on all loans other than those identified as impaired. General reserves are assigned to various homogenous loan pools, including commercial, commercial real estate, construction and development, residential real estate, and consumer. General reserves are assigned based on historical loan loss ratios determined by loan pool and internal risk ratings that are adjusted for various internal and external risk factors unique to each loan pool. The following table analyzes the activity in the allowance over the past five years. We had recoveries of $1,000 for the year ended December 31, 2019, and did not have any net charge-offs or recoveries for the year ended December 31, 2019 or 2018. Our allowance for loan losses was $6.5 million at December 31, 2019 compared to $5.7 million at December 31, 2018, an increase of 15.2%. The increase was primarily due to the growth of our loan portfolio. At December 31, 2019, our allowance for loan losses was 0.83% of total gross loans (net of overdrafts) and provided coverage of 287.2% of our nonperforming loans, compared to an allowance for loan losses to total gross loans (net of overdrafts) ratio of 0.94% as of December 31, 2018. We believe our allowance at December 31, 2019 was adequate to absorb potential losses inherent in our loan portfolio. Our allowance for loan losses totaled $5.7 million at December 31, 2018 compared to $4.5 million at December 31, 2017, $3.5 million at December 31, 2016 and $2.5 million at December 31, 2015. The increases in our allowance for loan losses in 2018 and 2017 were due to growth in our loan portfolio. The decrease in our allowance for loan losses as a percentage of total loans from December 31, 2018 to 2019 was primarily the result of extraordinary loan growth and to a lesser extent, a reduction in the historical peer loss rate during 2019. The slight decrease in the allowance for loan loss as a percentage of total gross loans in 2017 was primarily attributable to a favorable problem loan migration and improving risk factors within our loan portfolio. At December 31, 2018, our allowance for loan losses was 0.94% of total gross loans (net of overdrafts) compared to 0.96%, 1.09% and 0.99% at December 31, 2017, 2016 and 2015, respectively. We did not have any nonperforming loans at December 31, 2018, 2017, 2016 or 2015. The following table provides an allocation of the allowance for loan losses to specific loan types as of the end of the fiscal year for each of the past five years. At December 31, 2019, the recorded investment in impaired loans (consisting of nonaccrual loans, troubled debt restructured loans, loans past due 90 days or more and still accruing interest and other loans based on management’ judgment) was $5.1 million, $1.1 million of which required a specific reserve of $0.6 million, compared to a recorded investment in impaired loans of $0.3 million at December 31, 2018, which increase was due to one loan being placed in nonaccrual status in June, $0.4 million at December 31, 2017, $0.5 million at December 31, 2016 and $0.5 million at December 31, 2015. None of the impaired loans at December 31, 2018, 2017, 2016 or 2015 required a specific reserve. Impaired loans also include certain loans that were modified as troubled debt restructurings, or TDRs. At December 31, 2019, we had two loans amounting to $0.4 million that were considered to be TDRs, compared to two loans amounting to $0.4 million at December 31, 2018 and three loans totaling $0.4 million at December 31, 2017. We did not allocate any specific reserves to loans that have been modified as TDRs as of December 31, 2019 or 2018. Three loans amounting to $0.5 million were considered to be TDRs at December 31, 2016 and we did not allocate any specific reserves to these loans. Three loans amounting to $0.5 million were considered to be TDRs at December 31, 2015 and we did not allocate any specific reserves to these loans. Deposits Deposits are our primary source of funding. We offer a variety of deposit products including checking, NOW, savings, money market and time accounts all of which we actively market at competitive pricing. We generate deposits from our consumer and commercial clients through the efforts of our private bankers. We supplement our deposits with wholesale funding sources such as Quickrate and brokered deposits. However, we do not significantly rely on wholesale funding sources, which are generally viewed as less stable compared to core deposits due to the relatively higher price elasticity of demand for deposits from wholesale sources. As of December 31, 2019 and 2018, these wholesale deposits represented 4.6% and 3.99%, respectively, of our total deposits. Interest-bearing deposits increased $235.6 million, or 49.8%, from December 31, 2018 to December 31, 2019 primarily due to a $196.4 million increase in money market account balances and a $15.8 million increase in certificates of deposit. In order to fund our loan growth, all of our bankers are actively involved with our strategic efforts and are incentivized to grow core deposits. The average rate paid on interest-bearing deposits increased 50 basis points from 1.23% for the year ended December 31, 2018 to 1.73% for the year ended December 31, 2019. Rates paid on certificates of deposit increased 49 basis points, or 33.5%, over the same period. The increase in average rates paid on interest-bearing deposits and certificates of deposit was a result of a continued increase in market rates of interest during the first half of 2019, as well as upward competitive pricing pressures, partially offset by rate cuts during the last half of 2019. As of December 31, 2019, we had approximately $22.6 million in brokered deposits, 2.5% of total, that were classified as brokered deposits, an increase of approximately $2.7 million, or 13.5% from December 31, 2018. We did not obtain these brokered deposits through a deposit listing agency, but rather through an existing relationship with the Bank. However, these deposits meet the regulatory definition of brokered deposits and are reported accordingly. Interest-bearing deposits increased $114.7 million, or 31.7%, from December 31, 2017 to December 31, 2018. Certificates of deposit increased $18.3 million and money market accounts and NOW accounts increased $96.5 million. The average rate paid on interest-bearing deposits increased 33 basis points for the year ended December 31, 2018 compared to the year ended December 31, 2017. The average rate paid on certificates of deposit increased 42 basis points over the same period. The increase in average rates paid on interest-bearing deposits and certificates of deposit was a result of increasing market interest rates during 2018, as well as upward competitive pricing pressures. As of December 31, 2018, we had approximately $19.9 million in deposits, 3.2% of total, classified as brokered deposits, compared to no deposits classified as brokered deposits as of December 31, 2017. The following table presents the average balances and average rates paid on deposits for the periods indicated. The following table presents the ending balances and percentage of total deposits for the periods indicated. The following table presents the maturities of our certificates of deposit as of December 31, 2019. Borrowings We primarily use short-term and long-term borrowings to supplement deposits to fund our lending and investment activities. FHLB Advances. The FHLB allows us to borrow up to 25% of our assets on a blanket floating lien status collateralized by certain securities and loans. As of December 31, 2019, approximately $154.8 million in real estate loans were pledged as collateral for our FHLB borrowings. We utilize these borrowings to meet liquidity needs and to fund certain fixed rate loans in our portfolio. As of December 31, 2019, we had $55.0 million in outstanding advances and $55.9 million in additional available borrowing capacity from the FHLB based on the collateral that we have currently pledged. The following table sets forth certain information on our FHLB borrowings during the periods presented. Federal Reserve Bank of Atlanta. The Federal Reserve Bank of Atlanta has an available borrower in custody arrangement which allows us to borrow on a collateralized basis. No advances were outstanding under this facility as of December 31, 2019. Valley National Line of Credit. On December 19, 2019, the Company entered into a new $10.0 million secured revolving line of credit with Valley National Bank, N.A. Amounts drawn under this line of credit bears interest at the Prime Rate, as announced by The Wall Street Journal from time to time as its prime rate, and its obligations under this line of credit are secured by all of the issued and outstanding shares of capital stock of the Company, which we have pledged as security. Outstanding principal and interest under the line of credit is payable at maturity on December 19, 2020. As of December 31, 2019, approximately $10.0 million was drawn under this line of credit, the proceeds of which were primarily used to provide additional capital to support continued growth and also to cover expenses incurred in connection with entering into the line of credit. On February 12, 2020 the Company used a portion of the net proceeds from its IPO to repay all of the outstanding principal and accrued interest under the line of credit with Valley National Bank, N.A. Liquidity and Capital Resources Capital Resources Shareholders’ equity decreased $0.4 million for the year ended December 31, 2019 compared to 2018, primarily due to our repurchase of 225,000 shares of Class A Common Stock for an aggregate purchase price of $3.9 million. Net income resulted in an increase to retained earnings of $2.3 million as of December 31, 2019. Shareholders’ equity increased $22.1 million for the year ended December 31, 2018 compared to the year ended December 31, 2017. Net income resulted in an increase to retained earnings of $2.1 million as of December 31, 2018. Shares of common stock totaling 1,095,890 were issued upon the closing of our 2018 private offering, resulting in an increase to shareholders’ equity of approximately $20.0 million. We are 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 material effect on our 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. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require us to maintain minimum ratios of common equity Tier 1, Tier 2, and total capital as a percentage of assets and off-balance sheet exposures, adjusted for risk weights ranging from 0% to 150%. We are also required to maintain capital at a minimum level based on quarterly average assets, which is known as the leverage ratio. In July 2013, federal bank regulatory agencies issued a final rule that revised their risk-based capital requirements and the method for calculating risk-weighted assets to make them consistent with certain standards that were developed by Basel III and certain provisions of the Dodd-Frank Act. The final rule applies to all depository institutions and bank holding companies and savings and loan holding companies with total consolidated assets of more than $1 billion, which we refer to below as “covered” banking organizations. We were required to implement the new Basel III capital standards as of January 1, 2015 and January 1, 2019, respectively. As of December 31, 2019, we were in compliance with all applicable regulatory capital requirements to which we were subject, and the Bank was classified as “well capitalized” for purposes of the prompt corrective action regulations. As we deploy our capital and continue to grow our operations, our regulatory capital levels may decrease depending on our level of earnings. However, we intend to monitor and control our growth in order to remain in compliance with all regulatory capital standards applicable to us. The following table presents our regulatory capital ratios as of the dates indicated. The amounts presented exclude the capital conservation buffer. Liquidity In general terms, liquidity is a measurement of our ability to meet our cash needs. Our objective in managing our liquidity is to maintain our ability to fund loan commitments, purchase securities, accommodate deposit withdrawals or repay other liabilities in accordance with their terms, without an adverse impact on our current or future earnings. Our liquidity strategy is guided by policies that are formulated and monitored by our Asset Liability Management Committee, or ALCO, and senior management, including our Liquidity Contingency Policy, and which take into account the marketability of assets, the sources and stability of funding and the level of unfunded commitments. We regularly evaluate all of our various funding sources with an emphasis on accessibility, stability, reliability and cost-effectiveness. Our principal source of funding has been our clients’ deposits, supplemented by our short-term borrowings, primarily from FHLB borrowings. We believe that the cash generated from operations, our borrowing capacity and our access to capital resources are sufficient to meet our future operating capital and funding requirements. At December 31, 2019, we had the ability to generate approximately $108.4 million in additional liquidity through all of our available resources beyond our overnight funds sold position. In addition to the primary borrowing outlets mentioned above, we also have the ability to generate liquidity by borrowing from the Federal Reserve Discount Window and through brokered deposits. We recognize the importance of maintaining liquidity and have developed a Contingent Liquidity Plan, which addresses various liquidity stress levels and our response and action based on the level of severity. We periodically test our credit facilities for access to the funds, but also understand that as the severity of the liquidity level increases, certain credit facilities may no longer be available. We conduct quarterly liquidity stress tests and the results are reported to our Asset-Liability Management Committee and our Board. We believe the liquidity available to us is sufficient to meet our ongoing needs. We also view our investment portfolio as a liquidity source and have the option to pledge securities in our portfolio as collateral for borrowings or deposits, and/or sell selected securities. Our portfolio primarily consists of debt issued by the federal government and governmental agencies. The weighted-average maturity of our portfolio was 3.50 years and 4.43 years at December 31, 2019 and 2018, respectively, and had a net unrealized pre-tax loss of $0.1 and $0.5 million, respectively, in our available for sale securities portfolio as of those dates. Our average net overnight funds sold position (defined as funds sold plus interest-bearing deposits with other banks less funds purchased) was $25.3 million during the year ended December 31, of 2019 compared to an average net overnight funds sold position of $20.7 million for the year ended December 31, 2018. As we have continued to experience high organic growth, we have preferred to maintain our excess liquidity in assets with greater liquidity, such as federal funds sold, as opposed to less liquid, but slightly higher yielding, assets, like investment securities. We expect our capital expenditures over the next 12 months to be approximately $1.4 million, which will consist primarily of investments in consolidation of our core vendors after our acquisition of MBI, technology purchases for our new banking offices, business applications, information technology security needs as well as furniture, fixtures and equipment for our new banking offices. We expect that these capital expenditures will be funded with existing resources without impairing our ability to meet our ongoing obligations. Inflation The impact of inflation on the banking industry differs significantly from that of other industries in which a large portion of total resources are invested in fixed assets such as property, plant and equipment. Assets and liabilities of financial institutions are primarily all monetary in nature, and therefore are principally impacted by interest rates rather than changing prices. While the general level of inflation underlies most interest rates, interest rates react more to changes in the expected rate of inflation and to changes in monetary and fiscal policy. Contractual Obligations We have contractual obligations to make future payments on debt and lease agreements. While our liquidity monitoring and management consider both present and future demands for and sources of liquidity, the following table of contractual commitments focuses only on future obligations and summarizes our contractual obligations as of December 31, 2019. Off-Balance Sheet Items In the normal course of business, we enter into various transactions that, in accordance with GAAP, are not included in our consolidated balance sheets. We enter into these transactions to meet the financing needs of our clients. These transactions include commitments to extend credit and issue letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in our consolidated balance sheets. Our exposure to credit loss is represented by the contractual amounts of these commitments. The same credit policies and procedures are used in making these commitments as for on-balance sheet instruments. We are not aware of any accounting loss to be incurred by funding these commitments, however we maintain an allowance for off-balance sheet credit risk which is recorded in other liabilities on the consolidated balance sheet. Our commitments associated with outstanding letters of credit and commitments to extend credit expiring by period as of the date indicated are summarized below. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements. Unfunded lines of credit represent unused portions of credit facilities to our current borrowers that represent no change in credit risk in our portfolio. Lines of credit generally have variable interest rates. The maximum potential amount of future payments we could be required to make is represented by the contractual amount of the commitment, less the amount of any advances made. Letters of credit are conditional commitments issued by us to guarantee the performance of a client to a third party. In the event of nonperformance by the client in accordance with the terms of the agreement with the third party, we would be required to fund the commitment. If the commitment is funded, we would be entitled to seek recovery from the client from the underlying collateral, which can include commercial real estate, physical plant and property, inventory, receivables, cash or marketable securities. Our policies generally require that letter of credit arrangements contain security and debt covenants similar to those contained in loan agreements and our credit risk associated with issuing letters of credit is similar to the credit risk involved in extending loan facilities to our clients. The effect on our revenue, expenses, cash flows, and liquidity of the unused portions of these letters of credit commitments and letters of credit cannot be precisely predicted because there is no guarantee that the lines of credit will be used. Commitments to extend credit are agreements to lend funds to a client, as long as there is no violation of any condition established in the contract, for a specific purpose. Commitments generally have variable interest rates, 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 fully drawn, the total commitment amounts disclosed above do not necessarily represent future cash requirements. We evaluate each client’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if considered necessary by us, upon extension of credit is based on management’s credit evaluation of the client. We enter into forward commitments for the delivery of mortgage loans in our current pipeline. Interest rate lock commitments are entered into in order to economically hedge the effect of changes in interest rates resulting from our commitments to fund the loans. These commitments to fund mortgage loans, to be sold into the secondary market, (interest rate lock commitments) and forward commitments for the future delivery of mortgage loans to third party investors are considered derivatives. We attempt to minimize our exposure to loss under credit commitments by subjecting them to the same credit approval and monitoring procedures as we do for on-balance sheet instruments. Certain Performance Metrics The following table shows the return on average assets (computed as net income divided by average total assets), return on average equity (computed as net income divided by average equity) and average equity to average assets ratios for the years ended December 31, 2019, 2018 and 2017. Market Risk and Interest Rate Sensitivity Overview Market risk arises from changes in interest rates, exchange rates, commodity prices, and equity prices. We have risk management policies designed to monitor and limit exposure to market risk and we do not participate in activities that give rise to significant market risk involving exchange rates, commodity prices, or equity prices. In asset and liability management activities, our policies are designed to minimize structural interest rate risk. Interest Rate Risk Management Our net income is largely dependent on net interest income. Net interest income is susceptible to interest rate risk to the degree that interest-bearing liabilities mature or reprice on a different basis than interest earning assets. When interest-bearing liabilities mature or reprice more quickly than interest earning assets in a given period, a significant increase in market rates of interest could adversely affect net interest income. Similarly, when interest earning assets mature or reprice more quickly than interest-bearing liabilities, falling market interest rates could result in a decrease in net interest income. Net interest income is also affected by changes in the portion of interest earning assets that are funded by interest-bearing liabilities rather than by other sources of funds, such as noninterest-bearing deposits and shareholders’ equity. We have established what we believe to be a comprehensive interest rate risk management policy, which is administered by ALCO. The policy establishes limits of risk, which are quantitative measures of the percentage change in net interest income (a measure of net interest income at risk) and the fair value of equity capital (a measure of economic value of equity, or EVE, at risk) resulting from a hypothetical change in interest rates for maturities from one day to 30 years. We measure the potential adverse impacts that changing interest rates may have on our short-term earnings, long-term value, and liquidity by employing simulation analysis through the use of computer modeling. The simulation model captures optionality factors such as call features and interest rate caps and floors imbedded in investment and loan portfolio contracts. As with any method of gauging interest rate risk, there are certain shortcomings inherent in the interest rate modeling methodology used by us. When interest rates change, actual movements in different categories of interest earning assets and interest-bearing liabilities, loan prepayments, and withdrawals of time and other deposits, may deviate significantly from assumptions used in the model. Finally, the methodology does not measure or reflect the impact that higher rates may have on adjustable-rate loan clients’ ability to service their debts, or the impact of rate changes on demand for loan and deposit products. The balance sheet is subject to testing for interest rate shock possibilities to indicate the inherent interest rate risk. We prepare a current base case and several alternative interest rate simulations (-400, -300, -200, -100,+100, +200, +300 and +400 basis points (bps)), at least once per quarter, and report the analysis to ALCO and our Board. We augment our interest rate shock analysis with alternative interest rate scenarios on a quarterly basis that may include ramps, parallel shifts, and a flattening or steepening of the yield curve (non-parallel shift). In addition, more frequent forecasts may be produced when interest rates are particularly uncertain or when other business conditions so dictate. Our goal is to structure the balance sheet so that net interest earnings at risk over a 12-month period and the economic value of equity at risk do not exceed policy guidelines at the various interest rate shock levels. We attempt to achieve this goal by balancing, within policy limits, the volume of floating-rate liabilities with a similar volume of floating-rate assets, by keeping the average maturity of fixed-rate asset and liability contracts reasonably matched, by managing the mix of our core deposits, and by adjusting our rates to market conditions on a continuing basis. Analysis The following table indicates that, for periods less than one year, rate-sensitive assets exceeded rate-sensitive liabilities, resulting in a slightly asset-sensitive position. For a bank with an asset-sensitive position, otherwise refered to as a positive gap, rising interest rates would generally be expected to have a positive effect on net interest income, and falling interest rates would generally be expected to have the opposite effect. REPRICING GAP (1) Includes loans held for resale (2) Includes FRB and FHLB stock, which has been historically redeemable at par. CASH FLOW GAP (1) Includes loans held for sale (2) Includes FRB and FHLB stock, which has been historically redeemable at par. Measures of net interest income at risk produced by simulation analysis are indicators of an institution’s short-term performance in alternative rate environments. These measures are typically based upon a relatively brief period, and do not necessarily indicate the long-term prospects or economic value of the institution. The following table summarizes the results of our net interest income at risk analysis in simulating the change in net interest income and fair value of equity over a 12-month and 24-month horizon as of December 31, 2019, 2018 and 2017. Using an EVE, we analyze the risk to capital from the effects of various interest rate scenarios through a long-term discounted cash flow model. This measures the difference between the economic value of our assets and the economic value of our liabilities, which is an estimate of liquidation value. While this provides some value as a risk measurement tool, management believes net interest income at risk is more appropriate in accordance with the going concern principle. The following table illustrates the results of our EVE analysis as of December 31, 2019, 2018 and 2017. Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with 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 consolidated 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. We have identified the following accounting policies and estimates that, due to the difficult, subjective, or complex judgments and assumptions inherent in those policies and 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 consolidated financial statements are appropriate. Allowance for Loan Losses The allowance for loan losses provides for known and inherent losses in the loan portfolio based upon management’s best assessment of the loan portfolio at each balance sheet date. It is maintained at a level estimated to be adequate to absorb potential losses through periodic charges to the provision for loan losses. The allowance for loan losses consists of specific and general reserves. Specific reserves relate to loans classified as impaired. Loans are considered impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due in accordance with the contractual terms of the loan. Impaired loans include troubled debt restructurings, and performing and nonperforming loans. Impaired loans are reviewed individually and a specific allowance is allocated, if necessary, based on evaluation of either the fair value of the collateral underlying the loan or the present value of future cash flows calculated using the loan’s existing interest rate. General reserves relate to the remainder of the loan portfolio, including overdrawn deposit accounts, and are based on evaluation of a number of factors, such as current economic conditions, the quality and composition of the loan portfolio, loss history, and other relevant factors. Our loans are generally secured by specific items of collateral including real property, consumer assets, and business assets. However, the ability of borrowers to honor their contractual repayment obligations is substantially dependent on changing economic conditions. Because of the uncertainties associated with economic conditions, collateral values, and future cash flows on impaired loans, it is reasonably possible that management’s estimate of loan losses in the loan portfolio and the amount of the allowance needed may change in the future. The determination of the allowance for loan losses is, in large part, based on estimates that are particularly susceptible to significant changes in the economic environment and market conditions. In situations where the repayment of a loan is dependent on the value of the underlying collateral, an independent appraisal of the collateral’s current market value is customarily obtained and used in the determination of the allowance for loan loss. While management uses available information to recognize losses on loans, further reductions in the carrying amounts of loans may be necessary based on changes in economic conditions. Also regulatory agencies, as an integral part of their examination process, periodically review management’s assessments of the adequacy of the allowance for loan losses. Such agencies may require us to recognize additional losses based on their judgments about information available to them at the time of their examination. Fair Value Measurements Fair value is the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market for an asset or liability in an orderly transaction between market participants at the measurement date. The degree of management judgment involved in determining the fair value of a financial instrument is dependent upon the availability of quoted market prices or observable market inputs. For financial instruments that are traded actively and have quoted market prices or observable market inputs, there is minimal subjectivity involved in measuring fair value. However, when quoted market prices or observable market inputs are not fully available, significant management judgment may be necessary to estimate fair value. In developing our fair value estimates, we maximize the use of observable inputs and minimize the use of unobservable inputs. The fair value hierarchy defines Level 1 valuations as those based on quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 valuations include inputs based on quoted prices for similar assets or liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. Level 3 valuations are based on at least one significant assumption not observable in the market, or significant management judgment or estimation, some of which may be internally developed. Financial assets that are recorded at fair value on a recurring basis include investment securities available for sale, and loans held for sale. Recent Accounting Pronouncements The following provides a brief description of accounting standards that have been issued but are not yet adopted that could have a material effect on the our financial statements. Please also refer to the Notes to our consolidated financial statements included in this annual report for a full description of recent accounting pronouncements, including the respective expected dates of adoption and anticipated effects on our results of operations and financial condition. ASU 2016-13, Financial Instruments - Credit Loses (Topic 326) In June 2016, FASB issued guidance to replace the incurred loss model with an expected loss model, which is referred to as the current expected credit loss, or CECL, model. The CECL model is applicable to the measurement of credit losses on financial assets measured at amortized cost, including loan receivables and held to maturity debt securities. It also applies to off-balance sheet credit exposures not accounted for as insurance (i.e. loan commitments, standby letters of credit, financial guarantees and other similar instruments). We anticipated that this ASU would be effective for us on January 1, 2021, but the FASB announced on October 16, 2019, a delay of the effective date of ASU 2016-13 for smaller reporting companies until January 1, 2023. We are in the process of evaluating and implementing changes to credit loss estimation models and related processes. Updates to business processes and the documentation of accounting policy decisions are ongoing. We may recognize an increase in the allowance for credit losses upon adoption, recorded as a one-time cumulative adjustment to retained earnings. However, the magnitude of the impact on our consolidated financial statements has not yet been determined.

<s>[INST] expectations. Factors that could cause such differences include, but are nto limited to, those described in the section titled “Cautionary Note Regarding ForwardLooking Information”. Overview Our principal business is lending to and accepting deposits from small to medium sized businesses, the owners and operators of these businesses, as well as other professionals, entrepreneurs and high net worth individuals. We generate the majority of our revenue from interest earned on loans, investments and other interest earning assets, such as federal funds sold and interest earning deposits with other institutions; loan and deposit fees and service charges; and fees relating to the sale of mortgage loans, swap referrals and SBA loan originations. We incur interest expense on deposits and other borrowed funds, as well as operating expenses, such as salaries and employee benefits and occupancy expenses. 2019 Highlights Highlights of our performance and financial condition as of and for the year ended December 31, 2019 and other key events that occurred during 2019 are provided below. Results of Operations · Net income of $2.3 million, which represented an increase of $230 thousand, or 10.9%, compared to the same period in 2018. · Net interest income of $28.0 million, which represented an increase of $6.1 million, or 28.0%, compared to the same period in 2018. This increase was primarily due to loan growth and slightly increased yields on loans, partially offset by an increase in total deposits, as well as increased rates paid on deposit products. · Provision for loan losses was $0.9 million, which represented a decrease of approximately $288 thousand, or 25.0%, compared to the same period in 2018. · Noninterest income totaled $2.8 million, which represented an increase of $0.9 million, or 49.8%, compared to the same period in 2018. This increase was primarily due to increased swap referral fees. · Noninterest expense of $27.0 million, which represented an increase of $7.1 million, or 35.9%, compared to the same period in 2018. This increase was primarily due to increased employee headcount, opening additional bank locations and opening our Digital Innovation Center. Financial Condition · Total assets increased to $1.1 billion, which represented an increase of $323.5 million, or 44.3%, compared to December 31, 2018. This increase was largely attributable to net loan growth of $183.7 million. · Net loans increased to $785.2 million, an increase of $183.7 million, or 30.5%, compared to December 31, 2018. We experienced growth across all loan categories, with the largest growth experienced in commercial real estate, residential real estate, and commercial. · Nonperforming assets totaled $2.3 million, which includes three loans being classified as nonperforming and no loans accruing loans over 90 days past due. There were no nonperforming assets or loans accruing over 90 days past due as of December 31, 2018. · As of December 31, 2019, we were wellcapitalized, with a total riskbased capital ratio of 12.3%, a tier 1 riskbased capital ratio of 11.3%, a common equity tier 1 capital ratio of 11.3%, and a leverage ratio of 7.8%. As of December 31, 2019, all of our regulatory capital ratios exceeded the thresholds to be wellcapitalized under the applicable bank regulatory requirements. Other Highlights · In January 2019, we hired a private banking team from a large South Floridabased bank to establish our Doral, FL loan production office, which opened in July 2019. · In May 2019, we converted our Boca Raton, FL loan production office into a fullservice branch and we opened our fifth branch in Miami, FL (Dadeland). · In May 2019, we h [/INST] Positive. </s>

Greenrose Acquisition 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 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. Certain information contained in the discussion and analysis 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 “Special Note Regarding Forward-Looking Statements,” “Item 1A. Risk Factors” and elsewhere in this Annual Report on Form 10-K. Overview We are a blank check company incorporated on August 26, 2019 as a Delaware corporation and formed for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or similar business combination with one or more businesses or entities. We intend to effectuate our initial business combination using cash from the proceeds of the Initial Public Offering and the sale of the Private Units and Private Warrants, our capital stock, debt or a combination of cash, stock and debt. We have neither engaged in any operations nor generated any revenues to date. Our entire activity since inception has been to prepare for our Initial Public Offering, which was consummated on February 13, 2020. Results of Operations Our only activities from August 26, 2019 (inception) through December 31, 2019 were organizational activities and those necessary to consummate the Initial Public Offering, described below. Following the Initial Public Offering, we do not expect to generate any operating revenues until after the completion of our business combination. We expect to generate non-operating income in the form of interest income on cash and marketable securities held after 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 for due diligence expenses. For the period from August 26, 2019 (inception) through December 31, 2019, we had a net loss of $2,199, which consists of operating and formation costs. Liquidity and Capital Resources As of December 31, 2019, we had cash of $24,970. Until the consummation of the Initial Public Offering, our liquidity needs were satisfied through the receipt of $25,000 from our sale of the Founder’s Shares and advances from our Sponsor. On February 13, 2020, we consummated our Initial Public Offering of 15,000,000 Units, at a price of $10.00 per Unit, generating gross proceeds of $150,000,000. Simultaneously with the closing of the Initial Public Offering, we consummated the sale of 300,000 Private Units and 1,500,000 Private Warrants to our Sponsor and Imperial Capital and its designee, generating gross proceeds of $4,500,000. On February 14, 2020, in connection with the underwriters’ exercise of their over-allotment option in full, we consummated the sale of an additional 2,250,000 Units at a price of $10.00 per Unit, generating total gross proceeds of $22,500,000. In addition, we also consummated the sale of an additional 30,000 Private Units at $10.00 per Private Unit and 150,000 Private Warrants at $1.00 per Private Warrant, generating total gross proceeds of $450,000. Following the Initial Public Offering, the exercise of the over-allotment option and the sale of the Private Units and Private Warrants, a total of $172,500,000 was placed in the trust account. We incurred $4,419,274 of transaction costs, consisting of $3,450,000 of underwriting fees and $969,274 of other offering costs. We intend to use substantially all of the funds held in the trust account, to acquire a target business and to pay our expenses relating thereto, including a fee payable to Imperial Capital, upon consummation of our initial business combination for assisting us in connection with our initial business combination. To the extent that our capital stock is used in whole or in part as consideration to effect a business combination, the remaining funds held in the trust account will be used as working capital to finance the operations of the target business. Such working capital funds could be used in a variety of ways including continuing or expanding the target business’ operations, for strategic acquisitions and for marketing, research and development of existing or new products. Such funds could also be used to repay any operating expenses or finders’ fees which we had incurred prior to the completion of our business combination if the funds available to us outside of the trust account were insufficient to cover such expenses. We intend to use the funds held outside the trust account for identifying and evaluating prospective acquisition candidates, performing business due diligence on prospective target businesses, traveling to and from the offices, plants or similar locations of prospective target businesses, reviewing corporate documents and material agreements of prospective target businesses, selecting the target business to acquire and structuring, negotiating and consummating the business combination. In order to fund working capital deficiencies or finance transaction costs in connection with a business combination, the Insiders, or certain of our officers and directors or their affiliates 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. Up to $2,000,000 of notes may be convertible into Private Units, at a price of $10.00 per Private Unit, and/or Private Warrants, at a price of $1.00 per Private Warrant. The units and warrants would be identical to the Private Units and Private Warrants sold in the Private Placement. On March 26, 2020, we issued an unsecured promissory note (the “Note”) in the principal amount of $1,000,000 to the Sponsor. The Note is non-interest bearing and payable upon the consummation of a Business Combination. Up to $1,000,000 of such loans may be convertible into units at a price of $10.00 per unit and/or warrants at a price of $1.00 per warrant. The units would be identical to the Private Units and the warrants would be identical to the Private Warrants. We do not believe we will need to raise additional funds in order to meet the expenditures required for operating our business prior to our initial business combination. 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. 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. 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 our Sponsor a monthly fee of $10,000 for office space, utilities and secretarial and administrative support. We began incurring these fees on February 13, 2020 and will continue to incur these fees monthly until the earlier of the completion of the business combination and our liquidation. Critical Accounting Policies The preparation of financial statements and related disclosures in conformity with Generally Accepted Accounting Principles (“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. We have identified not identified any critical accounting policies. 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 financial statements.

<s>[INST] Overview We are a blank check company incorporated on August 26, 2019 as a Delaware corporation and formed for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or similar business combination with one or more businesses or entities. We intend to effectuate our initial business combination using cash from the proceeds of the Initial Public Offering and the sale of the Private Units and Private Warrants, our capital stock, debt or a combination of cash, stock and debt. We have neither engaged in any operations nor generated any revenues to date. Our entire activity since inception has been to prepare for our Initial Public Offering, which was consummated on February 13, 2020. Results of Operations Our only activities from August 26, 2019 (inception) through December 31, 2019 were organizational activities and those necessary to consummate the Initial Public Offering, described below. Following the Initial Public Offering, we do not expect to generate any operating revenues until after the completion of our business combination. We expect to generate nonoperating income in the form of interest income on cash and marketable securities held after 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 for due diligence expenses. For the period from August 26, 2019 (inception) through December 31, 2019, we had a net loss of $2,199, which consists of operating and formation costs. Liquidity and Capital Resources As of December 31, 2019, we had cash of $24,970. Until the consummation of the Initial Public Offering, our liquidity needs were satisfied through the receipt of $25,000 from our sale of the Founder’s Shares and advances from our Sponsor. On February 13, 2020, we consummated our Initial Public Offering of 15,000,000 Units, at a price of $10.00 per Unit, generating gross proceeds of $150,000,000. Simultaneously with the closing of the Initial Public Offering, we consummated the sale of 300,000 Private Units and 1,500,000 Private Warrants to our Sponsor and Imperial Capital and its designee, generating gross proceeds of $4,500,000. On February 14, 2020, in connection with the underwriters’ exercise of their overallotment option in full, we consummated the sale of an additional 2,250,000 Units at a price of $10.00 per Unit, generating total gross proceeds of $22,500,000. In addition, we also consummated the sale of an additional 30,000 Private Units at $10.00 per Private Unit and 150,000 Private Warrants at $1.00 per Private Warrant, generating total gross proceeds of $450,000. Following the Initial Public Offering, the exercise of the overallotment option and the sale of the Private Units and Private Warrants, a total of $172,500,000 was placed in the trust account. We incurred $4,419,274 of transaction costs, consisting of $3,450,000 of underwriting fees and $969,274 of other offering costs. We intend to use substantially all of the funds held in the trust account, to acquire a target business and to pay our expenses relating thereto, including a fee payable to Imperial Capital, upon consummation of our initial business combination for assisting us in connection with our initial business combination. To the extent that our capital stock is used in whole or in part as consideration to effect a business combination, the remaining funds held in the trust account will be used as working capital to finance the operations of the target business. Such working capital funds could be used in a variety of ways including continuing or expanding the target business’ operations, for strateg [/INST] Negative. </s>

Xerox Holdings Corp

2020-02-28

2019-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations In March 2019, Xerox Corporation (Xerox) announced plans to create a new public holding company, Xerox Holdings Corporation (Xerox Holdings), by implementing a holding company reorganization (the Reorganization). On July 31, 2019, Xerox completed the Reorganization. In the Reorganization, Xerox (the predecessor publicly held parent company) became a direct, wholly owned subsidiary of Xerox Holdings and Xerox Holdings became the successor public company. We believe implementation of a holding company structure will provide us with flexibility to develop and realize a range of strategic growth opportunities, including by pursuing different capital structures for new businesses, whether incubated or acquired. Refer to Note 1 - Basis of Presentation and Summary of Significant Accounting Policies - Corporate Reorganization, in the Consolidated Financial Statements for additional information regarding the Reorganization. Currently, Xerox Holdings' sole direct operating subsidiary is Xerox and therefore Xerox reflects the entirety of Xerox Holdings' operations. Accordingly, the following Management’s Discussion and Analysis (MD&A) solely focuses on the operations of Xerox and is intended to help the reader understand Xerox's business and its results of operations and financial condition. Throughout this Annual Report on Form 10-K, references are made to various notes in the Consolidated Financial Statements which appear in Part II, Item 8 of this Form 10-K, and the information contained in such notes is incorporated by reference into the MD&A in the places where such references are made. Throughout the MD&A that follows, references to “we,” “our,” the “Company,” and “Xerox” refer to Xerox Corporation and its subsidiaries. References to “Xerox Corporation” refer to the stand-alone company and do not include subsidiaries, unless otherwise noted. References to “Xerox Holdings Corporation” refer to the stand-alone parent company and do not include its subsidiaries, unless otherwise noted. Executive Overview With annual revenues of approximately $9 billion, we are a leading global provider of digital print technology and related services, software and solutions. We operate in a core market estimated at approximately $68 billion. Our primary offerings span three main areas: Xerox Services, Workplace Solutions and Graphic Communications and Production Solutions: • Xerox Services includes solutions and services that helps customers to optimize their print and communications infrastructure, apply automation and simplification to maximize productivity, and ensure the highest levels of related security. • Workplace Solutions includes two strategic product groups, Entry and Mid-Range, which share common technology, manufacturing and product platforms. Workplace Solutions revenues include the sale of products and supplies, as well as the associated technical service and financing of those products. • Graphic Communications and Production Solutions are designed for customers in the graphic communications, in-plant and production print environments with high-volume printing requirements. We also have digital solutions and software assets to compete in an adjacent Software and Services market that is estimated at approximately $34 billion. Our main offerings for this market are focused on: industry-specific Digital Solutions, Personalization & Communication Software and Content Management Software. In addition, a smaller portion of our revenues comes from non-core streams including paper sales in our developing market countries, wide-format systems and revenue from the license or sale of our technology. Headquartered in Norwalk, Connecticut, with approximately 27,000 employees, Xerox serves customers in approximately 160 countries. We have a broad and diverse base of customers by both geography and industry, ranging from SMBs to printing production (including graphic communications) companies, governmental entities, educational institutions and Fortune 1000 corporations. Our business does not depend upon a single customer, or a few customers, the loss of which would have a material adverse effect on our business. In 2019, approximately 40% of our revenue was generated outside the United States. Xerox 2019 Annual Report 21 Market and Business Strategy Our market and business strategy is to maintain overall leadership in our core market and increase our participation in the growth areas, while expanding into adjacent markets and leveraging our innovation capabilities to enter new markets. We have four strategic initiatives that we believe will position Xerox for success: • Optimize operations for simplicity -Continuously improve operating model for greater efficiency -Optimize the supply chain and supplier competitiveness -Leverage digital technologies to make it easier to do business with Xerox • Drive Revenue -Enhance the customer experience -Expand integrated solutions comprised of hardware, software and services -Focus on driving growth within the small and midsize businesses (SMB) • Re-energize the innovation engine -Invest in growing market segments such as 3D printing, AI and IoT -Leverage software capability to launch new services -Monetize new innovations • Focus on cash flow and increasing capital returns - Maximize cash flow generation - Return at least 50% of free cash flow to shareholders (Operating cash flows from continuing operations less capital expenditures) - Focus on ROI and internal rate of return to make capital allocation decisions Post-sale Based Business Model In 2019, 77% of our total revenue was post-sale based, which includes contracted services, equipment maintenance services, consumable supplies and financing, among other elements. These revenue streams generally follow equipment placements and provide some stability to our revenue and cash flows. Key indicators of future post sale revenue include installs and related removals of printers and multifunction devices, the number and type of machines in the field (MIF), page volumes (including the mix of pages printed on color devices) and the type and nature of related software and services provided to customers. Project Own It During the second half of 2018, we initiated a transformation project - Project Own It - centered on creating a more effective organization to enhance our focus on our customers and our partners, instill a culture of continuous improvement and improve our financial results. The primary goal of this project is to improve productivity by driving end-to-end transformation of our processes and systems to create greater focus, speed, accountability and effectiveness and to reduce costs. These efforts are considered critical to making us more competitive and giving us the capacity to invest in growth and maximize shareholder returns. Key opportunities under Project Own It include establishing more effective shared service centers (captive and through our outsource partners), rationalizing our IT infrastructure, reducing our real estate footprint, creating greater velocity in our supply chain and unlocking greater productivity in our supplier base. This project is also evaluating the sourcing of all of our products in an effort to optimize our options. Our approach is to analyze our potential options both by product category and holistically to determine what sourcing makes the most strategic and economic sense. An example of this effort is the expanded arrangement we recently entered into with HP Inc. in June 2019, which not only diversifies our supply chain but also enables us to add volume to our toner operations and broaden our software and services portfolio (See Supply Agreement with HP Inc. below). We incurred restructuring and related costs of $229 million for the year ended December 31, 2019 primarily related to costs incurred to implement initiatives under our business transformation projects including Project Own It. Refer to Restructuring and Related Costs section of the MD&A and Note 14 - Restructuring Programs in the Consolidated Financial Statements for additional information. Shared Services Arrangement with HCL Technologies In March 2019, as part of Project Own It, Xerox entered into a shared services arrangement with HCL Technologies (HCL) pursuant to which we transitioned certain global administrative and support functions, including, among others, selected information technology and finance functions (excluding accounting), from Xerox to HCL. The transition is expected to continue into 2020 and HCL is expected to make certain up-front and ongoing investments in software, tools and other technology to consolidate, optimize and automate the transferred functions with the goal of providing Xerox 2019 Annual Report 22 improved service levels and significant cost savings. The shared services arrangement with HCL includes a total aggregate spending commitment by us of approximately $1.3 billion over the next 7 years (includes approximately $100 million spent in 2019). However, we can terminate the arrangement at any time at our discretion, subject to payment of termination fees that decline over the term, or for cause. The spending commitment excludes restructuring and related costs we are expected to incur in connection with the transition of the contemplated functions - refer to Restructuring and Related Costs section of the MD&A and Note 14 - Restructuring Programs in the Consolidated Financial Statements for additional information. The transfer of employees associated with the HCL arrangement in certain countries was subject to compliance with works council and other employment regulatory requirements in those countries, which delayed the transfer as well as the expected savings from the arrangement. We incurred net charges of approximately $100 million for the year ended December 31, 2019 for services associated with this arrangement, which only reflects the cost associated with the employees transferred to date. The cost has been allocated to the various functional expense lines in the Consolidated Statements of Income based on an assessment of the nature and amount of the costs incurred for the various transferred functions prior to their transfer to HCL. Supply Agreement with HP Inc. In June 2019, we entered into an arrangement to expand our existing sourcing relationship with HP Inc. (HP). As part of the new arrangement, we will start sourcing certain A4 and entry-level A3 products from HP to diversify our supply chain. Many of these devices will operate with our ConnectKey software, a key differentiator in the marketplace. In addition, we will provide toner for both our printers included in this agreement and certain HP printers, which will allow us to add volume to our emulsion aggregation (EA) toner plant in Webster, NY. Further, as part of our growth strategy to increase our penetration of the small-to-medium size business (SMB) market, Xerox will also become a Device as a Service (DaaS) partner for HP in the U.S. We will be able to sell HP PCs, displays and accessories, with or without DaaS, to our U.S. SMB clients. Lastly, HP will also make DocuShare Flex, Xerox's cloud-based content management platform, available on commercial PCs distributed in the U.S., giving a major lift to our software growth strategy. Sales of Ownership Interests in Fuji Xerox Co., Ltd. and Xerox International Partners In November 2019, Xerox Holdings completed a series of transactions to restructure its relationship with FUJIFILM Holdings Corporation (FH), including the sale of its indirect 25% equity interest in Fuji Xerox (FX) for approximately $2.2 billion as well as the sale of its indirect 51% partnership interest in Xerox International Partners (XIP) for approximately $23 million (collectively the Sales). As a result of the Sales and the related strategic shift in our business, the historical financial results of our equity method investment in FX and our XIP business (which was consolidated) for the periods prior to the Sales, are reflected as a discontinued operation and their impact is excluded from continuing operations for all periods presented. The transactions with FH also included an OEM license agreement by and between FX and Xerox, granting FX the right to use specific Xerox Intellectual Property (IP) in providing certain named original equipment manufacturers (OEM’s) with products (such as printer engines) in exchange for an upfront license fee of $77 million. The license fee is recorded within Rental and other revenues (Services, maintenance and rentals). In addition, arrangements with FX whereby we purchase inventory from and sell inventory to FX, will continue after the Sales and, as a result of our Technology Agreement with Fuji Xerox which remains in effect through March 2021, we will continue to receive royalty payments for FX’s use of our Xerox brand trademark, as well as rights to access our patent portfolio in exchange for access to their patent portfolio. Lastly, the transactions included the dismissal of the $1 billion lawsuit FH had filed against Xerox after the termination in May 2018 of the proposed merger among FH/FX and Xerox announced in January 2018. Refer to Note 7 - Divestitures and Note 21 - Contingencies and Litigation for additional information regarding the divestiture and other transactions with FH, as well as Note 27 - Subsequent Events for additional information regarding our Technology Agreement with FX, in the Consolidated Financial Statements. Xerox 2019 Annual Report 23 The $77 million ($58 million after-tax) OEM license had the following impact on our financial results for the Fourth Quarter 2019 and Full Year 2019: _____________ CC - See "Currency Impact" section for description of Constant Currency. (1) Refer to the "Non-GAAP Financial Measures" section for an explanation of the non-GAAP financial measure. Proposed Transaction with HP Inc. In November 2019, Xerox proposed a business combination transaction with HP Inc. (HP) in which HP shareholders would receive $22 per share comprised of $17 per share in cash, and 0.137 shares of Xerox for each HP share. In January 2020, Xerox obtained $24 billion in financing commitments to support the proposed business combination transaction with HP. HP has rejected the proposal and refused to engage in mutual due diligence or negotiations regarding the proposal. In January 2020, Xerox nominated a slate of directors to HP’s board to be voted on at HP’s 2020 annual meeting of stockholders. Xerox intends to continue to pursue the proposed business combination transaction. In February 2020, Xerox increased its offer to HP shareholders to $24 per share comprised of $18.40 per share in cash and 0.149 shares of Xerox for each HP share. Refer to Note 27 - Subsequent Events in the Consolidated Financial Statements for additional information regarding the committed financing obtained in January 2020. Financial Overview Total revenue of $9.1 billion in 2019 decreased 6.2% from the prior year, including a 1.5-percentage point unfavorable impact from currency and a 0.8-percentage point favorable impact from the upfront OEM license fee of $77 million. The decrease in revenue reflected a 6.4% decrease in Post sale revenue, including a 1.5-percentage point unfavorable impact from currency and a 1.0-percentage point favorable impact from the OEM license; and a 5.3% decrease in Equipment sales revenue, including a 1.3-percentage point unfavorable impact from currency. The decline in Post sale revenue reflected the continuing trends of lower page volumes, an ongoing competitive price environment and a lower population of devices, as well as lower transactional revenue from unbundled supplies and paper primarily in our Latin America region. The decline in Equipment sales primarily reflected the impact of lower revenues from our mid-range products, which were partially impacted by organizational changes within the XBS sales organization that included the transition of a significant number of customer accounts from U.S. Enterprise in the first half of 2019. The impacts from the XBS organizational changes began to lessen in the second half of 2019. Net income from continuing operations attributable to Xerox was as follows: Xerox 2019 Annual Report 24 Net income from continuing operations attributable to Xerox for 2019 increased $342 million as compared to the prior year reflecting lower Other expenses, net, Transaction and related costs, net and Income taxes, partially offset by higher Restructuring and related costs. In addition, lower revenues were more than offset by cost and expense savings from our Project Own It transformation actions. Adjusted1 net income from continuing operations attributable to Xerox for 2019 increased $83 million as compared to the prior year primarily related to increased operating profits reflecting the continued benefits of cost and expense savings from Project Own It, which more than offset revenue declines. Adjustments in 2019 include Restructuring and related costs, Amortization of intangible assets, Transaction and related costs, net as well as non-service retirement-related costs and other discrete, unusual or infrequent items. Operating cash flow provided by continuing operations was $1,244 million in 2019 as compared to $1,082 million in 2018. The increase is primarily due to higher profits, which includes the benefit of the one-time upfront OEM license fee of $77 million, lower cash payments for restructuring, lower cash payments for Transaction and related costs, net, improved working capital2 and lower placements of equipment on operating leases, all of which were partially offset by lower run-off of finance receivables. Cash used in investing activities of continuing operations was $85 million in 2019 reflecting capital expenditures of $65 million and acquisitions of $42 million, which were partially offset by $21 million from the sale of non-core business assets. Cash used in financing activities was $1,834 million in 2019 reflecting payments of $960 million on Senior Notes, $600 million for share repurchases and dividend payments of $243 million. _____________ (1) Refer to the "Non-GAAP Financial Measures" section for an explanation of this non-GAAP financial measure. (2) Working capital reflects Accounts receivable, net, Inventories, Accounts payable and Accrued compensation and benefits cost. 2020 Outlook We expect total revenues to decline in 2020 by approximately 5.0%, or approximately 4.0% excluding the impact of revenue from the $77 million OEM license fee in 2019. We expect a minimal impact from translation currency on total revenues in 2020 based on January 2020 exchange rates. Both reported and adjusted1 earnings are expected to improve slightly from 2019, after excluding the impact of the OEM license, reflecting the continued benefits of cost reductions, which are expected to offset the impact of the projected decline in revenues. We expect 2020 operating cash flows from continuing operations to be approximately $1.3 billion, with capital expenditures of approximately $100 million. Our capital allocation plan for 2020 includes expected share repurchase by Xerox Holdings of at least $300 million. Macro Economic and Market Factors Tariffs - Our business, results of operations and financial condition may be negatively impacted by a potential increase in the cost of our products as a result of new or incremental trade protection measures such as, increased import tariffs, import or export restrictions and requirements and the revocation or material modification of trade agreements. In 2019, incremental tariff costs negatively impacted gross margin but the impact was minimal on a full year basis since the new tariffs were not effective until the fourth quarter. However, we do expect margins to be negatively impacted in future periods as a result of an increase in the cost of our imported products due to higher import tariffs. We are taking actions to mitigate the impact of these tariffs, such as raising prices on certain products, however, we currently estimate a year-over-year cost impact of approximately $20 million from higher tariffs in 2020. Brexit - In 2016, the U.K. approved an exit from the E.U., commonly referred to as Brexit and the U.K. withdrew from the E.U. on January 31, 2020. The future relationship between the U.K. and the E.U. remains uncertain as the U.K. and the E.U. work through the transition period that provides time for them to negotiate the details of their future relationship. The transition period is currently expected to end on December 31, 2020, and, if no agreement is reached, the default scenario would be a “no-deal” Brexit. In the event of a no-deal Brexit, the U.K. will leave the E.U. with no agreements in place beyond any temporary arrangements that have or may be put in place by the E.U. or individual E.U. Member States, and the U.K. as part of no-deal contingency efforts and those conferred by mutual membership of the World Trade Organization. Given the lack of comparable precedent, it is unclear what financial, trade and legal implications the U.K. leaving the E.U. with no agreements in place would have and how such withdrawal would affect us. Brexit creates global political and economic uncertainty, which may cause, among other consequences, volatility in exchange rates and interest rates and changes in regulations. Additionally, there may be potential risks to our supply chain including additional administrative requirements, customs delays, and possibly tariffs. We currently do not believe that these and other related effects will have a material impact on the Company’s consolidated financial position or operating results. However, we continue to assess the situation and expect to take any necessary steps to mitigate Xerox 2019 Annual Report 25 the potential volatility, increased costs or disruptions to our supply chain that may result from this matter. For the year ended December 31, 2019, revenues and assets in Europe, including the U.K., represented approximately 25% of our consolidated revenues and total assets, respectively. Coronavirus (COVID-19) - Xerox has no sales operations in China or South Korea, but sources a significant amount of product and/or components there. At this time, the coronavirus outbreak in China and South Korea has not impacted the company’s operations. Xerox is actively assessing possible implications to its supply chain and planned customer delivery on a daily basis to minimize any potential disruption and impact. Our suppliers in the affected regions are slowly resuming their operations. We continue to regularly communicate with suppliers and transportation partners and are currently activating business continuity plans and mitigation strategies as appropriate, including but not limited to premium airfreight, alternate sourcing, asset recovery and reverse logistics covering equipment, supplies and parts. If the coronavirus becomes more prevalent in the western hemisphere and businesses require their office employees to work from home for an extended period of time, sales and use of Xerox products and services could decline. Currency Impact To understand the trends in the business, we believe that it is helpful to analyze the impact of changes in the translation of foreign currencies into U.S. Dollars on revenue and expenses. We refer to this analysis as "constant currency", “currency impact” or “the impact from currency.” This impact is calculated by translating current period activity in local currency using the comparable prior year period's currency translation rate and is calculated for all countries where the functional currency is the local country currency. We do not hedge the translation effect of revenues or expenses denominated in currencies where the local currency is the functional currency. Management believes the constant currency measure provides investors an additional perspective on revenue trends. Currency impact can be determined as the difference between actual growth rates and constant currency growth rates. Approximately 40% of our consolidated revenues are derived from operations outside of the United States where the U.S. Dollar is normally not the functional currency. As a result, foreign currency translation had a 1.5-percentage point unfavorable impact on revenue in 2019 and a 0.7-percentage point favorable impact on revenue in 2018. Application of Critical Accounting Policies In preparing our Consolidated Financial Statements and accounting for the underlying transactions and balances, we apply various accounting policies. Senior management has discussed the development and selection of the critical accounting policies, estimates and related disclosures included herein with the Audit Committee of the Board of Directors. We consider the policies discussed below as critical to understanding our Consolidated Financial Statements, as their application places the most significant demands on management's judgment, since financial reporting results rely on estimates of the effects of matters that are inherently uncertain. In instances where different estimates could have reasonably been used, we disclosed the impact of these different estimates on our operations. In certain instances, such as revenue recognition for leases, the accounting rules are prescriptive; therefore, it would not have been possible to reasonably use different estimates. Changes in assumptions and estimates are reflected in the period in which they occur. The impact of such changes could be material to our results of operations and financial condition in any quarterly or annual period. Specific risks associated with these critical accounting policies are discussed throughout the MD&A, where such policies affect our reported and expected financial results. For a detailed discussion of the application of these and other accounting policies, refer to Note 1 - Basis of Presentation and Summary of Significant Accounting Policies in the Consolidated Financial Statements. Revenue Recognition Application of the various accounting principles in GAAP related to the measurement and recognition of revenue requires us to make judgments and estimates. Complex arrangements with nonstandard terms and conditions may require significant contract interpretation to determine the appropriate accounting. On January 1, 2018, we adopted ASU 2014-09, Revenue from Contracts with Customers (ASC Topic 606), which superseded nearly all existing revenue recognition guidance under U.S. GAAP. Refer to Note 4 - Revenue, in the Consolidated Financial Statements as well as Note 1 - Basis of Presentation and Summary of Significant Accounting Policies - Revenue Recognition - for additional information regarding our revenue recognition policies. Specifically, the revenue related to the following areas involves significant judgments and estimates: Bundled Lease Arrangements: We sell our equipment direct to end customers under bundled lease arrangements, which typically include the equipment, service, supplies and a financing component for which the customer pays a single negotiated monthly fixed minimum monthly payment for all elements over the contractual lease term. Sales made under bundled lease arrangements directly to end customers comprise approximately 35% of our equipment Xerox 2019 Annual Report 26 sales revenue. Revenues under bundled arrangements are allocated considering the relative standalone selling prices of the lease and non-lease deliverables included in the bundled arrangement. Lease deliverables include the equipment, financing, maintenance and other executory costs, while non-lease deliverables generally consist of the supplies and non-maintenance services. Sales to Distributors and Resellers: We utilize distributors and resellers to sell many of our technology products, supplies and services to end-user customers. Sales to distributors and resellers are generally recognized as revenue when products are shipped to such distributors and resellers. Distributors and resellers participate in various discount, rebate, price-support, cooperative marketing and other programs, and we record provisions and allowances for these programs as a reduction to revenue when the sales occur. Similarly, we also record estimates for sales returns and other discounts and allowances when the sales occur. We consider various factors, including a review of specific transactions and programs, historical experience and market and economic conditions when calculating these provisions and allowances. Total sales of equipment, supplies and parts to distributors and resellers were $1,343 million for the year ended December 31, 2019 and provisions and allowances recorded on these sales were approximately 25% of the associated gross revenues. Allowance for Doubtful Accounts and Credit Losses We continuously monitor collections and payments from our customers and maintain a provision for estimated credit losses based upon our historical experience adjusted for current conditions. We recorded bad debt provisions of $46 million, $36 million and $33 million in Selling, administrative and general (SAG) expenses in our Consolidated Statements of Income for the years ended December 31, 2019, 2018 and 2017, respectively. Although bad debt provisions increased in 2019, the provision continues to reflect the maintenance of a prudent credit policy. Reserves, as a percentage of trade and finance receivables, were 3.0% at December 31, 2019, as compared to 3.0% and 3.2% at December 31, 2018 and 2017, respectively. We continue to assess our receivable portfolio in light of the current economic environment and its impact on our estimation of the adequacy of the allowance for doubtful accounts. As discussed above, we estimated our provision for doubtful accounts based on historical experience and customer-specific collection issues. This methodology was consistently applied for all periods presented. During the five year period ended December 31, 2019, our reserve for doubtful accounts ranged from 3.0% to 3.7% of gross receivables. Holding all assumptions constant, a 0.5-percentage point increase or decrease in the reserve from the December 31, 2019 rate of 3.0% would change the 2019 provision by approximately $24 million. Refer to Note 8 - Accounts Receivable, Net and Note 9 - Finance Receivables, Net in the Consolidated Financial Statements for additional information regarding our allowance for doubtful accounts. Pension Plan Assumptions We sponsor defined benefit pension plans in various forms in several countries covering employees who meet eligibility requirements. Where legally possible, we have amended our major defined benefit pension plans to freeze current benefits and eliminate benefit accruals for future service, including our primary U.S. defined benefit plan for salaried employees, the Canadian Salary Pension Plan and the U.K. Final Salary Pension Plan. In certain Non-U.S. plans, we are required to continue to consider salary increases and inflation in determining the benefit obligation related to prior service. The Netherlands defined benefit pension plan has also been amended to reflect the Company's ability to reduce the indexation of future pension benefits within the plan in scenarios when the returns on plan assets are insufficient to cover that indexation. Several statistical and other factors that attempt to anticipate future events are used in calculating the expense, liability and asset values related to our defined benefit pension plans. These factors include assumptions we make about the expected return on plan assets, discount rate, lump-sum settlement rates, the rate of future compensation increases and mortality. Differences between these assumptions and actual experiences are reported as net actuarial gains and losses and are subject to amortization to net periodic benefit cost over future periods. Cumulative net actuarial losses for our defined benefit pension plans of $2.5 billion as of December 31, 2019 increased by $131 million from December 31, 2018, primarily due to the impact of lower discount rates and the resultant increase in the Pension Benefit Obligation as well as negative currency, partially offset by the excess of actual returns over expected returns and the recognition of actuarial losses through amortization and U.S. settlement losses. The total actuarial loss at December 31, 2019 is subject to offsetting gains or losses in the future due to changes in actuarial assumptions and will be recognized in future periods through amortization or settlement losses. We used a consolidated weighted average expected rate of return on plan assets of 4.6% for 2019, 4.5% for 2018 and 5.0% for 2017, on a worldwide basis. During 2019, the actual return on plan assets was a $1.2 billion gain as compared Xerox 2019 Annual Report 27 to an expected return of $443 million, with the difference largely due to positive equity market returns and the positive impact of decreasing interest rates on our fixed income investments. When estimating the 2020 expected rate of return, in addition to assessing recent performance, we considered the historical returns earned on plan assets, the rates of return expected in the future, particularly in light of current economic conditions, and our investment strategy and asset mix with respect to the plans' funds. The weighted average expected rate of return on plan assets we will use in 2020 is 4.1% with the decrease from 2019 in our non-U.S. plans. Another significant assumption affecting our defined benefit pension obligations and the net periodic benefit cost is the rate that we use to discount our future anticipated benefit obligations. In the U.S. and the U.K., which comprise approximately 75% of our projected benefit obligation, we consider the Moody's Aa Corporate Bond Index and the International Index Company's iBoxx Sterling Corporate AA Cash Bond Index, respectively, in the determination of the appropriate discount rate assumptions. The consolidated weighted average discount rate we used to measure our pension obligations as of December 31, 2019 and to calculate our 2020 expense was 2.3%; the rate used to calculate our obligations as of December 31, 2018 and our 2019 expense was 3.2%. The decrease reflects lower interest rates in both U.S. and non-U.S. regions. Holding all other assumptions constant, the following table summarizes the estimated impacts of a 0.25% change in the discount rate and a 0.25% change in the expected return on plan assets: One of the most significant and volatile elements of our net periodic defined benefit pension plan expense is settlement losses. Our primary domestic plans allow participants the option of settling their vested benefits through the receipt of a lump-sum payment. We recognize the losses associated with these settlements immediately upon the settlement of the vested benefits. Settlement accounting requires us to recognize a pro-rata portion of the aggregate unamortized net actuarial losses upon settlement. As noted above, cumulative unamortized net actuarial losses were $2.5 billion at December 31, 2019, of which the U.S. primary domestic plans, with a lump-sum feature, represented approximately $910 million. The pro-rata factor is computed as the percentage reduction in the projected benefit obligation due to the settlement of a participant's vested benefit. Settlement accounting is only applied when the event of settlement occurs - i.e. the lump-sum payment is made. Since settlement is dependent on an employee's decision and election, the level of settlements and the associated losses can fluctuate significantly from period to period. During the three years ended December 31, 2019, 2018 and 2017, U.S. plan settlements were $355 million, $660 million and $550 million, respectively, and the associated settlement losses on those plan settlements were $93 million, $173 million and $133 million, respectively. In 2020, on average, we estimate that approximately $100 million of plan settlements will result in settlement losses of approximately $25 million. The following is a summary of our benefit plan costs for the three years ended December 31, 2019, 2018 and 2017, as well as estimated amounts for 2020: _____________ (1) Excludes U.S. settlement losses. Xerox 2019 Annual Report 28 The following is a summary of our benefit plan funding for the three years ended December 31, 2019, 2018 and 2017, as well as estimated amounts for 2020: Contributions to our U.S. defined benefit plans in 2019 and estimated for 2020 are primarily for payments associated with our non-qualified plan in the U.S. and do not include any contributions for our tax-qualified defined benefit plans because none were required to meet the minimum funding requirements. Refer to Note 19 - Employee Benefit Plans in the Consolidated Financial Statements for additional information regarding defined benefit pension plan assumptions, expense and funding. Income Taxes We are subject to income taxes in the U.S. and numerous foreign jurisdictions. Significant judgments are required in determining the consolidated provision for income taxes. Our provision is based on nonrecurring events as well as recurring factors, including the taxation of foreign income. In addition, our provision will change based on discrete or other nonrecurring events such as audit settlements, tax law changes, changes in valuation allowances, etc., that may not be predictable. We record the estimated future tax effects of temporary differences between the tax bases of assets and liabilities and amounts reported in our Consolidated Balance Sheets, as well as operating loss and tax credit carryforwards. We regularly review our deferred tax assets for recoverability considering historical profitability, projected future taxable income, the expected timing of the reversals of existing temporary differences and tax planning strategies. Refer to Note 20 - Income and Other Taxes in the Consolidated Financial Statements for additional information regarding the valuation of our allowance against our deferred tax assets. Increases to our valuation allowance, through income tax expense, were $16 million, $3 million and $6 million for the years ended December 31, 2019, 2018 and 2017, respectively. There were other (decreases) increases to our valuation allowance, including the effects of currency, of $(14) million, $(41) million and $13 million for the years ended December 31, 2019, 2018 and 2017, respectively. These did not affect income tax expense in total as there was a corresponding adjustment to Deferred tax assets or Other comprehensive (loss) income. The following is a summary of gross deferred tax assets and the related valuation allowances for the three years ended December 31, 2019: We are subject to ongoing tax examinations and assessments in various jurisdictions. Accordingly, we may incur additional tax expense based upon our assessment of the more-likely-than-not outcomes of such matters. In addition, when applicable, we adjust the previously recorded tax expense to reflect examination results. Our ongoing assessments of the more-likely-than-not outcomes of the examinations and related tax positions require judgment and can materially increase or decrease our effective tax rate, as well as impact our operating results. Unrecognized tax benefits were $127 million, $108 million and $125 million at December 31, 2019, 2018 and 2017, respectively. On December 22, 2017, the Tax Cuts and Jobs Act (the Tax Act) was enacted in the U.S. The Tax Act significantly revised the U.S. corporate income tax system by, among other things, lowering the U.S. statutory corporate income tax rate from 35% to 21% and implementing a territorial tax system that includes a one-time transition tax on deemed repatriated earnings of foreign subsidiaries. Refer to Note 20 - Income and Other Taxes in the Consolidated Financial Statements for additional information regarding deferred income taxes, unrecognized tax benefits and the estimated impacts of the Tax Act. Xerox 2019 Annual Report 29 Business Combinations and Goodwill We allocate the fair value of purchase consideration to tangible assets, liabilities assumed and intangible assets acquired based on their estimated fair values. The excess of the fair value of purchase consideration over the fair values of these identifiable assets and liabilities is allocated to Goodwill. The allocation of the purchase consideration requires management to make significant estimates and assumptions, especially with respect to intangible assets. These estimates can include, but are not limited to, future expected cash flows of acquired customers, acquired technology and trade names from a market participant perspective, as well as estimates of useful lives and discount rates. Management’s estimates of fair value are based upon assumptions believed to be reasonable and when appropriate, include assistance from independent third-party valuation firms. During the measurement period, which is up to 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. Refer to Note 6 - Acquisitions in the Consolidated Financial Statements for additional information regarding the allocation of the purchase price consideration for our acquisitions. Our Goodwill balance was $3.9 billion at December 31, 2019. We assess Goodwill for impairment at least annually, during the fourth quarter based on balances as of October 1st, and more frequently if we believe indicators of impairment exist. The application of the annual Goodwill impairment test begins with the identification of reporting units, which requires judgment. Consistent with the determination that we had one operating segment, we determined that there is one reporting unit and therefore we tested Goodwill for impairment at the Company or entity level. The process of evaluating the potential impairment of goodwill is highly subjective and requires significant judgment. Our review of impairment starts with an assessment of qualitative factors to determine whether events or circumstances lead to a determination that it is more-likely-than-not that the fair value of the Company is less than net book value. Our qualitative assessment of the recoverability of goodwill, whether performed annually or based on specific events or circumstances, considers various macroeconomic, industry-specific and company-specific factors. These factors include: (i) severe adverse industry or economic trends; (ii) significant company-specific actions, including exiting an activity in conjunction with restructuring of operations; (iii) current, historical or projected deterioration of our financial performance; or (iv) a sustained decrease in our market capitalization below our net book value. After assessing the totality of events and circumstances, if we determine that it is not more-likely-than-not that the fair value of the Company is less than its net book value, no further assessment is performed. If we determine that it is more likely-than-not that the fair value of the Company is less than net book value, we move to a quantitative assessment or test of goodwill. If a quantitative test of goodwill is required, the determination of the fair value of the Company will involve the use of significant estimates and assumptions. Our quantitative goodwill impairment test uses both the income approach and the market approach to estimate fair value. The income approach is based on the discounted cash flow method that uses the Company's estimates for forecasted future financial performance including revenues, operating expenses, and taxes, as well as working capital and capital asset requirements. These estimates are developed as part of our long-term planning process based on assumed market segment growth rates and our assumed market segment share, estimated costs based on historical data and various internal estimates. Projected cash flows are then discounted to a present value employing a discount rate that properly accounts for the estimated market weighted-average cost of capital, as well as any risk unique to the subject cash flows. When performing our market approach, we rely specifically on the guideline public company method. Our guideline public company method incorporates revenues and earnings multiples from publicly traded companies with operations and other characteristics similar to our entity. The selected multiples consider entity's relative growth, profitability, size and risk relative to the selected publicly traded companies. In performing our 2019 annual Goodwill impairment test as of October 1st, we qualitatively assessed our Goodwill balance for impairment and concluded that Goodwill was not impaired. In performing the qualitative assessment, we considered the prior year excess of fair value over carrying value and, as noted previously, relevant events and conditions, including but not limited to, macroeconomic trends, industry and market conditions, overall financial performance, cost factors, company-specific events, and legal and regulatory factors including our current market capitalization in relation to our net book value. Our assessment indicated that consistent with the prior year assessment, we expect to offset revenue declines over the next year with cost reductions and productivity improvements. Accordingly, expected net cash flows were consistent with prior period projections. Subsequent to our fourth quarter impairment test, we did not identify any indicators of potential impairment that required an update to the annual impairment test. Refer to Note 13 - Goodwill and Intangible Assets, Net in the Consolidated Financial Statements for additional information regarding Goodwill. Xerox 2019 Annual Report 30 Revenue Results Summary Total Revenue Revenue for the three years ended December 31, 2019, 2018 and 2017 was as follows: _____________ CC - See "Currency Impact" section for description of Constant Currency. (1) Certain prior year amounts have been conformed to the current year presentation. Refer to Note 1 - Basis of Presentation and Summary of Significant Accounting Policies in the Consolidated Financial Statements for additional information. (2) In 2018, upon adoption of ASU 2014-09 Revenue Recognition, revenue from training related to equipment installation is now included in Equipment Sales. In 2017, this revenue was reported as Services, maintenance and rentals. (3)Refer to the "Geographic Sales Channels and Product and Offerings Definitions" section. (4) Includes equipment sale revenue of $433 million, $484 million and $458 million for the three years ended December 31, 2019, 2018 and 2017 respectively. Revenue Total revenue decreased 6.2% for the year ended December 31, 2019 including a 1.5-percentage point unfavorable impact from currency and an approximate 0.8-percentage point favorable impact from the OEM license fee. Total revenue decreased 3.3% for the year ended December 31, 2018 compared to the prior year, including a 0.7-percentage point favorable impact from currency. Total revenues included the following: Post sale revenue Post sale revenue primarily reflects contracted services, equipment maintenance, supplies and financing. These revenues are associated not only with the population of devices in the field, which is affected by installs and removals, but also by page volumes generated by the usage of such devices, and the revenue per printed page. Post sale revenue also includes transactional IT hardware sales and implementation services from our XBS organization. For the year ended December 31, 2019, Post sale revenue decreased 6.4% compared to the prior year including a 1.5-percentage point unfavorable impact from currency and an approximate 1.0-percentage point favorable impact from the OEM license fee. For the year ended December 31, 2018, Post sale revenue decreased 4.0% compared to the prior year including a 0.7-percentage point favorable impact from currency. Xerox 2019 Annual Report 31 Post sale revenue is comprised of the following: • Services, maintenance and rentals revenue includes rental and maintenance revenue (including bundled supplies) as well as the post sale component of the document services revenue from our Xerox Services offerings. ◦ For the year ended December 31, 2019, these revenues decreased 5.8%, including a 1.4-percentage point unfavorable impact from currency and an approximate 1.3-percentage point favorable impact from the OEM license fee. The decline at constant currency1 reflected the continuing trends of lower page volumes (including a higher mix of lower usage products), an ongoing competitive price environment and a lower population of devices, which are partially associated with continued lower Enterprise signings and lower installs from prior and current periods. These declines were larger in the U.S. during the first half as a result of organizational changes being implemented as part of our Project Own It transformation actions. The impact began to moderate late in the second quarter, and was much less in the second half of 2019. ◦ For the year ended December 31, 2018, these revenues decreased 5.5%, including a 0.2-percentage point favorable impact from currency. The decline at constant currency1 reflected the continuing trends of lower page volumes (including a higher mix of lower usage products), an ongoing competitive price environment and a lower population of devices, which are partially associated with continued lower signings and installs from prior periods. The lower population of devices is partially due to the loss of market share for multiple quarters leading up to the ConnectKey launch in mid-2017. Additionally, the prior year included $20 million of higher revenues associated with a licensing agreement. These impacts were partially offset by higher revenues from Xerox Services (formerly Managed Document Services) and our Xerox Business Solutions (XBS) business, formerly known as Global Imaging Systems, inclusive of acquisitions. • Supplies, paper and other sales includes unbundled supplies and other sales. ◦ For the year ended December 31, 2019, these revenues decreased 8.7%, including a 1.3-percentage point unfavorable impact from currency. The decline at constant currency1 primarily reflected the impact of lower supplies revenues, primarily associated with lower page volume trends as well as the impact of lower paper sales from developing markets (primarily from the Latin America region). ◦ For the year ended December 31, 2018, these revenues increased 1.3%, including a 0.1-percentage point unfavorable impact from currency. The increase reflects higher paper sales and higher IT sales from our XBS business. • Financing revenue is generated from financed equipment sale transactions. For the year ended December 31, 2019, Financing revenue decreased 9.0%, including a 1.5-percentage point unfavorable impact from currency, while Financing revenue for the year ended December 31, 2018 decreased 8.8% including a 1.2-percentage point favorable impact from currency. The decline in both periods reflected a continued decline in finance receivables balance due to lower equipment sales in prior periods and a greater mix of equipment sales to channels where our financing penetration rate and return is lower. Equipment sales revenue Equipment revenue for the three years ended December 31, 2019 was as follows: _____________ CC - See "Currency Impact" section for description of Constant Currency. (1) In 2018, upon adoption of ASU 2014-09 Revenue Recognition, revenue from training related to equipment installation is now included in Equipment sales (previously included in Post sale revenue). Prior year amounts have been adjusted to conform to this change. Equipment sales revenue Equipment sales revenue decreased 5.3% for the year ended December 31, 2019 including a 1.3-percentage point unfavorable impact from currency. The decline at constant currency1 was primarily driven by lower sales of our office-centric devices (entry and mid-range products) partially offset by higher sales of our production-centric devices (high-end) as well as the benefit of targeted price actions. For the year ended December 31, 2018, Equipment sales decreased 0.8% including a 0.4-percentage point favorable impact from currency. Equipment sales revenue in both years was impacted by price declines of approximately 5% (which were in-line with our historic declines). Xerox 2019 Annual Report 32 The change at constant currency1 reflected the following: • Entry ◦ For the year ended December 31, 2019, the decrease reflected lower sales of devices primarily in the indirect channels in EMEA, reflecting continued weakness and delayed decisions as a result of uncertainty in the economic environment, as well as lower revenues from our indirect channels in the U.S., reflecting targeted price investments in the fourth quarter of 2019, partially offset by higher installs. ◦ For the year ended December 31, 2018, the increase reflected higher sales of our ConnectKey devices through our indirect channels in the U.S. and developing markets. • Mid-range ◦ For the year ended December 31, 2019, the decrease reflected lower sales from our XBS sales organization, which continued to recover from the impact of organizational changes in the first half of 2019 that were implemented as part of our Project Own It transformation actions (including the transitioning of accounts to implement coverage changes, consolidation of real estate location and reduction of management layers), as well as lower revenues from our indirect channels in the U.S. and EMEA. The decrease was partially offset by higher revenues from our U.S. Enterprise organization, which had higher activity from light-production devices associated with the recent launch of PrimeLink (an entry-level production printer) and the benefit of a large account refresh in the second half. ◦ For the year ended December 31, 2018, the increase reflected higher sales of our ConnectKey devices through our Enterprise channel in the U.S., higher sales of lower-end devices in developing markets and higher sales from our XBS business. • High-end ◦ For the year ended December 31, 2019, the increase primarily reflected higher sales of color systems associated with continued demand for our Iridesse production press, as well as global demand for our newly-launched Baltoro inkjet press. The increase also reflected higher revenues from our U.S. Enterprise organization and from our indirect channels in the U.S., which was partially offset by lower revenues in EMEA, as well as lower sales from Versant (our lower-end production devices) and iGen print production systems. ◦ For the year ended December 31, 2018, the decrease primarily reflected lower sales from iGen, along with lower revenues from black-and-white systems consistent with market decline trends. These declines were only partially mitigated by demand for the Iridesse production press, as well as higher sales from our recently upgraded Brenva cut-sheet inkjet press. Revenue Metrics Installs reflect new placement of devices only (i.e., measure does not take into account removal of devices which may occur as a result of contract renewals or cancellations). Revenue associated with equipment installations may be reflected up-front Equipment sales or over time through rental income or as part of our Xerox Services revenues (which are both reported within our Post sale revenues), depending on the terms and conditions of our agreements with customers. Install activity includes Xerox Services and Xerox-branded products shipped to our XBS sales unit. Detail by product group (see Geographic Sales Channels and Product and Offerings Definitions) is shown below: Installs for the year ended December 31, 2019 were: Entry • Color multifunction devices were flat, reflecting higher installs of ConnectKey products primarily from our indirect channels in the U.S., offset by lower installs of devices from EMEA. • 4% decrease in black-and-white multifunction devices, reflecting lower activity primarily from U.S. Enterprise and EMEA, as well as from our developing regions in the Americas, partially offset by higher activity from our indirect channels in Canada, as well as XBS. Mid-Range(1) • 7% decrease in mid-range color installs, primarily reflecting lower installs of multifunction color devices through our U.S. enterprise, partially offset by higher installs of light-production devices that sit at the higher end of the portfolio range. • 17% decrease in mid-range black-and-white, reflecting, in part, global market trends. High-End(1) • 4% decrease in high-end color installs primarily reflecting lower activity from iGen and Versant production systems, partially offset by global demand for our newly-launched Baltoro inkjet press and continued strong demand for our Iridesse production press. • 14% decrease in high-end black-and-white systems reflecting global market trends. Xerox 2019 Annual Report 33 Installs for the year ended December 31, 2018 were: Entry • 12% increase in color multifunction devices, reflecting higher installs of our ConnectKey products through our indirect channels in the U.S. and Europe, as well as through our XBS business. • 17% increase in black-and-white multifunction devices, driven largely by higher activity from low-end devices in developing markets as well as higher installs of our ConnectKey devices through our indirect channels in the U.S. and Europe. Mid-Range(1) • 10% increase in mid-range color installs, reflecting higher demand from our ConnectKey devices through our large enterprise channel and our XBS business, as well as lower-end A3 devices in developing markets. • 8% increase in mid-range black-and-white, reflecting higher demand for our ConnectKey devices in our XBS business and developing markets. High-End(1) • 9% decrease in high-end color systems, as demand for our new Iridesse production press and cut-sheet inkjet products was offset by lower installs of iGen and lower-end production systems including Versant systems. • 18% decrease in high-end black-and-white systems reflecting market trends, partially offset by increased demand in our indirect U.S. channels and our developing markets. _____________ (1) Mid-range and High-end color installations exclude Fuji Xerox digital front-end sales; including Fuji Xerox digital front-end sales, Mid-range color devices decreased 7% and increased 9% for the years ended December 31, 2019 and 2018, respectively, while High-end color systems decreased 4% and 9% for the years ended December 31, 2019 and 2018, respectively. Geographic Sales Channels and Product and Offerings Definitions Our business is aligned to a geographic focus and is primarily organized on the basis of go-to-market sales channels, which are structured to serve a range of customers for our products and services. In 2019, we changed our geographic structure to create a more streamlined, flatter and more effective organization, as follows: • Americas, which includes our sales channels in the U.S. and Canada, as well as Mexico, and Central and South America. • EMEA, which includes our sales channels in Europe, the Middle East, Africa and India. • Other, which primarily includes sales to and royalties from Fuji Xerox, and our licensing revenue. Our products and offerings include: • “Entry”, which includes A4 devices and desktop printers. Prices in this product group can range from approximately $150 to $3,000. • “Mid-Range”, which includes A3 Office and Light Production devices that generally serve workgroup environments in mid to large enterprises. Prices in this product group can range from approximately $2,000 to $75,000+. • “High-End”, which includes production printing and publishing systems that generally serve the graphic communications marketplace and large enterprises. Prices for these systems can range from approximately $30,000 to $1,000,000+. • Xerox Services which includes solutions and services that span from managing print to automating processes to managing content. Our primary offerings are Intelligent Workplace Services (IWS), which is our rebranded Managed Print Services, as well as Digital and Cloud Print Services (including centralized print services). Xerox Services also includes Communications and Marketing Solutions. Xerox 2019 Annual Report 34 Costs, Expenses and Other Income Summary of Key Financial Ratios The following is a summary of our key financial ratios used to assess our performance: _____________ (1) Refer to the "Non-GAAP Financial Measures" section for an explanation of the non-GAAP financial measure. Pre-tax Income Margin Pre-tax income margin for the year ended December 31, 2019 of 9.1% increased 3.4-percentage points compared to 2018, including an approximate 0.8-percentage point favorable impact from the $77 million OEM license fee. This increase was primarily driven by lower Other expenses, net, and Transaction and related costs, net. The increase also reflected lower operating costs, primarily associated with the net benefits from our Project Own It transformation actions, which more than offset the adverse impact of lower revenues. These improvements were partially offset by higher Restructuring and related costs. Transaction currency had a 0.3-percentage point unfavorable impact. Pre-tax income margin for the year ended December 31, 2018 of 5.7% increased 0.4-percentage points compared to 2017. This increase was primarily driven by lower Restructuring and related costs and lower Other expenses, net, including lower non-service retirement-related costs. These improvements were partially offset by lower revenues, which were only partially offset by cost reductions from our business transformation actions and higher Transaction and related costs, net. Transaction currency had a 0.5-percentage point favorable impact. Pre-tax income margin includes Restructuring and related costs, the Amortization of intangible assets, Transaction and other related costs and Other expenses, net, all of which are separately discussed in subsequent sections. Adjusted1 Operating margin, discussed below, excludes these items. Adjusted1 Operating Margin Adjusted1 operating margin for the year ended December 31, 2019 of 13.1% increased 1.8-percentage points compared to 2018, primarily reflecting an approximate 0.7-percentage point favorable impact from the $77 million OEM license fee, as well as the impact of cost and expense reductions associated with our Project Own It transformation actions, which more than offset the pace of revenue decline. The increase also reflected a $44 million favorable impact from higher costs in the prior year related to the exit of a surplus real estate facility and the termination of certain IT projects. Adjusted1 operating margin also included a 0.3-percentage point unfavorable impact from transaction currency. Adjusted1 operating margin for the year ended December 31, 2018 of 11.3% was flat as compared to 2017, primarily reflecting cost reductions from our business transformation actions and lower compensation expense. Entirely offsetting these improvements was lower revenues and a 0.4-percentage point unfavorable impact within SAG expenses primarily associated with the exit of a surplus real estate facility (0.2-percentage point) and the termination of certain IT projects (0.2-percentage point). Adjusted1 operating margin also included a 0.4-percentage point favorable impact from transaction currency. _____________ (1) Refer to Operating Income and Margin reconciliation table in the "Non-GAAP Financial Measures" section. Xerox 2019 Annual Report 35 Gross Margin Total gross margin for the year ended December 31, 2019 of 40.3% increased 0.3-percentage points compared to 2018, primarily reflecting an approximate 0.6-percentage point favorable impact from the $77 million OEM license fee, as well as an unfavorable impact from transaction currency of 0.3-percentage points. Gross margin also reflects cost reductions from our business transformation actions as part of Project Own It, which were entirely offset by the impact of targeted pricing actions. Total gross margin for the year ended December 31, 2018 of 40.0% decreased 0.7-percentage points compared to 2017, primarily reflecting a less profitable mix of revenues and the impact of pricing, as well as lower post sale margin, partially offset by higher equipment margin and cost reductions from our business transformation actions. Gross margin includes the favorable impact from transaction currency of 0.4-percentage points. Equipment gross margin for the year ended December 31, 2019 of 32.6% decreased 1.3-percentage points compared to 2018, primarily as a result of targeted pricing actions, which were partially offset by savings from cost productivity, as well as a more profitable mix of revenues from the higher end of the portfolio. Equipment gross margin included the unfavorable impact from transaction currency of 0.8-percentage points. Equipment gross margin for the year ended December 31, 2018 of 33.9% increased 2.4-percentage points compared to 2017, reflecting savings from cost reduction initiatives, partially offset by the impact of pricing and a less profitable mix of revenues. Equipment gross margin included the favorable impact from transaction currency of 1.5-percentage points. Post sale gross margin for the year ended December 31, 2019 of 42.5% increased 0.7-percentage points compared to 2018, including an approximate 0.6-percentage point favorable impact from the $77 million OEM license fee, as well as cost reductions from our business transformation actions, offset by lower revenues and lower pricing on contract renewals. Post sale gross margin for the year ended December 31, 2018 of 41.8% decreased 1.5-percentage points compared to 2017, reflecting lower revenues, including an unfavorable mix of lower maintenance revenues and licensing revenues, as well as the impact of pricing, partially offset by cost reductions. Gross margins are expected to continue to be negatively impacted in future periods as a result of an increase in the cost of our imported products due to higher import tariffs. We are taking actions to mitigate the impact of these tariffs, such as raising prices on certain products, however, we currently estimate a year-over-year cost impact of approximately $20 million from higher tariffs in 2020. Research, Development and Engineering Expenses (RD&E) RD&E as a percentage of revenue for the year ended December 31, 2019 of 4.1% was flat compared to 2018. RD&E of $373 million for the year ended December 31, 2019, decreased $24 million from 2018, reflecting cost reductions from our Project Own It transformation actions, including lower sustaining engineering expenses, partially offset by modest investments in innovation in complementary market areas. RD&E as a percentage of revenue for the year ended December 31, 2018 of 4.1% was 0.1-percentage points lower compared to 2017. RD&E of $397 million for the year ended December 31, 2018 decreased $27 million from 2017 and reflected lower sustaining engineering expenses as well as cost reductions and lower expenses from the sale of a business and associated transfers of resources to third parties during the prior year. These impacts were partially offset by modest investments in innovation in complementary market areas. Xerox 2019 Annual Report 36 Selling, Administrative and General Expenses (SAG) SAG as a percentage of revenue of 23.0% decreased 1.6-percentage points for the year ended December 31, 2019 compared to 2018 primarily reflecting expense reductions from our business transformation actions. The decrease in SAG as a percentage of revenue includes the benefit from a 0.4-percentage point unfavorable impact from the exit of a real estate facility and the cancellation of certain IT projects in 2018. SAG expenses of $2,085 million for the year ended December 31, 2019 were $294 million lower than 2018, including an approximate $30 million unfavorable impact from currency. The decrease primarily reflected expense reductions from our Project Own It transformation actions as well as lower compensation expense; the reduction also includes the favorable impact of $44 million higher costs in 2018 related to the accelerated depreciation associated with the exit of a surplus real estate facility and the termination of certain IT projects. Bad debt expense for the year ended December 31, 2019 was $46 million or $10 million higher than the prior year primarily due to an increased level of sales-type leases as a result of our adoption of ASC Topic 842 - Leases and associated changes in the collectibility assessment of certain leases as well as an increased mix of high-end equipment sales (Refer to Note 3 - Adoption of New Leasing Standard - Lessor in the Consolidated Financial Statements for additional information regarding our adoption of ASC 842). On a trailing twelve-month basis (TTM), bad debt expense remained at less than one percent of total receivables. SAG as a percentage of revenue of 24.6% decreased 0.6-percentage points for the year ended December 31, 2018 compared to 2017 primarily reflecting the expense reductions associated with our business transformation actions. SAG as a percentage of revenue includes a 0.4-percentage point unfavorable impact associated with the exit of a surplus real estate facility and the termination of certain IT projects in 2018. SAG expenses of $2,379 million for the year ended December 31, 2018 were $135 million lower than 2017, including an approximate $14 million unfavorable impact from currency. The reduction primarily reflected expense reductions associated with our business transformation actions along with lower annual performance incentive compensation expense. These improvements were partially offset by $44 million of charges related to the accelerated depreciation from the early termination of a capital lease associated with a surplus facility ($22 million) and the cancellation of certain IT projects ($22 million) as we continue to evaluate the returns on our IT investments. Bad debt expense for the year ended December 31, 2018 was $36 million and was $3 million higher than the prior year and on a trailing twelve month basis (TTM) remained at less than one percent of receivables. Restructuring and Related Costs During the second half of 2018, we started our Project Own It transformation initiative. The primary goal of this initiative is to improve productivity by driving end-to-end transformation of our processes and systems to create organizational effectiveness and to reduce costs. We incurred restructuring and related costs of $229 million for the year ended December 31, 2019, primarily related to costs to implement initiatives under our business transformation projects including Project Own It. The following is a breakdown of those costs: ____________________________ (1) Reflects headcount reductions of approximately 1,000 employees worldwide for the year ended December 31, 2019. (2) Primarily related to the exit and abandonment of leased and owned facilities. For the year ended December 31, 2019, the charge includes the accelerated write-off of $39 million for leased right-of-use assets and $22 million for owned assets upon exit from the facilities, net of any potential sublease income and other recoveries. (3) Primarily includes additional costs incurred upon the exit from our facilities including decommissioning costs and associated contractual termination costs. (4) Reflects net reversals for changes in estimated reserves from prior period initiatives as well as $10 million in favorable adjustments from the early termination of prior period impaired leases for the year ended December 31, 2019. (5) Includes retention related severance and bonuses for employees expected to continue working beyond their minimum retention period before termination. (6) Reflects severance costs and other related costs we are contractually required to pay on employees transferred (approximately 2,200) as part of the shared service arrangement entered into with HCL Technologies. (7) Represents professional support services associated with our business transformation initiatives. Xerox 2019 Annual Report 37 2019 actions impacted several functional areas, with approximately 15% focused on gross margin improvements, approximately 80% focused on SAG reductions, and the remainder focused on RD&E optimization. Restructuring and asset impairment costs were $161 million for the year ended December 31, 2019 and included $81 million of severance costs related to headcount reductions of approximately 1,000 employees worldwide, $19 million of other contractual termination costs and $61 million of asset impairment charges. These costs were partially offset by $34 million of net reversals, primarily resulting from changes in estimated reserves from prior period initiatives as well as $10 million in favorable adjustments from the early termination of prior period impaired leases. The implementation of our Project Own It initiatives as well as other business transformation initiatives is expected to continue to deliver significant cost savings in 2020. While many initiatives are underway and have yet to yield the full transformation benefits expected upon their completion, the changes implemented thus far have improved our cost structure and are beginning to yield longer term benefits. However, expected savings associated with these initiatives may be offset to some extent by business disruption during the implementation phase as well as investments in new processes and systems until the initiatives are fully implemented and stabilized. We expect 2020 pre-tax savings of approximately $90 million from our 2019 restructuring actions. Restructuring and related costs of $157 million for the year ended December 31, 2018 include net restructuring and asset impairment charges of $156 million and $1 million of additional costs, primarily related to professional support services associated with the business transformation initiatives. Net restructuring and asset impairment charges included the following: • $175 million of severance costs related to headcount of approximately 2,700 employees globally. The average restructuring cost per employee was lower in 2018 as compared to 2017 due to the geographic mix of actions as well as reductions in benefits under our employee severance programs particularly with respect to actions in the U.S. The actions impacted multiple functional areas, with approximately 25% of the costs focused on gross margin improvements, 70% focused on SAG reductions and the remainder focused on RD&E optimization. • $14 million for lease termination costs primarily reflecting continued optimization of our worldwide operating locations. The above charges were partially offset by $33 million of net reversals for changes in estimated reserves from prior period initiatives, primarily reflecting unanticipated attrition and other job changes prior to completion of the restructuring initiatives. Restructuring Summary The restructuring reserve balance as of December 31, 2019 for all programs was $70 million, which is expected to be paid over the next twelve months. During 2020, we expect to incur additional restructuring and related charges of approximately $175 million for actions and initiatives that have not yet been finalized. Approximately $75 million of the full year charges are expected to be recognized in the first quarter of the year. Refer to Note 14 - Restructuring Programs in the Consolidated Financial Statements for additional information regarding our restructuring programs. Transaction and Related Costs, Net Transaction and related costs, net, were $12 million in 2019 and reflect approximately $5 million of costs associated with our announced proposal to acquire HP (refer to the “Proposed Transaction with HP Inc.” section in the Executive Overview for additional information). These costs are primarily related to legal costs and other related professional services and are expected to continue in future periods and may include additional types of costs. The remainder of the costs in 2019 related to the proposed combination transaction with Fuji Xerox, which was terminated in May 2018, and primarily include on-going costs for litigation associated with the terminated transaction as well as adjustments and recoveries associated with costs incurred in 2018 (refer to the “Sales of Ownership Interests in Fuji Xerox Co., Ltd. and Xerox International Partners" section in the Executive Overview for additional information regarding the FX transaction litigation). We continue to pursue additional recoveries from insurance carriers and other parties for costs and expenses related to the terminated transaction and therefore additional recoveries and adjustments may be recorded in future periods, when finalized. Transaction and related costs, net, were $68 million in 2018 and reflect costs related to the proposed combination transaction with Fuji Xerox primarily for third-party accounting, legal, consulting and other similar types of services as well as financing costs and costs associated with litigation that resulted from the proposed transaction. These costs were partially offset by insurance recoveries and a settlement refund from a financial adviser that had been associated with the terminated transaction. Xerox 2019 Annual Report 38 Amortization of Intangible Assets Amortization of intangible assets for the three years ended December 31, 2019, 2018 and 2017 was $45 million, $48 million and $53 million, respectively. The decrease of $3 million and $5 million in 2019 and 2018, respectively, as compared to prior year periods is primarily the result of a lower level of acquisitions over the past several years. In 2019, this impact was partially offset by the accelerated write-off of trade names associated with our realignment and consolidation of certain XBS sales units as part of Project Own It. Refer to Note 13 - Goodwill and Intangible Assets, Net in the Consolidated Financial Statements for additional information regarding our intangible assets. Worldwide Employment Worldwide employment was approximately 27,000 as of December 31, 2019 and decreased by approximately 5,400 from December 31, 2018. The reduction resulted from net attrition (attrition net of gross hires), a large portion of which is not expected to be backfilled, as well as the impact of organizational changes, including employees transferred as part of the shared service arrangement entered into with HCL Technologies earlier this year. Refer to the Shared Services Arrangement with HCL Technologies section in the Executive Overview for additional information. Other Expenses, Net Non-financing interest expense Non-financing interest expense for the year ended December 31, 2019 of $105 million was $9 million lower than 2018. When non-financing interest expense is combined with financing interest expense (Cost of financing), total interest expense decreased by $10 million from the prior year. The decrease is primarily due to a lower debt balance reflecting the repayment of approximately $960 million of debt maturing in 2019. Non-financing interest expense for the year ended December 31, 2018 of $114 million was $5 million lower than 2017. When non-financing interest expense is combined with financing interest expense (Cost of financing), total interest expense decreased by $6 million from the prior year. The decrease is primarily due to a lower debt balance reflecting the repayments of approximately $265 million of debt in 2018 and $800 million in 2017. Refer to Note 16 - Debt in the Consolidated Financial Statements for additional information regarding our debt activity as well as information regarding the allocation of interest expense. Non-service retirement-related costs Non-service retirement-related costs decreased $132 million for the year ended December 31, 2019 as compared to the prior year primarily due to the favorable impact of a 2018 amendment to our U.S. Retiree Health Plan and lower losses from pension settlements in the U.S. of $93 million, an $80 million decrease compared to the prior year. Non-service retirement-related costs decreased $38 million for the year ended December 31, 2018 as compared to the prior year primarily due to the favorable impact of higher pension contributions and asset returns in the prior year, as well as the favorable impact of an amendment to our U.S. Retiree Health Plan. The favorable impacts were partially offset by higher losses from pension settlements in the U.S. of $173 million, a $40 million increase compared to the prior year. The higher level of settlements was primarily due to an expected increase in interest rates. Refer to Note 19 - Employee Benefit Plans in the Consolidated Financial Statements for additional information regarding non-service retirement-related costs. Xerox 2019 Annual Report 39 Gain on sales of businesses and assets The gain on sales of businesses and assets in both 2019 and 2018 reflect the sales of non-core business assets. The gain in 2017 includes a gain of $13 million from the sale of a research facility in Grenoble, France. Litigation matters Litigation matters for 2019 were $9 million lower than the prior year reflecting the favorable resolution of certain litigation matters in 2019. Contract termination costs Contract termination costs for 2019 were a $12 million credit reflecting an adjustment to a $43 million penalty recorded in the fourth quarter 2018 associated with the termination of a related IT services arrangement. The penalty was associated with a minimum purchase commitment that would not be fulfilled due to the termination of a related IT services arrangement. The credit in 2019 reflects a change in estimate regarding the expected spending in the run-off of this terminated IT services arrangement and the amount due under the minimum purchase agreement. The minimum purchase commitment had originally been entered into in connection with the sale of our Information Technology Outsourcing (ITO) business in 2015. Loss on sales of accounts receivable Represents the loss incurred on our sales of accounts receivable. The decrease in loss reflects the termination of several receivable sale programs in 2017. Refer to Sales of Accounts Receivable in the Capital Resources and Liquidity section and Note 8 - Accounts Receivable, Net in the Consolidated Financial Statements for additional information regarding our sales of receivables. Loss on early extinguishment of debt During 2017, we recorded a $7 million net loss associated with the repayment of $475 million in Senior Notes, as well as a $13 million loss associated with the tender and exchange of certain Senior Notes. Income Taxes The 2019 effective tax rate was 21.8% and includes a credit of $35 million related to the 2017 Tax Act (the Tax Act) which is discussed below. On an adjusted1 basis, the 2019 effective tax rate was 26.1%. Both rates were higher than the U.S. statutory tax rate of 21% primarily due to state taxes. In addition to excluding the impact of the Tax Act, the adjusted1 effective tax rate excludes the tax impacts associated with the following charges: Restructuring and related costs, Amortization of intangible assets, Transaction and related costs, net, non-service retirement related costs as well as other discrete, unusual or infrequent items as described in our Non-GAAP Financial Measures section. The 2018 effective tax rate was 45.0% and included a charge of $89 million related to the 2017 Tax Act which is discussed below. On an adjusted1 basis, the 2018 effective tax rate was 27.0%. Both rates were higher than the U.S. statutory tax rate of 21% primarily due to the geographical mix of profits. In addition to excluding the impact of the Tax Act, the adjusted1 effective tax rate excludes the tax impacts associated with the following charges: Restructuring and related costs, Amortization of intangible assets, Transaction and related costs, net, non-service retirement related costs as well as other discrete, unusual or infrequent items as described in our Non-GAAP Financial Measures section. The 2017 effective tax rate was 89.1% and included a charge of $400 million related to the 2017 Tax Act which is discussed below. On an adjusted1 basis, the 2017 effective tax rate was 24.7%. This rate was lower than the U.S. statutory tax rate of 35% primarily due to foreign tax credits, the redetermination of certain unrecognized tax positions upon conclusion of several audits and the geographical mix of profits. In addition to excluding the impact of the Tax Act, the adjusted1 effective tax rate excludes the tax impacts associated with the following charges: Restructuring and related costs, Amortization of intangible assets, non-service retirement related costs and other discrete items. Xerox operations are widely dispersed. However, no one country outside of the U.S. is a significant factor in determining our overall effective tax rate. The tax impact from these non U.S. operations on our full year effective tax rate for 2019 was not material. Refer to Note 20 - Income and Other Taxes in the Consolidated Financial Statements for additional information regarding the geographic mix of income before taxes and the related impacts on our effective tax rate. Our effective tax rate is based on nonrecurring events as well as recurring factors, including the taxation of foreign income. In addition, our effective tax rate will change based on discrete or other nonrecurring events that may not be predictable. Excluding the effects of the Restructuring and related costs, Amortization of intangible assets, Transaction and related costs, net, non-service retirement-related costs and other discrete items, we anticipate that our adjusted1 effective tax rate will be approximately 24% to 27% for full year 2020. _____________ (1) Refer to the Effective Tax Rate reconciliation table in the "Non-GAAP Financial Measures" section. Xerox 2019 Annual Report 40 Tax Cuts and Jobs Act (the Tax Act) On December 22, 2017, the Tax Cuts and Jobs Act (the Tax Act) was enacted. The Tax Act significantly revised the U.S. corporate income tax system by, among other things, lowering the U.S. statutory corporate income tax rate from 35% to 21% and implementing a territorial tax system that includes a one-time transition tax on deemed repatriated earnings of foreign subsidiaries. We recorded the following charges (credits) to Income tax expense associated with the Tax Act: The net charge of $454 million included the following components: Foreign tax effects: The deemed repatriation tax associated with the Tax Act was $164 million and was based on total post-1986 earnings and profits (E&P) that had previously been deferred from U.S. income taxes. We utilized our existing foreign tax credit carryforwards to settle this deemed repatriation tax. Our net charge for the Tax Act also included a charge of $99 million for other tax liabilities and adjustments resulting from our actual and anticipated distributions of our net accumulated foreign E&P. As a consequence of the Tax Act, we now no longer consider our post 1986 E&P indefinitely reinvested. Deferred tax assets and liabilities: Our net charge includes a $191 million charge for the remeasurement of certain deferred tax assets and liabilities based on the new statutory income tax rate of 25%, inclusive of estimated state taxes. Refer to Note 20 - Income and Other Taxes in the Consolidated Financial Statements for additional information regarding the estimated impacts of Tax Act. Equity in Net Income of Unconsolidated Affiliates In November 2019, Xerox Holdings sold its remaining indirect 25% equity interest in Fuji Xerox, which had been previously accounted for as an equity method investment. Accordingly, our remaining Investment in Affiliates, at Equity at December 31, 2019 largely consists of several minor investments in entities in the Middle East region. Refer to Note 1 - Basis of Presentation and Summary of Significant Accounting Policies and Note 7 - Divestitures, in the Consolidated Financial Statements for additional information regarding the sale Fuji Xerox. _____________ (1) Equity in net income for Fuji Xerox is reported in Income from discontinued operations, net of tax for all years presented. The equity in net income for Fuji Xerox in 2019 is through the date of sale. For the year ended December 31, 2019 equity income from Fuji Xerox increased $122 million as compared to 2018, primarily due to lower restructuring costs of $75 million as well as an out-of-period adjustment of $28 million in 2018. For the year ended December 31, 2018, equity income from Fuji Xerox decreased $77 million as compared to 2017, primarily due to higher restructuring costs of $85 million as well as an out-of-period adjustment of approximately $28 million partially offset by improved operations. Refer to Note 12 - Investment in Affiliates, at Equity in the Consolidated Financial Statements for additional information regarding our equity investments. Net Income from Continuing Operations Net income from continuing operations attributable to Xerox for the year ended December 31, 2019 was $648 million, or $2.78 per diluted share. On an adjusted1 basis, Net income from continuing operations attributable to Xerox was $828 million, or $3.55 per diluted share, and includes adjustments for Restructuring and related costs, Amortization of intangible assets, Transaction and related costs, net as well as non-service retirement-related costs and other discrete, unusual or infrequent items, including the impact from the Tax Act, as describe in our Non-GAAP Financial Measures. Net income from continuing operations attributable to Xerox for the year ended December 31, 2018 was $306 million, or $1.16 per diluted share. On an adjusted1 basis, Net income from continuing operations attributable to Xerox was $745 million, or $2.88 per diluted share, and includes adjustments for Restructuring and related costs, Amortization of Xerox 2019 Annual Report 41 intangible assets, Transaction and related costs, net as well as non-service retirement-related costs and other discrete, unusual or infrequent items, including the impact from the Tax Act, as described in our Non-GAAP Financial Measures. Net income from continuing operations attributable to Xerox for the year ended December 31, 2017 was $66 million, or $0.20 per diluted share and includes an estimated non-cash charge of $400 million for the impacts associated with the Tax Act. Refer to the Tax Cuts and Jobs Act (the Tax Act) section above, as well as Note 20 - Income and Other Taxes in the Consolidated Financial Statements for additional information. On an adjusted1 basis, Net income from continuing operations attributable to Xerox was $770 million, or $2.93 per diluted share, and includes adjustments for Restructuring and related costs, Amortization of intangible assets, Transaction and related costs, net as well as non-service retirement-related costs, and other discrete, unusual or infrequent items, as described in our Non-GAAP Financial Measures. Refer to Note 26 - Earnings per Share in the Consolidated Financial Statements, for additional information regarding the calculation of basic and diluted earnings per share. _____________ (1) Refer to the Net Income and EPS reconciliation table in the "Non-GAAP Financial Measures" section. Discontinued Operations Discontinued operations relate to the November 2019 Sales of our indirect 25% equity interest in Fuji Xerox (FX) and our indirect 51% partnership interest in Xerox International Partners (XIP), which had been consolidated. Refer to Note 7 - Divestitures in the Consolidated Financial Statements for additional information regarding discontinued operations. Other Comprehensive Income The historical statement of Comprehensive Income has not been revised to reflect the Sales of our investments in Fuji Xerox and XIP and instead reflects discontinued operations as a final adjustment to the Accumulated Other Comprehensive Loss (AOCL) balances at December 31, 2019. Accordingly, all reported amounts in 2018 and 2017 reflect movements in AOCL for both continuing operations and discontinued operations. Refer to Note 7 - Divestitures in the Consolidated Financial Statements for additional information regarding discontinued operations. Other comprehensive income attributable to Xerox was $46 million in 2019 and included the following: i) net translation adjustment gains of $62 million reflecting aggregate translation gains of $45 million from the strengthening of most of our major foreign currencies against the U.S. Dollar during 2019, as well as a reclassification of $17 million of accumulated translation losses from AOCL into earnings as a result of the divestiture of our investments in FX and XIP; ii) $10 million of net losses from changes in defined benefit plans reflecting net losses of $138 million associated with defined benefit plan changes during 2019, primarily as a result of lower discount rates, partially offset by the reclassification of $148 million of accumulated losses from AOCL into earnings as a result of the divestiture of our investments in FX and XIP; and iii) $6 million in unrealized losses, net. Other comprehensive income attributable to Xerox was $183 million in 2018 and included the following:i) $409 million of net gains from the changes in defined benefit plans primarily due to prior service credits resulting from an amendment to our U.S. and Canadian Retiree Health plans, settlements and the positive impacts from currency on accumulated net actuarial losses, as well as a $43 million out-of-period pension adjustment (refer to Note 1 - Basis of Presentation and Summary of Significant Accounting Policies in the Consolidated Financial Statements for additional information on the out-of-period adjustment); ii) $16 million in unrealized gains, net, and iii) net translation adjustment losses of $242 million reflecting the weakening of most of our major foreign currencies against the U.S. Dollar. Other comprehensive income attributable to Xerox was $589 million in 2017 and included the following: i) net translation adjustment gains of $483 million reflecting the strengthening of most of our major foreign currencies against the U.S. Dollar, partially offset by the weakening of the Brazilian Real; and ii) $106 million of net gains from the changes in defined benefit plans primarily due to net actuarial gains and settlements partially offset by the negative impacts from currency on accumulated net actuarial losses. Refer to our discussion of Pension Plan Assumptions in the Application of Critical Accounting Policies section of the MD&A as well as Note 19 - Employee Benefit Plans in the Consolidated Financial Statements for additional information regarding changes in our defined benefit plans. Refer to Note 17 - Financial Instruments in the Consolidated Financial Statements for additional information regarding our foreign currency derivatives and associated unrealized gains and losses. Recent Accounting Pronouncements Refer to Note 1 - Basis of Presentation and Summary of Significant Accounting Policies in the Consolidated Financial Statements for a description of recent accounting pronouncements including the respective dates of adoption and the effects on results of operations and financial conditions. Xerox 2019 Annual Report 42 Capital Resources and Liquidity Our liquidity is primarily dependent on our ability to continue to generate positive cash flows from operations. Additional liquidity is also 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 and 2018, total cash, cash equivalents and restricted cash were $2,795 million and $1,148 million, respectively. The increase from 2018 reflects the proceeds received from the sales of our ownership Interests in Fuji Xerox Co., Ltd. and Xerox International Partners of $2,233 million less payments of $554 million on maturing Senior Notes in the fourth quarter 2019. Refer to Note 7 - Divestitures in the Consolidated Financial Statements for additional information regarding the divestiture. • We expect operating cash flows from continuing operations to be approximately $1.3 billion in 2020, reflecting continued improvements in working capital and increased earnings. • As of December 31, 2019 and 2018, there were no borrowings or letters of credit outstanding under our $1.8 billion Credit Facility. The company did not borrow under its Credit Facility during 2019 and its $1.8 billion Commercial Paper program was terminated in 2019. • We have consistently delivered positive cash flows from operations driven by our post-sale-based revenue model and cost reduction initiatives, such as Project Own It. Operating cash flows from continuing operations were $1,244 million and $1,082 million for the years ended December 31, 2019 and 2018, respectively. Operating cash flow from continuing operations was a use of $249 million in 2017 and reflected the impact of certain one-time actions to improve our capital structure and simplify certain processes including $500 million of additional voluntary contributions to our U.S. tax-qualified defined benefit plans as well as the impact of approximately $350 million from the termination of certain accounts receivable sales programs as well as certain classification changes as a result of our adoption of ASU 2016-15 Statement of Cash Flows - Classification of Certain Cash Receipts and Cash Payments. Operating cash flows adjusted for the above noted impacts are included in the following reconciliation: _____________ (1) Net cash provided by (used in) operating activities from continuing operations. Xerox 2019 Annual Report 43 Cash Flow Analysis The following summarizes our cash flows for the three years ended December 31, 2019, 2018 and 2017, as reported in our Consolidated Statements of Cash Flows in the accompanying Consolidated Financial Statements: Cash Flows from Operating Activities Net cash provided by operating activities of continuing operations was $1,244 million for the year ended December 31, 2019. The $162 million increase in operating cash from 2018 was primarily due to the following: • $95 million increase due to lower placements of equipment on operating leases. • $92 million increase primarily due to lower levels of inventories partially reflecting lower sales volume and improved inventory management. • $58 million increase from the after-tax impact of the OEM license agreement with FX. • $47 million increase due to lower net payments for transaction and related costs as current year payments are primarily limited to costs related to on-going litigation. • $65 million decrease due to a lower net run-off of finance receivables. • $54 million decrease from the change in accounts payable primarily related to lower inventory and other spending as well as the year-over-year timing of supplier and vendor payments. • $21 million decrease from accounts receivable primarily due to the timing of invoicing and collections. Net cash provided by operating activities of continuing operations was $1,082 million for the year ended December 31, 2018. The $1,331 million increase in operating cash from 2017 was primarily due to the following: • $692 million increase due to prior year contributions of $635 million to our domestic tax-qualified defined benefit plans, which includes an incremental voluntary contribution of $500 million. • $562 million increase from accounts receivable primarily due to the prior year termination of all accounts receivable sales arrangements in North America and all but one arrangement in Europe and the prior year reclassification of $213 million of collections of deferred proceeds from the sales of accounts receivable to investing. • $90 million increase from lower inventory levels primarily due to a decline in equipment sales and the impact of the product launch in the prior year. • $65 million increase due to the prior year payment of restricted cash balances in connection with the termination of our accounts receivable sales arrangements. • $51 million increase from lower restructuring payments. • $45 million decrease due to net payments for transaction and related costs. • $43 million decrease due to dividends received in the prior year from equity investments representing the accumulation of earnings over multiple years. • $31 million decrease due to higher equipment on operating leases. Xerox 2019 Annual Report 44 Cash Flows from Investing Activities Net cash used in investing activities of continuing operations was $85 million for the year ended December 31, 2019. The $56 million change in cash from 2018 was primarily due to the following: • $42 million decrease from acquisitions. • $38 million decrease due to lower proceeds from the sales of assets. • $25 million increase reflecting lower capital expenditures. Net cash used in investing activities of continuing operations was $29 million for the year ended December 31, 2018. The $194 million decrease in cash from 2017 was primarily due to the following: • $213 million decrease is primarily a result of the termination of certain accounts receivables sales arrangements in fourth quarter 2017. • $127 million decrease due to the prior year receipt of the final payment on the performance-based instrument associated with our 1997 sale of The Resolution Group (TRG). • $20 million decrease due to proceeds from the prior year sale of the Xerox Research Centre in Grenoble, France. • $57 million increase from the sale of non-core business assets of $31 million and the sale of surplus buildings in Ireland of $26 million in 2018. • $87 million increase due to no acquisitions in 2018. • $29 million increase due to the prior year refund of cash received in 2016 for a cancelled business agreement. Cash Flows from Financing Activities Net cash used in financing activities for Xerox Holdings, on a consolidated basis, was $1,834 million for the year ended December 31, 2019. The $533 million increase in the use of cash from 2018 was primarily due to the following: • $643 million increase from net debt activity. 2019 reflects payments of $960 million on Senior Notes compared to prior year payments of $265 million on Senior Notes, $25 million related to the termination of a capital lease obligation and $19 million of bridge facility costs. • $26 million decrease due to lower common stock dividends. • $100 million decrease from lower share repurchases due to timing. Net cash used in financing activities for Xerox, on a consolidated basis, was $1,834 million for the year ended December 31, 2019. Dividends of $181 million and share repurchases of $300 million were through the date of the holding company reorganization previously noted (July 31. 2019 - Refer to Note 1 - Basis of Presentation and Summary of Significant Accounting Policies - Corporate Reorganization, in the Consolidated Financial Statements for additional information regarding the Reorganization). Distributions to Xerox Holdings were $373 million and are subsequent to the date of the reorganization and are primarily to fund Xerox Holdings continuing dividends to shareholders and share repurchases. Xerox's distributions to the parent are expected to continue on a regular basis in the future with those distributions primarily being used by Xerox holdings to fund dividends and share repurchases. Net cash used in financing activities for both Xerox Holdings and Xerox, on a consolidated basis, were $1,301 million for the year ended December 31, 2018. The $316 million increase in the use of cash from 2017 was primarily due to the following: • $700 million increase due to the resumption of share repurchases in 2018. • $161 million increase resulting from the prior year final cash adjustment with Conduent Incorporated. • $515 million decrease from net debt activity. 2018 reflects payments of $265 million on Senior Notes, $25 million related to the termination of a capital lease obligation and $19 million of bridge facility costs. 2017 reflects proceeds of $1.0 billion on new Senior Notes offset by payments of $1,475 million on Senior Notes, net payments of $326 million on the tender and exchange of certain Senior Notes, and other payments and transaction costs of $24 million. • $22 million decrease due to lower common stock dividends of $19 million and preferred stock dividends of $3 million. Cash, Cash Equivalents and Restricted Cash Refer to Note 15 - Supplementary Financial Information in the Consolidated Financial Statements for additional information regarding Cash, cash equivalents and restricted cash. Adoption of New Leasing Standard On January 1, 2019, we adopted ASU 2016-02, Leases (ASC Topic 842). This update, as well as additional amendments and targeted improvements issued in 2018 and early 2019, supersedes existing lease accounting guidance found under ASC 840, Leases (ASC 840) and requires the recognition of right-of-use (ROU) assets and lease obligations by lessees for those leases originally classified as operating leases under prior lease guidance. Xerox 2019 Annual Report 45 Operating leases ROU assets, net and operating lease liabilities were reported in the Consolidated Balance Sheets as follows: Refer to Note 1 - Basis of Presentation and Summary of Significant Accounting Policies and Note 2 - Adoption of New Leasing Standard - Lessee in the Consolidated Financial Statements for additional information regarding the adoption of this standard. Debt and Customer Financing Activities The following summarizes our total debt: _____________ (1) Effective with the adoption of ASU 2016-02, Leases (ASC Topic 842), capital lease obligations are no longer classified as debt and are now reported in Other current and non-current liabilities. Refer to Note 1 - Basis of Presentation and Summary of Significant Accounting Policies, Note 2 - Adoption of New Leasing Standard - Lessee and Note 15 - Supplementary Financial Information in the Consolidated Financial Statements for additional information. (2) Fair value adjustments include the following: (i) fair value adjustments to debt associated with terminated interest rate swaps, which are being amortized to interest expense over the remaining term of the related notes; and (ii) changes in fair value of hedged debt obligations attributable to movements in benchmark interest rates. Hedge accounting requires hedged debt instruments to be reported inclusive of any fair value adjustment. Refer to Note 16 - Debt in the Consolidated Financial Statements for additional information regarding our debt. Finance Assets and Related Debt We provide lease equipment financing to our customers. Our lease contracts permit customers to pay for equipment over time rather than at the date of installation. Our investment in these contracts is reflected in total finance assets, net. We primarily fund our customer financing activity through cash generated from operations, cash on hand, sales and securitizations of finance receivables and proceeds from capital markets offerings. We have arrangements, in certain international countries and domestically, with our small and mid-sized customers in which third-party financial institutions independently provide lease financing directly to our customers, on a non-recourse basis to Xerox. In these arrangements, we sell and transfer title of the equipment to these financial institutions. Generally, we have no continuing ownership rights in the equipment subsequent to its sale; therefore, the unrelated third-party finance receivable and debt are not included in our Consolidated Financial Statements. The following represents our total finance assets, net associated with our lease and finance operations: ____________ (1) Includes (i) Billed portion of finance receivables, net, (ii) Finance receivables, net and (iii) Finance receivables due after one year, net as included in our Consolidated Balance Sheets. (2) The change from December 31, 2018 includes an increase of $3 million due to currency. Xerox 2019 Annual Report 46 Our lease contracts permit customers to pay for equipment over time rather than at the date of installation; therefore, we maintain a certain level of debt (that we refer to as financing debt) to support our investment in these lease contracts, which are reflected in total finance receivables, net. For this financing aspect of our business, we maintain an assumed 7:1 leverage ratio of debt to equity as compared to our finance assets. Based on this leverage, the following represents the breakdown of total debt between financing debt and core debt: _____________ (1) Finance receivables debt is the basis for our calculation of “Cost of financing” expense in the Consolidated Statements of Income. In 2020, we expect to continue leveraging our finance assets at an assumed 7:1 ratio of debt to equity. Capital Market Activity During 2019 we repaid $960 million of maturing Senior Notes and there were no new Senior Notes issued. Refer to Note 16 - Debt in the Consolidated Financial Statements for additional information. Financial Instruments Refer to Note 17 - Financial Instruments in the Consolidated Financial Statements for additional information. Sales of Accounts Receivable The net impact from the sales of accounts receivable on reported net cash flows is summarized below: _____________ (1) Represents the difference between current and prior year fourth quarter accounts receivable sales adjusted for the effects of: (i) the deferred proceeds, (ii) collections prior to the end of the year and (iii) currency. (2) 2017 includes a decrease of approximately $350 million associated with the termination of certain accounts receivable sale programs in the fourth quarter 2017. Refer to Note 8 - Accounts Receivable, Net in the Consolidated Financial Statements for additional information regarding our accounts receivable sales arrangements. Share Repurchase Programs - Treasury Stock In connection with the reorganization of Xerox Corporation’s corporate structure into a holding company structure, in July 2019, Xerox Holdings Corporation’s Board of Directors authorized a $1.0 billion share repurchase program (exclusive of any commissions and other transaction fees and costs related thereto.) This program replaced the $1.0 billion of authority remaining under Xerox Corporation’s previously authorized share repurchase program. During 2019, Xerox Holdings repurchased 9.1 million shares of our common stock for an aggregate cost of $300 million, including fees. No additional shares have been repurchased since December 31, 2019. Including the shares repurchased under Xerox Corporation's previously authorized share repurchase program, Xerox Holdings repurchased 18.3 million shares of our common stock for an aggregate cost of $600 million, including fees, during 2019. The cumulative total of shares repurchased by Xerox Holdings, including the shares repurchased under Xerox Corporation's previously authorized program from July 2018, is 44.4 million shares at a cost of $1.3 billion, including fees. During 2018, Xerox Corporation repurchased 26.1 million shares of our common stock for an aggregate cost of $700 million, including fees. No shares were repurchased in 2017. For information related to the Reorganization of Xerox Corporation and Xerox Holdings, refer to Note 1 - Basis of Presentation and Summary of Significant Accounting Policies in the Consolidated Financial Statements. For additional information regarding our share repurchase program, refer to Note 23 - Shareholders' Equity in the Consolidated Financial Statements. Xerox 2019 Annual Report 47 Dividends Aggregate dividends of $226 million, $251 million and $259 million were declared on common stock in 2019, 2018 and 2017, respectively. The decrease in dividends since 2017 primarily reflects lower shares of common stock outstanding as a result of our share repurchase programs. Aggregate dividends of $14 million in 2019, 2018 and 2017, respectively, were declared on preferred stock. Liquidity and Financial Flexibility We manage our worldwide liquidity using internal cash management practices, which are subject to (i) the statutes, regulations and practices of each of the local jurisdictions in which we operate, (ii) the legal requirements of the agreements to which we are a party and (iii) the policies and cooperation of the financial institutions we utilize to maintain and provide cash management services. Our principal debt maturities are in line with historical and projected cash flows and are spread over the next five years as follows (in millions): _____________ (1) Includes fair value adjustments. Foreign Cash At December 31, 2019, we had $2.7 billion of cash and cash equivalents on a consolidated basis of which approximately $655 million was held outside of the U.S. by our foreign subsidiaries. As a result of the Tax Act enacted in December 2017, the estimated tax impacts associated with future repatriation of our foreign cash have been reflected in our financial statements as of December 31, 2019 and 2018. Refer to Note 20 - Income and Other Taxes in our Consolidated Financial Statements for additional information. Loan Covenants and Compliance At December 31, 2019, we were in full compliance with the covenants and other provisions of our Credit Facility and Senior Notes. We have the right to terminate the Credit Facility without penalty. Failure to comply with material provisions or covenants of the Credit Facility and Senior Notes could have a material adverse effect on our liquidity and operations and our ability to continue to fund our customers' purchases of Xerox equipment. Refer to Note 16 - Debt in the Consolidated Financial Statements for additional information regarding debt arrangements. Xerox 2019 Annual Report 48 Contractual Cash Obligations and Other Commercial Commitments and Contingencies At December 31, 2019, we had the following contractual cash obligations and other commercial commitments and contingencies: _____________ (1) Refer to Note 16 - Debt in the Consolidated Financial Statements for additional information regarding debt and interest on debt. (2) Refer to Note 2 - Adoption of New Leasing Standard - Lessee in the Consolidated Financial Statements for additional information related to minimum operating lease commitments. (3) Fuji Xerox: The amount included in the table reflects our estimate of purchases over the next year and is not a contractual commitment. Refer to Note 12 - Investments in Affiliates, at Equity in the Consolidated Financial Statements for additional information related to transactions with Fuji Xerox. (4) Flex: We outsource certain manufacturing activities to Flex. The amount included in the table reflects our estimate of purchases over the next year and is not a contractual commitment. In the past two years, actual purchases from Flex averaged approximately $243 million per year. (5) HCL: We outsource certain global administrative and support functions, including, among others, selected information technology and finance functions (excluding accounting), as part of a shared services arrangement with HCL Technologies (HCL). The amounts included in the table reflect our estimate of purchases over the next seven years. (6) Other purchase commitments: We enter into other purchase commitments with vendors in the ordinary course of business. Our policy with respect to all purchase commitments is to record losses, if any, when they are probable and reasonably estimable. We currently do not have, nor do we anticipate, material loss contracts. (7) Total obligations do not include payments for the deemed repatriation tax recorded as part of the estimated charge for the Tax Act as we expect to utilize our existing foreign tax credit carryforwards to settle this obligation. Refer to Note 20 - Income and Other Taxes in the Consolidated Financial Statements for additional information regarding the estimated charge associated with the Tax Act. Pension and Retiree Health Benefit Plans We sponsor defined benefit pension plans and retiree health plans that require periodic cash contributions. Our 2019 cash contributions for these plans were $141 million for our defined benefit pension plans and $30 million for our retiree health plans. In 2020, based on current actuarial calculations, we expect to make contributions of approximately $135 million to our worldwide defined benefit pension plans and $35 million to our retiree health benefit plans. There are no contributions required in 2020 for our U.S. tax-qualified defined benefit plans to meet the minimum funding requirements. Contributions to our defined benefit pension plans in subsequent years will depend on a number of factors, including the investment performance of plan assets and discount rates as well as potential legislative and plan changes. At December 31, 2019, the net unfunded balances of our U.S. and Non-U.S. defined benefit pension plans were $1,105 million and $107 million, respectively, or $1,212 million in the aggregate, which is a $58 million increase from the balance at December 31, 2018. The increase is primarily due to an increase in the benefit obligation due to the impact of lower discount rates, offset by favorable asset returns. Approximately $815 million of the $1,212 million net unfunded balance is attributable to certain plans that do not require funding. Cash contributions to our retiree health plans are made each year to cover medical claims costs incurred during the year. The amounts reported in the above table as retiree health payments represent our estimate of future benefit payments. Our retiree health benefit plans are non-funded and are primarily related to domestic operations. The unfunded balance of our retiree health plans of $385 million at December 31, 2019 is consistent with the prior year. Refer to Note 19 - Employee Benefit Plans in the Consolidated Financial Statements for additional information regarding contributions to our defined benefit pension and retiree health plans. Fuji Xerox We purchased products, including parts and supplies, from Fuji Xerox totaling $1.3 billion, $1.5 billion and $1.6 billion in 2019, 2018 and 2017, respectively. Our product supply agreements with Fuji Xerox are designed to support the entire product lifecycle, end-to-end, including the availability of spare parts, consumables and technical support throughout Xerox 2019 Annual Report 49 the time such products are with our customers. Our purchase orders under such agreements are made in the normal course of business and typically have a lead time of three months. Related party transactions with Fuji Xerox are discussed in Note 12 - Investments in Affiliates, at Equity in the Consolidated Financial Statements. Brazil Contingencies Our Brazilian operations have received or been the subject of numerous governmental assessments related to indirect and other taxes. These tax matters principally relate to claims for taxes on the internal transfer of inventory, municipal service taxes on rentals and gross revenue taxes. We are disputing these tax matters and intend to vigorously defend our positions. Based on the opinion of legal counsel and current reserves for those matters deemed probable of loss, we do not believe that the ultimate resolution of these matters will materially impact our results of operations, financial position or cash flows. Below is a summary of our Brazilian tax contingencies: The decrease in the unreserved portion of the tax contingency, inclusive of any related interest was primarily related to closed cases. With respect to the unreserved tax contingency, the majority has been assessed by management as being remote as to the likelihood of ultimately resulting in a loss to the Company. In connection with the above proceedings, customary local regulations may require us to make escrow cash deposits or post other security of up to half of the total amount in dispute, as well as additional surety bonds and letters of credit, which include associated indexation. Generally, any escrowed amounts would be refundable and any liens on assets would be removed to the extent the matters are resolved in our favor. We are also involved in certain disputes with contract and former employees. Exposures related to labor matters are not material to the financial statements as of December 31, 2019. We routinely assess all these matters as to probability of ultimately incurring a liability against our Brazilian operations and record our best estimate of the ultimate loss in situations where we assess the likelihood of an ultimate loss as probable. Other Contingencies and Commitments As more fully discussed in Note 21 - Contingencies and Litigation in the Consolidated Financial Statements, we are involved in a variety of claims, lawsuits, investigations and proceedings concerning: securities law; governmental entity contracting, servicing and procurement law; intellectual property law; environmental law; employment law; the Employee Retirement Income Security Act (ERISA); and other laws and regulations. In addition, guarantees, indemnifications and claims may arise during the ordinary course of business from relationships with suppliers, customers and non-consolidated affiliates. Nonperformance under a contract including a guarantee, indemnification or claim could trigger an obligation of the Company. We determine whether an estimated loss from a contingency should be accrued by assessing whether a loss is deemed probable and can be reasonably estimated. Should developments in any of these areas cause a change in our determination as to an unfavorable outcome and result in the need to recognize a material accrual, or should any of these matters result in a final adverse judgment or be settled for significant amounts, they could have a material adverse effect on our results of operations, financial position and cash flows in the period or periods in which such change in determination, judgment or settlement occurs. Unrecognized Tax Benefits As of December 31, 2019, we had $127 million of unrecognized tax benefits. This represents the tax benefits associated with various tax positions taken, or expected to be taken, on domestic and foreign tax returns that have not been recognized in our financial statements due to uncertainty regarding their resolution. The resolution or settlement of these tax positions with the taxing authorities is at various stages and, therefore, we are unable to make a reliable estimate of the eventual cash flows by period that may be required to settle these matters. In addition, certain of these matters may not require cash settlement due to the existence of credit and net operating loss carryforwards, as well as other offsets, including the indirect benefit from other taxing jurisdictions that may be available. Refer to Note 20 - Income and Other Taxes in the Consolidated Financial Statements for additional information regarding unrecognized tax benefits. Xerox 2019 Annual Report 50 Off-Balance Sheet Arrangements We may occasionally utilize off-balance sheet arrangements in our operations (as defined by the SEC Financial Reporting Release 67 (FRR-67), “Disclosure in Management’s Discussion and Analysis about Off-Balance Sheet Arrangements and Aggregate Contractual Obligations”). Accounts receivable sales facilities arrangements that we enter into may have off-balance sheet elements. During 2017, we terminated all accounts receivable sales arrangements in North America and all but one arrangement in Europe. Refer to Note 8 - Accounts Receivable, Net in the Consolidated Financial Statements for further information regarding accounts receivable sales. As of December 31, 2019, we do not believe we have any off-balance sheet arrangements that have, or are reasonably likely to have, a material current or future effect on financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. In addition, see the preceding table for the Company's contractual cash obligations and other commercial commitments and contingencies and Note 21 - Contingencies and Litigation in the Consolidated Financial Statements for additional information regarding contingencies, guarantees, indemnifications and warranty liabilities. Non-GAAP Financial Measures We have reported our financial results in accordance with generally accepted accounting principles (GAAP). In addition, we have discussed our results using the non-GAAP measures described below. We believe these non-GAAP measures allow investors to better understand the trends in our business and to better understand and compare our results. Accordingly, we believe it necessary to adjust several reported amounts, determined in accordance with GAAP, to exclude the effects of certain items as well as their related income tax effects. A reconciliation of these non-GAAP financial measures to the most directly comparable financial measures calculated and presented in accordance with GAAP are set forth below in the following tables. These non-GAAP financial measures should be viewed in addition to, and not as a substitute for, the company’s reported results prepared in accordance with GAAP. Adjusted Earnings Measures • Net income and Earnings per share (EPS) • Effective tax rate The above measures were adjusted for the following items: Restructuring and related costs: Restructuring and related costs include restructuring and asset impairment charges as well as costs associated with our transformation programs beyond those normally included in restructuring and asset impairment charges. Restructuring consists of costs primarily related to severance and benefits paid to employees pursuant to formal restructuring and workforce reduction plans. Asset impairment includes costs incurred for those assets sold, abandoned or made obsolete as a result of our restructuring actions, exiting from a business or other strategic business changes. Additional costs for our transformation programs are primarily related to the implementation of strategic actions and initiatives and include third-party professional service costs as well as one-time incremental costs. All of these costs can vary significantly in terms of amount and frequency based on the nature of the actions as well as the changing needs of the business. Accordingly, due to that significant variability, we will exclude these charges since we do not believe they provide meaningful insight into our current or past operating performance nor do we believe they are reflective of our expected future operating expenses as such charges are expected to yield future benefits and savings with respect to our operational performance. Amortization of intangible assets: The amortization of intangible assets is driven by our acquisition activity which can vary in size, nature and timing as compared to other companies within our industry and from period to period. The use of intangible assets contributed to our revenues earned during the periods presented and will contribute to our future period revenues as well. Amortization of intangible assets will recur in future periods. Transaction and related costs, net: Transaction and related costs, net reflects expenses incurred in connection with i) our announced proposal to acquire HP Inc. and ii) our planned transaction with Fujifilm/Fuji Xerox, which was terminated in May 2018, including costs related to litigation resulting from the terminated transaction and other shareholder actions. The costs are primarily for third-party legal, accounting, consulting and other similar type professional services as well as potential legal settlements. These costs are considered incremental to our normal operating charges and were incurred or are expected to be incurred solely as a result of the planned transactions. Accordingly, we are excluding these expenses from our Adjusted Earnings Measures in order to evaluate our performance on a comparable basis. Xerox 2019 Annual Report 51 Non-service retirement-related costs: Our defined benefit pension and retiree health costs include several elements impacted by changes in plan assets and obligations that are primarily driven by changes in the debt and equity markets as well as those that are predominantly legacy in nature and related to employees who are no longer providing current service to the company (e.g. retirees and ex-employees). These elements include (i) interest cost, (ii) expected return on plan assets, (iii) amortization of prior plan amendments, (iv) amortized actuarial gains/losses and (v) the impacts of any plan settlements/curtailments. Accordingly, we consider these elements of our periodic retirement plan costs to be outside the operational performance of the business or legacy costs and not necessarily indicative of current or future cash flow requirements. This approach is consistent with the classification of these costs as non-operating in other expenses, net. Adjusted earnings will continue to include the service cost elements of our retirement costs, which is related to current employee service as well as the cost of our defined contribution plans. Other discrete, unusual or infrequent items: In addition, we have also excluded the following additional items given their discrete, unusual or infrequent nature and their impact on our results for the period: • Contract termination costs - IT services. • Impacts associated with the Tax Cuts and Jobs Act (the Tax Act) enacted in December 2017. • Losses on early extinguishment of debt. • A benefit from the remeasurement of a tax matter that related to a previously adjusted item. We believe the exclusion of these items allows investors to better understand and analyze the results for the period as compared to prior periods and expected future trends in our business. Adjusted Operating Income and Margin We calculate and utilize adjusted operating income and margin measures by adjusting our reported pre-tax income and margin amounts. In addition to the costs and expenses noted as adjustments for our Adjusted Earnings measures, adjusted operating income and margin also exclude the remaining amounts included in Other expenses, net, which are primarily non-financing interest expense and certain other non-operating costs and expenses. We exclude these amounts in order to evaluate our current and past operating performance and to better understand the expected future trends in our business. Constant Currency (CC) Refer to the Currency Impact section in the MD&A for discussion of this measure and its use in our analysis of revenue growth. Summary Management believes that all of these non-GAAP financial measures provide an additional means of analyzing the current period’s results against the corresponding prior period’s results. However, these non-GAAP financial measures should be viewed in addition to, and not as a substitute for, the company’s reported results prepared in accordance with GAAP. Our non-GAAP financial measures are not meant to be considered in isolation or as a substitute for comparable GAAP measures and should be read only in conjunction with our consolidated financial statements prepared in accordance with GAAP. Our management regularly uses our supplemental non-GAAP financial measures internally to understand, manage and evaluate our business and make operating decisions. These non-GAAP measures are among the primary factors management uses in planning for and forecasting future periods. Compensation of our executives is based in part on the performance of our business based on these non-GAAP measures. Xerox 2019 Annual Report 52 Net Income and EPS reconciliation _____________ (1) Net income and EPS from continuing operations attributable to Xerox. (2) Refer to Effective Tax Rate reconciliation. (3) For those periods that exclude the preferred stock dividend, the average shares for the calculations of diluted EPS include 7 million shares associated with our Series A Convertible preferred stock, as applicable. (4) Represents common shares outstanding at December 31, 2019 as well as shares associated with our Series A convertible preferred stock plus potential dilutive common shares used for the calculation of diluted earnings per share for the year ended December 31, 2019. Effective Tax Rate reconciliation _____________ (1) Pre-tax Income and Income tax expense from continuing operations. (2) Refer to Net Income and EPS reconciliation for details. (3) The tax impact on Adjusted Pre-Tax Income from continuing operations is calculated under the same accounting principles applied to the Reported Pre-Tax Income under ASC 740, which employs an annual effective tax rate method to the results. Operating Income and Margin reconciliation _____________ (1) Pre-tax Income and revenue from continuing operations. (2) Includes non-service retirement-related costs of $18 million, $150 million and $188 million for the years ended December 31, 2019, 2018 and 2017, respectively. Xerox 2019 Annual Report 53

<s>[INST] Currently, Xerox Holdings' sole direct operating subsidiary is Xerox and therefore Xerox reflects the entirety of Xerox Holdings' operations. Accordingly, the following Management’s Discussion and Analysis (MD&A) solely focuses on the operations of Xerox and is intended to help the reader understand Xerox's business and its results of operations and financial condition. Throughout this Annual Report on Form 10K, references are made to various notes in the Consolidated Financial Statements which appear in Part II, Item 8 of this Form 10K, and the information contained in such notes is incorporated by reference into the MD&A in the places where such references are made. Throughout the MD&A that follows, references to “we,” “our,” the “Company,” and “Xerox” refer to Xerox Corporation and its subsidiaries. References to “Xerox Corporation” refer to the standalone company and do not include subsidiaries, unless otherwise noted. References to “Xerox Holdings Corporation” refer to the standalone parent company and do not include its subsidiaries, unless otherwise noted. Executive Overview With annual revenues of approximately $9 billion, we are a leading global provider of digital print technology and related services, software and solutions. We operate in a core market estimated at approximately $68 billion. Our primary offerings span three main areas: Xerox Services, Workplace Solutions and Graphic Communications and Production Solutions: Xerox Services includes solutions and services that helps customers to optimize their print and communications infrastructure, apply automation and simplification to maximize productivity, and ensure the highest levels of related security. Workplace Solutions includes two strategic product groups, Entry and MidRange, which share common technology, manufacturing and product platforms. Workplace Solutions revenues include the sale of products and supplies, as well as the associated technical service and financing of those products. Graphic Communications and Production Solutions are designed for customers in the graphic communications, inplant and production print environments with highvolume printing requirements. We also have digital solutions and software assets to compete in an adjacent Software and Services market that is estimated at approximately $34 billion. Our main offerings for this market are focused on: industryspecific Digital Solutions, Personalization & Communication Software and Content Management Software. In addition, a smaller portion of our revenues comes from noncore streams including paper sales in our developing market countries, wideformat systems and revenue from the license or sale of our technology. Headquartered in Norwalk, Connecticut, with approximately 27,000 employees, Xerox serves customers in approximately 160 countries. We have a broad and diverse base of customers by both geography and industry, ranging from SMBs to printing production (including graphic communications) companies, governmental entities, educational institutions and Fortune 1000 corporations. Our business does not depend upon a single customer, or a few customers, the loss of which would have a material adverse effect on our business. In 2019, approximately 40% of our revenue was generated outside the United States. Xerox 2019 Annual Report 21 Market and Business Strategy Our market and business strategy is to maintain overall leadership in our core market and increase our participation in the growth areas, while expanding into adjacent markets and leveraging our innovation capabilities to enter new markets. We have four strategic initiatives that we believe will position Xerox for success: Optimize operations for simplicity Continuously improve operating model for greater efficiency Optimize the supply chain and supplier competitiveness Leverage digital technologies to make it easier to do business with Xerox Drive Revenue Enhance the customer experience Expand integrated solutions comprised of hardware, software and services Focus on driving growth within the small and midsize businesses (SMB) Reenergize the innovation engine Invest in growing market segments such as 3D printing, AI and IoT Leverage software capability to launch new services Monetize new innovations Focus on cash flow and increasing capital returns Maximize cash flow generation Return at least 50% of free cash flow to shareholders (Operating cash flows from continuing operations less capital expenditures) Focus on ROI and internal rate of return to make capital allocation decisions Postsale Based Business Model In 2019, 77% of [/INST] Negative. </s>

Village Farms International, Inc.

2020-04-01

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This discussion contains forward-looking statements that involve risks and uncertainties. When reviewing the discussion below, you should keep in mind the substantial risks and uncertainties that impact our business. In particular, we encourage you to review the risks and uncertainties described in “Risk Factors” in Part I, Item 1A in this Annual Report on Form 10-K. These risks and uncertainties could cause actual results to differ materially from those projected or implied by our forward-looking statements contained in this report. These forward-looking statements are made as of the date of this management’s discussion and analysis, and we do not intend, and do not assume any obligation, to update these forward-looking statements, except as required by law. All amounts are expressed in thousands of United States dollars unless otherwise stated. Overview VFF is a corporation existing under the Canada Business Corporations Act. The Company’s principal operating subsidiaries are Village Farms Canada Limited Partnership (“VFCLP”), Village Farms, L.P. (“VFLP”) and VF Clean Energy, Inc. (“VFCE”). On June 6, 2017, VFF entered into a shareholders’ agreement in respect of the operation and governance of Pure Sunfarms Corp. (“Pure Sunfarms”) in which pursuant to the settlement agreement dated as of March 2, 2020 (the “Settlement Agreement”) entered into with Emerald Health Therapeutics Inc. (“Emerald”), VFF currently owns a 57.4% interest (at December 31, 2019 owned 53.5% interest). On February 27, 2019, VFF entered into a joint venture agreement in respect of the operation and governance of Village Fields Hemp USA LLC (“VFH”) in which VFF owns a 65% interest. On May 21, 2019, the Company entered into a joint venture agreement in respect of Arkansas Valley Green and Gold Hemp (“AVGGH”). AVGGH is 60% owned by VFF, 35% owned by Arkansas Valley Hemp, LLC (“AV Hemp”) and 5% owned by VFH. Our operating Segments JV Cannabis Segment The Company’s Joint Venture, Pure Sunfarms is a licensed producer and supplier of cannabis products to be sold to other licensed providers and provincial governments across Canada and internationally. Pure Sunfarms-branded dried cannabis products are sold directly to private retailers and provincial/territorial wholesalers. Produce Segment We are marketers and distributors of premium-quality, greenhouse-grown tomatoes, bell peppers and cucumbers in North America. These premium products are grown in sophisticated, highly intensive agricultural greenhouse facilities located in British Columbia and Texas. The Company also markets and distributes premium tomatoes, peppers and cucumbers produced under exclusive arrangements with other greenhouse producers. The Company primarily markets and distributes under its Village Farms® brand name to retail supermarkets and dedicated fresh food distribution companies throughout the United States and Canada. Energy Segment Through its subsidiary VFCE, owns and operates a 7.0-megawatt power plant from landfill gas that generates electricity and provides thermal heat, in colder months, to one of the Company’s adjacent British Columbia greenhouse facilities and sells electricity to the British Columbia Hydro and Power Authority (“BC Hydro”). Presentation of Financial Results Our consolidated results of operations (prior to net income) for each of the three years ended December 31, 2019, 2018 and 2017 presented below reflect the operations of our consolidated wholly- owned subsidiaries, which as of December 31, 2019, does not include our Pure Sunfarms, VFH and AVGGH joint ventures. The equity in earnings from those joint ventures is reflected in our net income for each of the three years ended December 31, 2019, 2018 and 2017 presented below. For information regarding the results of operations from our joint ventures, see “Reconciliation of GAAP Results to Proportionate Results” below. Results of Operations Consolidated Financial Performance (In thousands of U.S. dollars, except per share amounts) (1) Adjusted EBITDA is not a recognized earnings measure and does not have a standardized meaning prescribed by GAAP. Therefore, Adjusted EBITDA may not be comparable to similar measures presented by other issuers. See “Non-GAAP Measures” for a definition and reconciliation of Adjusted EBITDA to net income (loss), the nearest comparable measurement under GAAP. Management believes that Adjusted EBITDA is a useful supplemental measure in evaluating the performance of the Company. Adjusted EBITDA includes the Company’s majority non-controlling interest in Pure Sunfarms, 65% interest in VFH and 60% interest in AVGGH. A summary of sales by product group in our greenhouse produce business, follows: We caution you that our results of operations for the three years ended December 31, 2019 may not be indicative of our future performance, particularly in light of the ongoing and developing COVID-19 pandemic. We are currently unable to assess the ultimate impact of the COVID-19 pandemic on our business and our results of operations for future periods. JV Cannabis Business (1) For the year ended December 31, 2019 compared to the year ended December 31, 2018. Sales Our majority non-controlling share of sales of Pure Sunfarms for the year ended December 31, 2019 was $37,000 from $1,845 for the year ended December 31, 2018. Total Pure Sunfarms sales consisted of close to 25,675 kilograms of flower and trim during the year ended December 31, 2019, at an average sales price of approximately $2.25 per gram (CAD $2.92 per gram). Included in the sales is the amount from the settlement with Emerald. During 2019 8% of sold grams went directly to retail, 82% was sold wholesalers as flower and 10% to wholesales as trim. Cost of Goods Our majority non-controlling share of cost of sales of Pure Sunfarms for the year ended December 31, 2019 was $9,009 from $576 for the year ended December 31, 2018 (based on total grams sold of close to 24,600 kilograms), or approximately $0.59 per gram (CAD$0.78 per gram). Selling, General and Administrative Expense Our majority non-controlling share of selling, general and administrative expenses of Pure Sunfarms for the year ended December 31, 2019 was $4,568 from $1,349 for the year ended December 31, 2018 the increase is mostly related to increases in sales and marketing cost as well as Health Canada Regulatory fees. Net Income Our majority non-controlling share of net income for the year ended December 31, 2019 was $16,276 versus a loss of ($171) for the year ended December 31, 2018. Adjusted EBITDA Our majority non-controlling share of Adjusted EBITDA for the year ended December 31, 2019 was $20,558 versus ($14) for the year ended December 31, 2018. The increase is related to increases in sales. Notes: (1) The GAAP treatment of our equity earning of our Joint Venture (“Pure Sunfarms”) is different than under IFRS. Under GAAP the Emerald shares held in escrow and not fully paid for by Emerald are not considered issued pursuant to the GAAP concept of ‘hypothetical liquidation’. As a result, under GAAP, our ownership percentage for all of 2017, January through March of 2018 and March through December of 2019 was higher than its economic interest of 50% (53.5% effective November 19, 2019). Accordingly, for those periods with a higher deemed ownership percentage, we received a higher allocation of profits and losses during the periods in which there were outstanding escrow shares. The effective profit and loss allocation - on a weighted average basis in 2019 were 57.9%, in 2018 was 52.2% and in 2017 was 87.5%. Consolidated Results Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 Sales Sales for the year ended December 31, 2019 decreased ($5,432), or (4%), to $144,568 compared to $150,000 for the year ended December 31, 2018. The decrease in sales is primarily due to a decrease in our own production revenues of ($9,348) partially offset by an increase in supply partner revenues of $5,191. The decrease in our own production revenues of ($9,348) or (12%) is primarily due to a decrease of (8%) in our product volume. The decrease in our own production volume is primarily due to a clean-out in one of our facilities (which did not occur in the last three years) and ongoing plant disease pressure at our Texas facilities. The net price for all tomato pounds sold decreased (1.4%) for the year ended December 31, 2019 compared to the year ended December 31, 2018 due to a decrease in the average selling price of the commodity items; beefsteak and TOVs as compared to 2018. The decrease in net price in the commodity item prices was due to the continual push by retailers to lower prices. Pepper prices increased 7% and pepper pounds increased 8% over the comparable period in 2018. Cucumber prices decreased (7%) and cucumber pieces decreased (13%) for the year ended December 31, 2019 as compared to the year ended December 31, 2018. Cost of Sales Cost of sales for the year ended December 31, 2019 increased $11,230, or 8%, to $151,913 from $140,683 for the year ended December 31, 2018, due to an increase in the 2019 contract sales cost of 11% versus 2018 and an increase in the cost per pound of our own grown product in Texas due to decreased volume and higher labor costs. The increase in labor cost is due to the utilization of higher hourly rate contract laborers versus VFF employees for the 2018/2019 crop as compared to prior years. The decrease in our own production volume is primarily due to ongoing plant disease pressure at our Texas facilities and a clean-out in one of our facilities (which did not occur in the last three years). Selling, General and Administrative Expenses Selling, general and administrative expenses for the year ended December 31, 2019 increased $2,654, or 19%, to $16,762 from $14,108 for the year period ended December 31, 2018. The increase is due to public company costs such as investor relations, legal, listing fees and incremental costs of converting to full U.S. GAAP and U.S. reporting compliance. Stock Compensation Expenses Stock compensation expenses for the year ended December 31, 2019 was $4,714 from $1,454 for the year ended December 31, 2018. The incremental increase in stock compensation is primarily related to the vesting of performance share grants in 2019 that were earned in relation to developments in Pure Sunfarms, as well as the incremental cost of issuing higher valued stock options. Interest Expense Interest expense, for the year ended December 31, 2019 decreased $180 to $2,614 from $2,794 for the year period ended December 31, 2018. The decrease is due to lower debt balances. Share of Income from Joint Ventures Our share of income from its joint ventures for the year ended December 31, 2019 was $13,777 compared to a loss of ($171) for the year ended December 31, 2018. The increase in income is primarily attributed to the Joint Venture having selling operations for the entire year ended December 31, 2019 whereas it started selling operations in October for the year ended December 31, 2018. For information regarding the results of operations from our joint ventures, see “Reconciliation of U.S. GAAP Results to Proportionate Results” below. Income Taxes (Recovery) Income tax recovery for the year ended December 31, 2019 was a recovery $5,866 compared to a recovery of $2,300 for the year ended December 31, 2018. The increase is due to a decrease in taxable income in year-ended December 31, 2019 from the year-ended December 31, 2018. Pure Sunfarms, VFH and AVGHH are all reported post-tax and therefore do not affect our tax calculation. Gain on Disposal of Assets The Company recognized for the year ended December 31, 2019 a gain of $13,564 primarily from the contribution of one of our greenhouse facilities in Delta, British Columbia to Pure Sunfarms. The gain represents the difference between book value and C$25,000. Net Income (Loss) Net income (loss) for the year ended December 31, 2019 had an income of $2,325 from a loss of ($7,515) for the year ended December 31, 2018. The increase is a result as an equity pick-up from Pure Sunfarms, partially offset by an increase in the loss from our produce business. Adjusted EBITDA Adjusted EBITDA for the year period ended December 31, 2019 decreased ($1,787) to $851 from $2,638 for the year period ended December 31, 2018, primarily as a result of a decrease in sales and an increase in cost of sales and selling, general and administrative expenses. See the reconciliation of Adjusted EBITDA to net income in “Non-GAAP Measures-Reconciliation of Net Earnings to Adjusted EBITDA”. Year Ended December 31, 2018 Compared to the Year Ended December 31, 2017 Sales Sales for the year ended December 31, 2018 decreased ($8,406), or (5%), to $150,000 compared to $158,406 for the years ended December 31, 2017. The decrease in sales is due to the loss of tomato production from the Delta 3 facility, which was contributed to the Joint Venture in 2017, and our decreased production at its Texas facilities. The net price for all tomato pounds sold was an increase of 4% for the year ended December 31, 2018 compared to the year ended December 31, 2017 due to a higher percent of higher priced tomato production in 2018 compared to 2017. Pepper prices decreased (2%) and pounds increased 38% over the comparable period in 2017. Cucumber prices decreased (1%) and pieces decreased (15%) for the year ended December 31, 2018 as compared to the year ended December 31, 2017. Cost of Sales Cost of sales for the year ended December 31, 2018 decreased ($3,750), or (3%), to $140,683 from $144,433 for the year ended December 31, 2017, primarily due to no tomato production from the Delta 3 facility ($5,371) and a decrease in costs in Texas due to a decrease in pounds sold from the Texas facilities partially offset by an increase of 6% in contract sales costs. Selling, General and Administrative Expenses Selling, general and administrative expenses for the year ended December 31, 2018 decreased ($767), or (5%), to $14,108 from $14,875 for the year period ended December 31, 2017. The decrease is due to legal costs occurred in the year ended December 31, 2017 during formation of the Joint Venture. Stock Compensation Expenses Stock compensation expenses for the year ended December 31, 2018 was $1,454 which was a slight decrease from $1,519 for the year ended December 31, 2017. Interest Expense Interest expense for the year ended December 31, 2018 increased $99 to $2,794 from $2,695 for the year period ended December 31, 2017. The increase is due to interest rate increases partially offset by a decrease in the outstanding debt balances. Share of Loss from Joint Ventures Our share of loss from its Joint Venture for the year ended December 31, 2018 was ($171) from ($468) for the year ended December 31, 2017. The decreased loss is primarily attributed to the Joint Venture’s commencing selling operation in October 2018. This income was able to offset most of the salaries and other administrative costs. For information regarding the results of operations from our joint ventures, see “Reconciliation of U.S. GAAP Results to Proportionate Results” below. Income Taxes (Recovery) Income tax recovery for the year ended December 31, 2018 was a recovery of $2,300 compared to a recovery of $763 for the year ended December 31, 2017. The increased income tax recovery is due lower gross profit from operations. Gain on Sale of Assets No gains were recognized in 2018. The Company recognized for the year period ended December 31, 2017 a loss of ($8) related to a write-off of an asset from our Texas facility. Net Income (Loss) Net income (loss) for the year ended December 31, 2018 decreased to a loss of ($7,515) from the loss of ($4,757) for the year ended December 31, 2017. The increased (loss) is due to a decrease in net sales caused by the loss of the Delta 3 facility and production shortfalls in Texas which were partially offset by a decrease in the cost of sales. The production shortfall in Texas increases the cost per pound of tomatoes sold as fixed costs are expensed over less pounds. Adjusted EBITDA Adjusted EBITDA for the year period ended December 31, 2018 decreased ($3,812) to $2,638 from $6,450 for the year period ended December 31, 2017, primarily as a result of an increase in income loss from consolidated entities. See the reconciliation of Adjusted EBITDA to net income in “Non-GAAP Measures-Reconciliation of Net Earnings to Adjusted EBITDA”. Liquidity and Capital Resources Capital Resources The Company expects to provide or obtain adequate financing to maintain and improve its property, plant and equipment, to fund working capital produce needs and invest in the Joint Venture for the foreseeable future from cash flows from operations, and, as needed, from additional borrowings under the Credit Facilities (as defined below) or additional equity financing. As described below, we are currently not in compliance with the covenants of our Credit Facilities and have had to obtain waivers from our lenders, and we are currently in discussions to amend or enter into new Credit Facilities in the second quarter of 2020. The Company has a term loan financing agreement with a Canadian creditor (the “FCC Loan”). This non-revolving variable rate term loan has a maturity date of May 1, 2021 and a balance of $31,306 as at December 31, 2019 (December 31, 2018-$34,385). The outstanding balance is repayable by way of monthly installments of principal and interest based on an amortization period of 15 years, with the balance and any accrued interest to be paid in full on May 1, 2021. As at December 31, 2019, borrowings under the FCC Loan were subject to an interest rate of 6.391% (December 31, 2018 - 7.082%), which is determined based on our debt to EBITDA ratio and the applicable LIBOR rate. Our Company is also party to a variable rate line of credit agreement with BMO that has a maturity date of May 31, 2021 (the “Operating Loan” and together with the FCC Loan, the “Credit Facilities”). The Operating Loan is subject to margin requirements stipulated by the bank based on produce sales. As at December 31, 2019, $2,000 was drawn on the Operating Loan (December 31, 2018-$2,000), which is available to a maximum of C$13,000, less outstanding letters of credit of US$150 and C$38. As security for the FCC Loan, the Company has provided promissory notes, a first mortgage on the VFF-owned greenhouse properties (excluding the Delta 3 and Delta 2 greenhouse facilities) and general security agreements over its assets. In addition, the Company has provided full recourse guarantees and has granted security therein. The carrying value of the assets and securities pledged as collateral as at December 31, 2019 was $146,377 (December 31, 2018 - $101,263). As security for the Operating Loan, the Company has provided promissory notes and a first priority security interest over its accounts receivable and inventory. In addition, the Company has granted full recourse guarantees and security therein. The carrying value of the assets pledged as collateral as at December 31, 2019 was $24,915 (December 31, 2018 - $36,248). The borrowings are subject to certain positive and negative covenants, which include debt coverage ratios. As at December 31, 2019, the Company received a waiver for its annual debt service coverage and debt to EBITDA covenants under its Term Loan for the year ended December 31, 2019 and was in compliance with all of its other Credit Facility covenants under its Credit Facilities. Accrued interest payable on the credit facilities and loans as at December 31, 2019 was $162 (December 31, 2018-$184) and these amounts are included in accrued liabilities in the consolidated statements of financial position. On February 13, 2019, the Joint Venture entered into a credit agreement with BMO, as agent and lead lender, and FCC, as lender, in respect of a C$20,000 secured non-revolver term loan (the “PSF Credit Facility”). At December 31, 2019 the outstanding amount on the loan was C$19,000. The PSF Credit Facility, which matures on February 7, 2022, is secured by the Delta 3 greenhouse facility and contains customary financial and restrictive covenants. The Company is not a party to the PSF Credit Facility but has guaranteed up to C$10 in connection with the PSF Credit Facility. The Company closed equity offerings on October 22, 2019 and March 24, 2020. The October 22, 2019 public offering raised C$26,934 (net proceeds) through the issuance of 3,059,000 Common Shares at a price of C$9.40 per Common Share. The March 24, 2020 public offering raised C$10,711 (net proceeds) through the issuance of 3,593,750 Common Shares at a price of C$3.20 per Common Share. Summary of Cash Flows Operating Activities For the year ended December 31, 2019, cash flows from operating activities before changes in non-cash working capital, totalled ($19,902) (2018 - $1,527). The decrease in cash flows from operating activities is due to a decrease in sales and an increase in cost of sales for the year ended December 31, 2019. Investing Activities For the year ended December 31, 2019, cash flow from investing activities consisted of ($14,507) in note to Joint Venture, ($2,287) in capital expenditures and ($96) investment in our joint ventures (2018 - $10,462 in note to Joint Venture and $3,093 in net capital expenditures). The joint venture notes made for the year ended December 31, 2019 was $13,323 to VF Hemp and $1,184 to AVGGH and for the year ended December 31, 2018 $10,873 to Pure Sunfarms. Financing Activities For the year ended December 31, 2019, the cash provided by financing activities primarily consisted of the issuance of Common Shares of $34,226, proceeds from the exercise of share options and warrants of $674, debt payments of, net ($3,423), and payments on capital lease obligations of ($90) (2018 - proceeds from the issuance of Common Shares of $23,492, proceeds from the exercise of share options of $283, offset by net term debt payments of ($706), and payments on capital lease obligations of ($71)). Contractual Obligations and Commitments Information regarding our contractual obligations as at December 31, 2019 is set forth in the table below: We intend to make additional equity contributions to the Joint Venture estimated to be up to C$16,000 in the early part of 2020. As of March 27, 2020, we have made equity contributions to the Joint Venture of C$8,000 with the intention of making an additional $8,000 in late March or early April. The Company may be required to make additional equity contributions to Pure Sunfarms based on Pure Sunfarms ability to generate positive cash flow from its operations. Off-Balance Sheet Arrangements The Company does not have any off-balance sheet arrangements. Non-GAAP Measures References in this MD&A to “Adjusted EBITDA” are to earnings (including the equity in earnings of the Joint Venture) before interest, taxes, depreciation and amortization (“EBITDA”), as further adjusted to exclude foreign currency exchange gains and losses on translation of long-term debt, unrealized gains on the changes in the value of derivative instruments, stock compensation, and gains and losses on asset sales. Adjusted EBITDA is a cash flow measure that is not recognized under GAAP and does not have a standardized meaning prescribed by GAAP. Therefore, Adjusted EBITDA may not be comparable to similar measures presented by other issuers. Investors are cautioned that Adjusted EBITDA should not be construed as an alternative to net income or loss determined in accordance with GAAP as an indicator of our performance or to cash flows from operating, investing and financing activities as measures of liquidity and cash flows. Management believes that Adjusted EBITDA is an important measure in evaluating the historical performance of the Company. We also present Adjusted EBITDA, earnings per share and diluted earnings per share on a proportionate segment basis. Each of the components of Adjusted EBITDA, on a proportionate segment basis (which include our proportionate share of the Joint Venture and VFH and AVGGH (“Hemp”) operations), are presented in the table Reconciliation of GAAP to Proportionate Results below. We believe that the ability of investors to assess our overall performance may be improved by the disclosure of proportionate segment Adjusted EBITDA, earnings per share and diluted earnings per share, given that our joint ventures represent a significant percentage of our net income. Reconciliation of Net Income to Adjusted EBITDA The following table reflects a reconciliation of net income to Adjusted EBITDA, as presented by the Company: Notes: (1) The GAAP treatment of our equity earning of our Joint Venture (“Pure Sunfarms”) is different than under IFRS. Under GAAP the Emerald shares held in escrow are not considered issued until paid for pursuant to the GAAP concept of ‘hypothetical liquidation’. As a result, under GAAP, our ownership percentage for all of 2017, January through March of 2018 and March through December of 2019 was higher than its economic interest of 50% (53.5% effective November 19, 2019). Accordingly, for those periods with a higher deemed ownership percentage, we received a higher allocation of profits and losses during the periods in which there were outstanding escrow shares that were not yet paid for by Emerald. The effective profit and loss allocation - on a weighted average basis in 2019 was 57.9%, in 2018 was 52.2% and in 2017 was 87.5%. Reconciliation of U.S. GAAP Results to Proportionate Results The following tables are a reconciliation of the GAAP results to the proportionate results (which include our proportionate share of the Joint Venture and VFH and AVGGH (“Hemp”) operations): Notes: (1) The adjusted consolidated financial results have been adjusted to include our share of revenues and expenses from Pure Sunfarms and Hemp on a proportionate accounting basis, on which management bases its operating decisions and performance evaluation. GAAP does not allow for the inclusion of the joint ventures on a proportionate basis. These results include additional non-GAAP measures such as Adjusted EBITDA. The adjusted results are not generally accepted measures of financial performance under GAAP. Our method of calculating these financial performance measures may differ from other companies and accordingly, they may not be comparable to measures used by other companies. (2) Adjusted EBITDA is not a recognized earnings measure and does not have a standardized meaning prescribed by GAAP. Therefore, Adjusted EBITDA may not be comparable to similar measures presented by other issuers. See “Non-GAAP Measures”. Management believes that Adjusted EBITDA is a useful supplemental measure in evaluating the performance of the Company. Consolidated Adjusted EBITDA includes our majority non-controlling interest Pure Sunfarms, our 65% interest in VFH and our 60% interest in AVGGH. New Accounting Pronouncements Adopted In February 2016, the Financial Account Standard Board (“FASB”) issued Accounting Standard Update (“ASU”) 2016-02, Leases, and has subsequently issued several supplemental and/or clarifying ASUs (collectively, “Topic 842”), which requires a dual approach for lease accounting under which a lessee would account for leases as finance leases or operating leases. Both finance leases and operating leases may result in the lessee recognizing a right of use asset and a corresponding lease liability. For finance leases, the lessee would recognize interest expense and amortization of the right-of-use asset, and for operating leases, the lessee would recognize lease expense on a straight-line basis. On January 1, 2019, the Company adopted Topic 842, using the modified retrospective method and did not restate prior periods. The Company elected to utilize the package of practical expedients that allows us to 1) not reassess whether any expired or existing contracts are or contain leases, 2) retain the existing classification of lease contracts as of the date of adoption, and 3) not reassess initial direct costs for any existing leases. Our classes of assets include land leases, building leases and equipment leases. On adoption, the Company recognized lease liabilities in relation to leases which had previously been classified as ‘operating leases’ under the principles of Topic 842. These lease liabilities were measured at the present value of the remaining lease payments, discounted using the borrowing rate of the Company. The weighted average incremental borrowing rate applied to the lease liabilities on January 1, 2019 was 6.25%. These leases are included in right-of-use assets, short-term lease liabilities and long-term lease liabilities in the consolidated statements of financial position. Right-of-use assets are amortized on a straight-line basis over the lease term. For leases previously classified as finance leases the entity recognized the carrying amount of the lease asset and lease liability immediately before transition as the carrying amount of the right-of-use asset and the lease liability at the date of initial application. Additionally, the Company has elected the short-term lease exception for all classes of assets, and does not apply the recognition requirements for leases of 12 months or less, and recognizes lease payments for short-term leases as expense either straight-line over the lease term or as incurred depending on whether the lease payments are fixed or variable. These elections are applied consistently for all leases. The recognized right-of-use assets relate to the following types of assets: New Accounting Pronouncements Not Yet Adopted In December 2019, the FASB issued ASU 2019-12, “Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes.” ASU 2019-12 simplifies the accounting for income taxes by removing exceptions within the general principles of Topic 740 regarding the calculation of deferred tax liabilities, the incremental approach for intraperiod tax allocation, and calculating income taxes in an interim period. In addition, the ASU adds clarifications to the accounting for franchise tax (or similar tax). which is partially based on income, evaluating tax basis of goodwill recognized from a business combination, and reflecting the effect of any enacted changes in tax laws or rates in the annual effective tax rate computation in the interim period that includes the enactment date. The ASU is effective for fiscal years beginning after December 15, 2020 and will be applied either retrospectively or prospectively based upon the applicable amendments. Early adoption is permitted. The adoption of this standard is not expected to have a material impact on our consolidated financial statements and related disclosures. In August 2018, the FASB issued ASU 2018-13, “Fair Value Measurement (Topic 820)-Disclosure Framework-Changes to the Disclosure Requirements for Fair Value Measurement.” ASU 2018-13 removes the disclosure requirement for the amount and reasons for transfers between Level 1 and Level 2 fair value measurements as well as the process for Level 3 fair value measurements. In addition, the ASU adds the disclosure requirements for changes in unrealized gains and losses included in other comprehensive income (loss) for recurring Level 3 fair value measurements held at the end of the reporting period as well as the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements. The ASU is effective for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years and will be applied on a retrospective basis to all periods presented. Early adoption is permitted. The adoption of this standard is not expected to have a material impact on our consolidated financial statements and related disclosures. In June 2016, the FASB issued ASU 2016-13, “Financial Instruments-Credit Losses.” The standard, including subsequently issued amendments, requires a financial asset measured at amortized cost basis, such as accounts receivable and certain other financial assets, to be presented at the net amount expected to be collected based on relevant information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. This ASU is effective for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years, and requires the modified retrospective approach. Early adoption is permitted. Based on the composition of our trade receivables and other financial assets, current market conditions, and historical credit loss activity, the adoption of this standard is not expected to have a material impact on our consolidated financial statements and related disclosures. Critical Accounting Estimates and Judgments Inventories and cost of sales Cost of sales is based upon incurred costs, and estimated costs to be incurred, of each crop allocated to both actual and estimated future yields over each crop cycle. The estimates of future yields are reviewed at each reporting period for accuracy. However, numerous factors such as weather, diseases and prevailing market conditions can impact the estimation of pricing, costs, and future yields. The estimated costs to be incurred are based on references to historical costs and updated for discussions with suppliers and senior management. Inventories include the actual cost of the crop not yet defined as a biological asset, packaging supplies, and purchased produce, less the amounts that have been expensed in cost of sales. Income taxes and deferred income tax assets or liabilities Management uses judgment and estimates in determining the appropriate rates and amounts in recording deferred taxes, giving consideration to timing and probability. Actual taxes could vary significantly from these estimates as a result of future events, including changes in income tax law or the outcome of reviews by tax authorities and related appeals. The resolution of these uncertainties and the associated final taxes may result in adjustment to our tax assets and tax liabilities. The recognition of deferred income tax assets is subject to judgment and estimation over whether these amounts can be realized.

<s>[INST] All amounts are expressed in thousands of United States dollars unless otherwise stated. Overview VFF is a corporation existing under the Canada Business Corporations Act. The Company’s principal operating subsidiaries are Village Farms Canada Limited Partnership (“VFCLP”), Village Farms, L.P. (“VFLP”) and VF Clean Energy, Inc. (“VFCE”). On June 6, 2017, VFF entered into a shareholders’ agreement in respect of the operation and governance of Pure Sunfarms Corp. (“Pure Sunfarms”) in which pursuant to the settlement agreement dated as of March 2, 2020 (the “Settlement Agreement”) entered into with Emerald Health Therapeutics Inc. (“Emerald”), VFF currently owns a 57.4% interest (at December 31, 2019 owned 53.5% interest). On February 27, 2019, VFF entered into a joint venture agreement in respect of the operation and governance of Village Fields Hemp USA LLC (“VFH”) in which VFF owns a 65% interest. On May 21, 2019, the Company entered into a joint venture agreement in respect of Arkansas Valley Green and Gold Hemp (“AVGGH”). AVGGH is 60% owned by VFF, 35% owned by Arkansas Valley Hemp, LLC (“AV Hemp”) and 5% owned by VFH. Our operating Segments JV Cannabis Segment The Company’s Joint Venture, Pure Sunfarms is a licensed producer and supplier of cannabis products to be sold to other licensed providers and provincial governments across Canada and internationally. Pure Sunfarmsbranded dried cannabis products are sold directly to private retailers and provincial/territorial wholesalers. Produce Segment We are marketers and distributors of premiumquality, greenhousegrown tomatoes, bell peppers and cucumbers in North America. These premium products are grown in sophisticated, highly intensive agricultural greenhouse facilities located in British Columbia and Texas. The Company also markets and distributes premium tomatoes, peppers and cucumbers produced under exclusive arrangements with other greenhouse producers. The Company primarily markets and distributes under its Village Farms® brand name to retail supermarkets and dedicated fresh food distribution companies throughout the United States and Canada. Energy Segment Through its subsidiary VFCE, owns and operates a 7.0megawatt power plant from landfill gas that generates electricity and provides thermal heat, in colder months, to one of the Company’s adjacent British Columbia greenhouse facilities and sells electricity to the British Columbia Hydro and Power Authority (“BC Hydro”). Presentation of Financial Results Our consolidated results of operations (prior to net income) for each of the three years ended December 31, 2019, 2018 and 2017 presented below reflect the operations of our consolidated wholly owned subsidiaries, which as of December 31, 2019, does not include our Pure Sunfarms, VFH and AVGGH joint ventures. The equity in earnings from those joint ventures is reflected in our net income for each of the three years ended December 31, 2019, 2018 and 2017 presented below. For information regarding the results of operations from our joint ventures, see “Reconciliation of GAAP Results to Proportionate Results” below. Results of Operations Consolidated Financial Performance (In thousands of U.S. dollars, except per share amounts) (1) Adjusted EBITDA is not a recognized earnings measure and does not have a standardized meaning prescribed by GAAP. Therefore, Adjusted EBITDA may not be comparable to similar measures presented by other issuers. See “NonGAAP Measures” for a definition and reconciliation of Adjusted EBITDA to net income (loss), the nearest comparable measurement under GAAP. Management believes that Adjusted EBITDA is a useful supplemental measure in evaluating the performance of the Company [/INST] Negative. </s>

Casper Sleep Inc.

2020-03-19

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 "Selected Consolidated Financial and Other Data" and our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This discussion 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 factors, including those set forth under "Risk Factors" and in other parts of this Annual Report on Form 10-K. A discussion of the year ended December 31, 2018 compared to the year ended December 31, 2017 has been reported previously in our our Final Prospectus, under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations." Overview As a pioneer of the Sleep Economy, we bring the benefits of cutting-edge technology, data, and insights directly to consumers. We focus on building direct relationships with consumers, providing a human experience, and making shopping for sleep joyful. We meet consumers wherever they are, online and in person, providing a fun and engaging experience, while reducing the hassles associated with traditional purchases. Our products seek to address real life sleep challenges by optimizing for a variety of factors that impact sleep like the microclimate under the covers by regulating humidity and temperature; comfort and support, through the use of high-quality materials and ergonomic designs; and the ambience and sleep environment, through smart devices that provide sleep-conducive lighting. We also work to address "the little things" in our products, offering innovative features to make the sleep experience better and less stressful. Casper Labs innovates throughout the Sleep Economy. Based in San Francisco, Casper Labs has over 25,000 square feet of fabrication and test space, featuring state-of-the-art capabilities to test against a wide range of factors affecting sleep quality. Casper Labs controls every aspect of our product offerings, including design and construction, material performance requirements, manufacturing protocols, supplier selection, packaging specifications, and quality assurance. We believe that no other company in the category has our level of product development talent, resources, or expertise. We distribute our products through a flexible, multi-channel approach combining our direct-to-consumer channel, including our e-commerce platform and retail stores, with our retail partnerships. Our presence in physical retail stores has proven complementary to our e-commerce channel, as we believe interaction with multiple channels has created a synergistic "network effect" that increases system-wide sales as a whole. We believe our multi-channel expansion creates synergies and that these channels, to date, have proven to be complementary, not cannibalistic. As of December 31, 2019, we distributed our products directly to our customers in seven countries through our e-commerce platform, our 60 Casper stores, and our 18 retail partners, including with Amazon, Costco, Hudson's Bay Company, and Target. Through our high-quality and innovative product portfolio, synergistic multi-channel go-to-market strategy and unwavering focus on our consumers, we have experienced significant growth across channels: • For the years 2019 and 2018, our net revenue was $439.3 million and $357.9 million, respectively, representing an increase of 22.7%. • Our direct-to-consumer revenue was $350.5 million in 2019, up 13.0% from 2018. Our revenue from retail partnerships was $88.8 million in 2019, up 86.0% from 2018. • In the past five years, we have grown from being a strictly e-commerce business to developing into a multi-channel business, operating 60 retail stores and working with 18 retail partners as of December 31, 2019. • We have invested significantly in our sophisticated, integrated marketing strategy, with $154.6 million in marketing expenditure in 2019. Factors Affecting our Financial Condition and Results of Operations Our financial condition and results of operations have been, and will continue to be, affected by a number of important factors, including the following: Ability to Grow Our Brand Awareness. Our brand name and image are integral to the growth of our business and to the implementation of our strategies for expanding our business. We believe our brand sets us apart from our competitors, and is essential to our ability to engage and to stay connected with prospective and existing customers as they discover, evaluate, and purchase our suite of products and services. This continued customer engagement helps to inform and accelerate our culture of innovation and improves how we execute our vision of becoming the world's most loved and largest sleep company. In these ways, our brand directly contributes to and drives our growth. We believe that as brand awareness grows and deepens, we will continue to strengthen our ability to create and capture value across the Sleep Economy, enhancing our competitive advantages in a category that we believe no other single company understands better. We believe the consistency and quality of our messaging has helped us build our brand into a household name and create a large and highly engaged consumer following. We believe our brand strength will enable us to continue to expand across both markets and products, allowing us to access a global market. Ability to Grow Our Direct-to-Consumer Presence and Network of Retail Partnerships. We distribute our products through a flexible multi-channel approach combining our direct-to-consumer channel, including our e-commerce platform and retail stores, with retail partnerships. But whether consumers engage us through our website, at our stores, or through a retail partner-and whether they're looking for information, content, or to purchase-we believe those who interact with Casper have an experience that is genuine, trustworthy and approachable, as well as fun and playful across every channel. We intend to continue leveraging our marketing strategy to drive increased consumer traffic to both casper.com and to our physical retail locations. As of December 31, 2019, we operated 60 retail store locations in key cities in the United States and Canada. Additionally, as of December 31, 2019, we had 18 retail partners, including Amazon, Costco, Hudson's Bay Company, and Target, among others. Our research indicates that these partnerships not only expand our consumer base but also provide access to future consumers that have yet to engage with the Casper brand. We believe our retail channel improves our consumer experience, attracting and educating more consumers about Casper, which in turn attracts more partners to our brand thereby further enhancing our ability to generate revenue. We continue to evaluate partnerships with a wide variety of retailers, including online retailers, big-box retailers, department stores and specialty retailers. Investments in Research and Development and Ability to Improve Existing Products and Introduce New Products Based on Superior Innovation. Casper is constantly investing in and improving existing products and introducing new products and services with proprietary technologies to address the full Sleep Arc. For example, we recently expanded our existing mattress product offering by designing new hybrid mattresses that combine our proprietary foam technology with resilient springs. Casper Labs, our over 25,000 square foot advanced research facility in San Francisco, enables us to develop, rapidly prototype and test multiple design iterations. We thoughtfully curate our product and services offerings utilizing high-quality materials and advanced manufacturing processes to create a differentiated experience. The improvement of existing products and the introduction of new products have been, and we expect will continue to be, integral to our growth. We believe our rigorous approach to creating and improving our products has helped redefine and grow the addressable market that we call the Sleep Economy. This in turn offers consumers more opportunities to interact with us and purchase from us, which drives new consumer as well as repeat consumer business. Cost-Effective Acquisition of New Consumers and Retention of Existing Customers. To continue to grow our business, we must acquire new consumers as well as retain existing customers in a cost-effective manner. We continually evolve our marketing strategies, and adjust our messages, the amount we spend on advertising and the channels in which we spend. We have made, and we expect that we will continue to make, significant investments in attracting new consumers, including through traditional, digital, social media and original Casper content. It is critical for us to maintain reasonable costs for these marketing efforts relative to sales derived from new consumers. We believe our multi-channel expansion creates synergies and that these channels, to date, have proven to be complementary, not cannibalistic. Moreover, we expect our marketing efficiency (which we define as net revenue as a percentage of total media spend over a specific time period) to improve over time as sales through our owned retail stores and retail partners increase. Because increasing sales through these channels requires minimal incremental marketing investment, we believe we will be able to drive natural leverage in our marketing efficiency. As we continue to launch new products and improve existing products, we expect customers generating repeat revenue to grow due to our efforts to create a differentiated and joyful experience, eliminating friction and boundaries. Importantly, 23% of customers in our direct-to-consumer channel in 2019 were repeat customers. Competitive Industry Dynamics. We operate in the highly competitive mattress, soft goods, bedroom furniture, sleep technology and services industries, among others industries. The competitive environment of the industries in which we operate continually subjects us to the risk of loss of market share, loss of significant customers, reductions in margins, discounting by competitors, and to the challenge of acquiring new customers. While the mattress industry is highly consolidated and is dominated by a few long-standing players, the soft goods, bedroom furniture, sleep technology and services industries are highly fragmented, which presents opportunities for growth in each of those markets. We combine our offerings with a differentiated in-store experience and high-quality consumer experience, which has enabled us to continue to grow our market share and drive revenue. Disciplined Approach to Operations. As we scale our business, we intend to continue to drive continued operational improvement so that we can provide quality products and services to ensure the best possible consumer experiences while improving our revenue and controlling our costs. In particular, we plan to drive operational efficiencies through a focus on reducing product return rates, price optimization, investing in our supply chain, improving the efficiency and enhancing performance of our marketing investments, and realizing economies of scale. Impact of Novel Coronavirus Casper is closely monitoring how the spread of the novel coronavirus is affecting its employees, customers and business operations. We have developed preparedness plans to help protect the safety of our employees and retail customers, while safely continuing business operations. Due to the spread of the outbreak in New York, California, and elsewhere where we have corporate offices, we have temporarily restricted access to our offices until at least March 27, 2020 and implemented a mandatory remote work policy during this period. In addition, over the past several weeks, we have worked with our manufacturing, logistics and other supply chain partners to build communication and monitoring processes for all aspects of our product and delivery supply chain. To date, we have not seen a material impact on our supply chain, inventory availability or delivery capacity. In addition, as of the date of this Annual Report on Form 10-K, the outbreak has caused us to temporarily close our retail stores located in North America through March 27, 2020. As a result, we expect that the novel coronavirus outbreak will impact our revenues, results of operations and financial condition. We are, however, carefully monitoring shifts by customers from our physical retail to our online platform. Moreover, we have not, to date, experienced a material impact due to the novel coronavirus outbreak on sales with our retail partners. We are, however, continuing to work closely with our retail partners to monitor the situation. At this time, there is significant uncertainty relating to the trajectory of the novel coronavirus outbreak and impact of related responses. The continued spread of the outbreak may further impact our business, financial condition or results of operations. See "Risk Factors-Risks Related to Our Business-The novel coronavirus outbreak could adversely impact our business, financial condition and results of operations." Components of our Results of Operations Revenue, Net Revenue, net is comprised of global sales through our direct-to-consumer channels and our retail partnerships. Revenue, net reflects the impact of product returns as well as discounts for certain sales programs and promotions. Revenue, net comprises the consideration received or receivable for the sale of goods and services in the ordinary course of our activities net of returns and promotions. Promotions are occasionally offered, primarily in the form of discounts, and are recorded as a reduction of gross revenue at the date of revenue recognition. We typically accept sales returns during a 30- or 100-night trial period, depending on the product, with our mattresses having a 100-night trial period. A sales return accrual is estimated based on historical return rates and is then adjusted for any current trends as appropriate. Returns are netted against the sales allowance reserve for the period. Sales are recognized as deferred revenue at the point of sale and are recognized as revenue upon the delivery to the consumer. Revenue through our direct-to-consumer channels is recognized upon in-store or home delivery to the consumer, as applicable, and retail partnership revenue is recognized upon the transfer of control, on a per contract basis. Cost of Goods Sold Cost of goods sold consists of costs of purchased merchandise, including freight, duty, and non-refundable taxes incurred in delivering goods to our consumers and distribution centers, packaging and component costs, warehousing and fulfilment costs, damages, and excess and obsolete inventory write-downs. Gross Profit and Gross Margin We calculate gross profit as revenue, net less cost of goods sold. We calculate gross margin as gross profit divided by net revenue for a specific period of time. Gross margin in our direct-to-consumer channel, including company-owned retail stores and e-commerce sales, is generally higher than that on sales to our retail partnerships. Our gross margin may in the future fluctuate from period to period based on a number of factors, including cost of purchased merchandise and components, the mix of products and services we sell and the mix of channels through which we sell our products. We have historically experienced that gross margin, by product, tends to increase over time as we realize cost efficiencies as a result of economies of scale, sourcing strategies and product re-engineering programs. In addition, our ability to continue to reduce the cost of our products is critical to increasing our gross margin over the long-term. Operating Expenses Operating expenses consist of sales and marketing, and general and administrative expenses, including research and development. Sales and Marketing Expenses. Sales and marketing expenses represent the largest component of our operating expenses and consist primarily of advertising and marketing promotions of our products and services as well as consulting and contractor expenses. We expect our sales and marketing expenses to increase in absolute dollars as we continue to promote our offerings. At the same time, we also anticipate that these expenses will decrease as a percentage of our sales revenue, net over time, as we improve marketing efficiencies and grow channels that require lower sales and marketing support. General and Administrative Expenses. General and administrative expenses consist of personnel-related costs for our retail operations, finance, legal, human resources, and IT functions, as well as litigation expenses, credit card fees, professional services, rent and operating costs associated with our retail stores, depreciation and amortization, and other administrative expenses. General and administrative expenses also include research and development expenses consisting primarily of personnel related expenses, consulting and contractor expenses, tooling, test equipment and prototype materials. 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 compliance costs associated with becoming a public company. However, we expect our general and administrative expenses to decrease as a percentage of our sales revenue, net over time, as we scale our business. Income Tax Expense We account for income taxes in accordance with ASC Topic 740, Income Taxes-Under this method, deferred tax assets and liabilities are determined based on the temporary differences between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. We classify all deferred income tax assets and liabilities as noncurrent on our 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 the deferred tax assets. In making such a determination, we consider all available positive and negative evidence, including taxable income in prior carryback years (if carryback is permitted under the relevant tax law), the timing of the reversal of existing taxable temporary differences, tax-planning strategies and projected future taxable income. Please refer to Note 10 to our audited consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K 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. Seasonality and Quarterly Comparability Our revenue includes a seasonal component, with the highest sales activity normally occurring during the second and third quarters of the year due to back-to-school, home moves and other seasonal factors, along with seasonal promotions we offer during these quarters. The timing of on-boarding new retail partnerships, which typically launch with large inventory buy-ins, and the timing of launching new products may also impact comparability between periods. These factors can also impact our working capital and/or inventory balances in a given period. Results of Operations Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 The following table sets forth information comparing the components of operations and comprehensive loss for the periods indicated. Revenue, Net Revenue, net was $439.3 million for the year ended December 31, 2019, an increase of $81.4 million, or 22.7%, compared to $357.9 million for the year ended December 31, 2018. Revenue, net increased as a result of sales through our direct-to-consumer and retail partnership channels and the introduction of new products. Direct-to-consumer sales increased 13.0% compared to the year ended December 31, 2018 as we continued to gain market share and expand our retail presence to 60 stores, with 37 net new stores opened at various points throughout the year ended December 31, 2019. Sales to retail partners increased 86.0% compared to the year ended December 31, 2018, driven by growth of sales activity by existing partners, the introduction of seven new partners to end the year with 18 partners, and the expansion of our product offerings. Gross Profit and Cost of Goods Sold Gross profit was $215.4 million for the year ended December 31, 2019, an increase of $57.7 million, or 36.6%, compared to $157.8 million for the year ended December 31, 2018. Cost of goods sold was $223.8 million for the year ended December 31, 2019, an increase of $23.7 million, or 11.8%, compared to $200.1 million for the year ended December 31, 2018. Gross margin for the year ended December 31, 2019 was 49.0% compared to 44.1% for the year ended December 31, 2018. The increase in gross margin was largely driven by implementing supply chain initiatives designed to reduce product unit costs and introducing new higher margin products, which has had a favorable impact to our cost of goods sold. Sales and Marketing Expense Sales and marketing expenses were $154.6 million for the year ended December 31, 2019, an increase of $28.4, or 22.5%, compared to $126.2 million for the year ended December 31, 2018. Sales and marketing expenses increased as we continued to invest in driving traffic to our e-commerce website, market our products to consumers and build our brand. Sales and marketing expenses as a percentage of revenue, net was 35.2% for the year ended December 31, 2019, comparable to 35.3% for the year ended December 31, 2018, and reflective of our ability to maintain efficiency, even as our overall investment in sales and marketing increased. General and Administrative Expenses General and administrative expenses were $149.6 million for the year ended December 31, 2019, an increase of $26.0 million, or 21.1%, compared to $123.5 million for the year ended December 31, 2018. General and administrative expenses increased as we invested to support our growing business, particularly in retail stores and product development. We believe innovation is a key differentiator and invest significant resources in research and development to drive product innovation to improve sleep quality. General and administrative expenses as a percentage of revenue, net decreased from 34.5% for the year ended December 31, 2018 to 34.1% for the year ended December 31, 2019 reflecting the slowing growth in general and administrative expenses relative to growth in revenue, net. Other (Income) Expense, Net Other expense, net was $4.2 million for the year ended December 31, 2019, an increase of $4.1 million compared to income of $92.0 thousand for the year ended December 31, 2018. The increase in other expense, net was due to interest incurred on our Subordinated Facility and Senior Secured Facility. Income Tax Expense Income tax expense was $87.0 thousand for the year ended December 31, 2019, an increase of $48.0 thousand compared to income tax expense of $39.1 thousand for the year ended December 31, 2018. The increase in income tax was immaterial. Key Operating Metrics and Non-GAAP Financial Measures We prepare and analyze operating and financial data to assess the performance of our business and allocate our resources. The key operating performance and financial metrics and indicators we use are set forth below. The following table sets forth our key performance indicators for the year ended December 31, 2019 and 2018. Gross Margin. Gross margin is defined as gross profit divided by sales revenue, net. Adjusted EBITDA. Adjusted EBITDA is a supplemental measure of our performance that is not required by, or presented in accordance with, GAAP. Adjusted EBITDA is not a measurement of our financial performance under GAAP and should not be considered as an alternative to net income or any other performance measure derived in accordance with GAAP. We define Adjusted EBITDA as net loss before interest (income) expense, income tax expense and depreciation and amortization as further adjusted to exclude the impact of stock-based compensation expense, restructuring costs, costs associated with legal settlements, and expenses incurred in connection with our initial public offering. We caution investors that amounts presented in accordance with our definition of Adjusted EBITDA may not be comparable to similar measures disclosed by our competitors, because not all companies and analysts calculate Adjusted EBITDA in the same manner. We present Adjusted EBITDA because we consider them to be important supplemental measures of our performance and believe it is frequently used by securities analysts, investors, and other interested parties in the evaluation of companies in our industry. Management believes that investors' understanding of our performance is enhanced by including this non-GAAP financial measure as a reasonable basis for comparing our ongoing results of operations. Management uses Adjusted EBITDA: • as a measurement of operating performance because it assists us in comparing the operating performance of our business on a consistent basis, as it removes the impact of items not directly resulting from our core operations; • for planning purposes, including the preparation of our internal annual operating budget and financial projections; • to evaluate the performance and effectiveness of our operational strategies; and • to evaluate our capacity to expand our business. By providing this non-GAAP financial measure, together with the reconciliation, we believe we are enhancing investors' understanding of our business and our results of operations, as well as assisting investors in evaluating how well we are executing our strategic initiatives. Adjusted EBITDA has limitations as an analytical tool, and should not be considered in isolation, or as an alternative to, or a substitute for net income or other financial statement data presented in our consolidated financial statements as indicators of financial performance. Some of the limitations are: • such measures do not reflect our cash expenditures; • such measures do not reflect changes in, or cash requirements for, our working capital needs; • although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future and such measures do not reflect any cash requirements for such replacements; and • other companies in our industry may calculate such measures differently than we do, limiting their usefulness as comparative measures. Due to these limitations, Adjusted EBITDA should not be considered as measures of discretionary cash available to us to invest in the growth of our business. We compensate for these limitations by relying primarily on our GAAP results and using these non-GAAP measures only supplementally. As noted in the table below, Adjusted EBITDA includes adjustments to exclude the impact of stock-based compensation expense and material infrequent items, including but not limited to the costs of our initial public offering, restructuring, costs associated with legal settlements, and acquisitions or divestitures, among other items. It is reasonable to expect that these items will occur in future periods. However, we believe these adjustments are appropriate because the amounts recognized can vary significantly from period to period, do not directly relate to the ongoing operations of our business and may complicate comparisons of our internal operating results and operating results of other companies over time. In addition, Adjusted EBITDA includes adjustments for other items that we do not expect to regularly record following our initial public offering. Each of the normal recurring adjustments and other adjustments described in this paragraph and in the reconciliation table below help management with a measure of our core operating performance over time by removing items that are not related to day-to-day operations. The following table reconciles Adjusted EBITDA to the most directly comparable GAAP financial performance measure, which is net loss: (a)Represents non-cash stock-based compensation expense. (b)Represents costs associated with reorganizing our international organizational structure, including severance, contract termination costs, and other exit activities. (c)Amounts related to litigations settlements. (d)Represents expenses incurred for professional, consulting, legal, and accounting services performed in connection with our initial public offering, which are not indicative of our ongoing costs and which were discontinued following the completion of our initial public offering. Liquidity and Capital Resources Sources of Funds Our principal sources of liquidity are our cash and cash equivalents, our Senior Secured Facility (as defined herein), our Subordinated Facility (as defined herein), and working capital from operations. Cash and cash equivalents consist primarily of cash on deposit with banks and investments in money market funds. As of December 31, 2019, we had $67.4 million of cash and cash equivalents. Funding Requirements Our primary requirements for liquidity and capital are to fund operating losses as we continue to scale our business, for increased working capital requirements and inventory management to meet increased consumer demand, for increased capital expenditures to grow our retail store presence, as well as for general corporate needs. Historically, these cash requirements have been met through funds raised by the sale of common equity, utilization of our Senior Secured Facility and cash provided by gross margin. We believe that our sources of liquidity and capital will be sufficient to finance our growth strategy and resulting operations, planned capital expenditures and the additional expenses we expect to incur for at least the next 12 months. However, we cannot assure you that cash provided by operating activities or cash and cash equivalents will be sufficient to meet our future needs. If we are unable to generate sufficient cash flows from operations in the future, we may have to obtain additional financing. If we obtain additional capital by issuing equity, the interests of our existing stockholders will be diluted. If we incur additional indebtedness, that indebtedness may contain significant financial and other covenants that may significantly restrict our operations. We cannot assure you that we could obtain refinancing or additional financing on favorable terms or at all. See "Risk Factors-Risks Related to Our Business-Our ability to raise capital in the future may be limited, and our failure to raise capital when needed could prevent us from growing." Our capital expenditures consist primarily of retail infrastructure, leasehold improvements, product development and computers and hardware. In December 2018, we signed a new agreement for a headquarters in New York for a period of 15 years with a five-year renewal option. Rent payments began on the new headquarters in January 2020. Historical Cash Flows The following table shows summary cash flow information for the years ended December 31, 2019 and 2018: Operating Activities. Net cash used in operating activities consists of net loss adjusted for certain non-cash items, including share-based compensation, property and equipment depreciation, long-term deferred rent and deferred income taxes, as well as the effect of changes in inventory and other working capital amounts. For the year ended December 31, 2019, net cash used in operating activities was $44.3 million and was comprised primarily of net loss of $93.0 million, decreased by $21.6 million related to non-cash adjustments, primarily related to deferred rent, depreciation and amortization, and share based compensation. Changes in working capital decreased cash used in operating activities by $27.1 million, primarily due to an increase in accrued expenses of $35.8 million, and an increase in other liabilities of $19.6 million, partially offset by an increase in prepaid and other assets of $16.5 million, and an increase in accounts receivable of $8.0 million. For the year ended December 31, 2018, net cash used in operating activities was $72.3 million and was comprised of net loss of $92.1 million, decreased by $9.0 million related to non-cash adjustments, primarily related to depreciation and amortization, and share-based compensation. Changes in working capital decreased cash used in operating activities by $10.8 million, primarily due to an increase in accrued expenses of $8.4 million and accounts payable of $10.2 million, as well as other liabilities of $8.6 million, partially offset by an increase in accounts receivable of $10.5 million, an increase in inventory of $8.7 million and decreases in prepaid expenses and other assets of $2.7 million, respectively. Investing Activities. Our net cash used in investing activities primarily consists of purchases of property and equipment and issuances of notes receivables. For the year ended December 31, 2019, net cash used in investing activities was $50.8 million and was primarily comprised of $54.8 million in purchases of property and equipment, partially offset by a $4.0 million decrease in notes receivable. For the year ended December 31, 2018, net cash used in investing activities was $12.0 million and was primarily comprised of investment in property and equipment primarily to support our retail store expansion. Financing Activities. For the year ended December 31, 2019, net cash provided by financing activities was $133.9 million and primarily consisted of net proceeds of $1.3 million from our Senior Secured Facility, net proceeds of $50.0 million from our Subordinated Facility, and $82.6 million from the issuance of equity and exercise of stock options. For the year ended December 31, 2018, net cash provided by financing activities primarily consisted of net proceeds of $14.6 million from our Senior Secured Facility, and $0.3 million from the issuance of equity and the exercise of stock options. Senior Secured Facility On April 27, 2016, Casper Sleep Inc. and Casper Science LLC entered into a loan and security agreement with Pacific Western Bank (as amended by the first amendment dated as of November 20, 2017, as amended by the second amendment dated as of August 14, 2018, as amended by the third amendment dated as of December 12, 2018 and as further amended by the fourth amendment and joinder dated as of March 1, 2019), which we refer to, as amended, as the Senior Secured Facility. Pursuant to the fourth amendment and joinder dated as of March 1, 2019, Casper Sleep Retail LLC was joined as a borrower to the Senior Secured Facility. Borrowings under the Senior Secured Facility accrue interest at an annual rate equal to the greater of (i) the prime rate or (ii) 3.50%. The "prime rate" is defined as the variable rate of interest, per annum, most recently announced by Pacific Western Bank, as its "prime rate," whether or not such announced rate is the lowest rate available from Pacific Western Bank. A nominal annual fee is due each October 1, and, upon a liquidity event or change of control, which as defined under the Senior Secured Facility includes an initial public offering of our equity securities, a certain one-time success fee of $150,000 will become due and payable to Pacific Western Bank. The Senior Secured Facility contains certain affirmative and negative covenants, including, among other things, restrictions on indebtedness, liens, dividends and distributions, investments, mergers or consolidations and a minimum amount of cash resources or assets we are required to maintain. Currently, the Senior Secured Facility consists of a $25.0 million revolving credit facility that becomes due and payable on September 1, 2020. As of December 31, 2019, we had $15.9 million outstanding and $7.6 million of letters of credit issued pursuant to the Senior Secured Facility with $1.5 million remaining available for borrowing. Subordinated Facility On March 1, 2019, Casper Sleep Inc., Casper Science LLC and Casper Sleep Retail LLC entered into a growth capital loan and security facility agreement with TriplePoint Venture Growth BDC Corp., as lender and collateral agent, and TriplePoint Capital LLC, as lender (or, together with TriplePoint Venture Growth BDC Corp., TriplePoint), which provided for a $50.0 million growth capital loan facility, which we refer to as the Subordinated Facility. The Subordinated Facility allows for expansion up to an additional $50.0 million upon request and approval following full utilization of the initial loan, and has a maturity, at our option, of up to five years. In connection with the Subordinated Facility, on March 1, 2019, we entered into two warrant agreements with TriplePoint Venture Growth BDC Corp. and TriplePoint Capital LLC for 19,201 shares of Series D preferred stock and 12,801 shares of Series D preferred stock, respectively, at an exercise price per share of $31.24715. TriplePoint's right under the warrant agreements to purchase the Series D preferred stock will be available for the greater of (i) seven years from March 1, 2019 or (ii) one year from the effective date of an initial public offering, subject to certain exercise conditions. In the event these warrant agreements are exercised after an initial public offering, TriplePoint will have the right to purchase under the warrant agreements the common stock into which each share of the Series D preferred stock is convertible at the time of such exercise. Borrowings under the Subordinated Facility accrue interest at the prime rate (which, as defined in the Subordinated Facility, shall be as published in the Wall Street Journal with a floor of 5.25%) plus an applicable margin set forth in the table of terms. The table of terms sets forth 18 options that range on term, amortization, interest rate and other features that can range from an annual interest rate of the prime rate plus 0.0% margin for a three-month interest-only term and up to a prime plus 7.25% margin for a 48-month interest-only term. End of term payments range from 0.25% of each advance for a three-month term up to 8.25% for each advance with a 48-month repayment option. The Subordinated Facility also has a 1.25% one-time facility fee for the committed amount, which is initially $50.0 million. There is a 1.5% prepayment penalty in the event that the loan is prepaid within the first 18 months with no prepayment penalty thereafter. The Subordinated Facility contains certain affirmative and negative covenants, including, among others, restrictions on liens, indebtedness, mergers or acquisitions, investments, dividends or distributions, fundamental changes and affiliate transactions. As of December 31, 2019, we had $50.0 million outstanding under the Subordinated Facility. On August 9, 2019, $25.0 million was drawn down pursuant to the Subordinated Facilitiy subject to a 48-month interest-only term with an interest rate of prime plus 7.25%. On November 1, 2019, an additional 25.0 million was drawn down pursuant to the Subordinated Facility subject to a 36-month interest-only term with an interest rate of prime plus 6.0%. As of December 31, 2019, we were in compliance with all covenants under the Subordinated Facility. See "Description of Indebtedness-Subordinated Facility." Series D Equity Fund Raise From February 2019 through October 2019, we sold to 31 accredited investors an aggregate of 2,656,763 shares of Series D preferred stock, par value $0.000001 per share, at a per share purchase price of $31.24715, for an aggregate purchase price of approximately $83.0 million in connection with our Series D financing. Initial Public Offering On February 10, 2020, in connection with our initial public offering, we issued and sold 8,350,000 shares of our common stock at a price to the public of $12.00 per share, resulting in net proceeds to us of approximately $88.4 million, after deducting the underwriting discount of approximately $6.5 million and offering expenses of approximately $5.3 million. Contractual Obligations The following table sets forth our contractual obligations as of December 31, 2019: (1)Represents the amount outstanding as of December 31, 2019 under our Senior Secured Facility and our Subordinated Facility. Off-Balance Sheet Arrangements As of December 31, 2019, we did not have any off-balance sheet arrangements. Recent Accounting Pronouncements See Note 15 to our audited consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K for further information on certain accounting standards that have been adopted during 2018 and 2019 or that have not yet been required to be implemented and may be applicable to our future operations. Critical Accounting Policies and Estimates Revenue Recognition Revenue comprises the consideration received or receivable for the sale of goods in the ordinary course of our activities. Revenue is presented net of estimated returns, sales allowances and discounts. Shipping and other transportation costs are recorded in cost of goods sold. Promotions are offered to consumers primarily in the form of discounts and recorded as a reduction of gross sales at the date of the corresponding transaction. We accept sales returns during a 30 or 100-night trial period, depending on the product. A sales return accrual is estimated based on historical return rates and is adjusted for any current trends, as appropriate. Returns are netted against the sales allowance reserve for the period. Sales are recognized as deferred revenue at the point of sale, and are converted to revenue upon delivery to the consumer. The sales deferral period and subsequent revenue recognition date is the estimated delivery date based on the date of shipment. E-commerce and retail revenue are recognized upon delivery to the customer, and retail partnership revenue is recognized upon the transfer of control on a per contract basis. On January 1, 2019, we adopted Topic 606 "Revenue from Contracts with Customers," which did not have a material impact on our results of operations. See Note 15 to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K for additional information on assessment of recently issued accounting pronouncements. Accounts Receivable Accounts receivable is composed primarily of amounts due from retail partners of $25.3 million and $13.9 million, from financial institutions related to credit card sales amounting to $5.8 million and $5.3 million, and other receivables of $0.0 million and $3.9 million as of December 31, 2019 and 2018, respectively. We do not maintain an allowance for doubtful accounts as a majority of receivables come from trusted retail partnerships that to date have no uncollected accounts. As of December 31, 2019, there was no reserve deemed necessary. Inventory Inventories primarily consist of merchandise purchased for resale, as well as costs to deliver merchandise to our warehouse. The Company's inventory is stated using weighted average costing. We perform an analysis to determine whether it is appropriate or not to maintain a reserve for excess and obsolete inventory. The reserve is based on historical experience related to the disposal of identified inventory. Obsolete inventory is defined as inventory held in excess of two years, and most of our inventory is just-in-time and many of our products have not been in existence for two years. Additionally, we perform a review of all on hand inventory to determine if any items are deemed obsolete based on specific facts and circumstances. As of December 31, 2019, a reserve has been made in the amount of $2.5 million. Additionally, we had purchase obligations in the amount of $17.5 million as of December 31, 2019, that will continue into 2020. There are no purchase obligations beyond 2020. Storage costs, indirect administrative overhead and certain selling costs related to inventories are expensed in the period incurred. Raw materials consist of boxes, replacements parts and components used in the creation of products such as foam, pillows and springs. Finished goods are comprised of completed goods, including mattresses, pillows, sheets, furniture and dog beds. Additionally, other inventory consists of deferred cost of goods sold and purchase order clearing. The Company writes down inventory as a result of excess and obsolete inventories, or when it believes that the net realizable value of inventories is less than the carrying value. Property and Equipment Property and equipment are stated at cost less accumulated depreciation. Depreciation on property and equipment is calculated on the straight-line method over the estimated useful lives of the assets. The estimated useful lives of furniture, fixtures, computers, technology hardware, and vehicles range from 3 to 5 years. Our purchased software is amortized over 7 years. Leasehold improvements are depreciated over the shorter of their useful life or the related lease term (without consideration of option renewal terms). Long-lived assets, such as property, and equipment, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If circumstances require a long-lived asset or asset group be tested for possible impairment, we first compare undiscounted cash flows expected to be generated by that asset or asset group to its carrying amount. If the carrying amount of the long-lived asset or asset group is not recoverable on an undiscounted cash flow basis, an impairment is recognized to the extent that the carrying amount exceeds its fair value. Fair value is determined using various valuation techniques including discounted cash flow models, quoted market values, and third-party independent appraisals, as considered necessary. Income Taxes We account for income taxes in accordance with ASC Topic 740, "Income Taxes." Under this method, deferred tax assets and liabilities are determined based on the temporary differences between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. We classify all deferred income tax assets and liabilities as noncurrent on our 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 the deferred tax assets. In making such a determination, we consider all available positive and negative evidence, including taxable income in prior carryback years (if carryback is permitted under the relevant tax law), the timing of the reversal of existing taxable temporary differences, tax-planning strategies, and projected future taxable income. Please refer to Note 10 to our audited consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K 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. Stock-Based Compensation Compensation cost for all stock-based awards, including options to purchase stock, 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. Stock-based compensation cost is recognized over the requisite service periods of awards, which is typically four years. The actual forfeiture rate applied is based on historical forfeitures. The estimated number of stock 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. See Note 7 to our audited consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K for a complete description of the accounting for stock-based awards. We also issue stock-based compensation to some of our non-employee consultants. We account for equity awards to non-employees in accordance with FASB ASC Topic 505-50, Equity-Based Payments to Non-Employees, which requires the fair value of an award to non-employees be remeasured at fair value as the award vests. Upon completion of the underlying performance obligation, or the vesting period, these cease to be revalued.

<s>[INST] Overview As a pioneer of the Sleep Economy, we bring the benefits of cuttingedge technology, data, and insights directly to consumers. We focus on building direct relationships with consumers, providing a human experience, and making shopping for sleep joyful. We meet consumers wherever they are, online and in person, providing a fun and engaging experience, while reducing the hassles associated with traditional purchases. Our products seek to address real life sleep challenges by optimizing for a variety of factors that impact sleep like the microclimate under the covers by regulating humidity and temperature; comfort and support, through the use of highquality materials and ergonomic designs; and the ambience and sleep environment, through smart devices that provide sleepconducive lighting. We also work to address "the little things" in our products, offering innovative features to make the sleep experience better and less stressful. Casper Labs innovates throughout the Sleep Economy. Based in San Francisco, Casper Labs has over 25,000 square feet of fabrication and test space, featuring stateoftheart capabilities to test against a wide range of factors affecting sleep quality. Casper Labs controls every aspect of our product offerings, including design and construction, material performance requirements, manufacturing protocols, supplier selection, packaging specifications, and quality assurance. We believe that no other company in the category has our level of product development talent, resources, or expertise. We distribute our products through a flexible, multichannel approach combining our directtoconsumer channel, including our ecommerce platform and retail stores, with our retail partnerships. Our presence in physical retail stores has proven complementary to our ecommerce channel, as we believe interaction with multiple channels has created a synergistic "network effect" that increases systemwide sales as a whole. We believe our multichannel expansion creates synergies and that these channels, to date, have proven to be complementary, not cannibalistic. As of December 31, 2019, we distributed our products directly to our customers in seven countries through our ecommerce platform, our 60 Casper stores, and our 18 retail partners, including with Amazon, Costco, Hudson's Bay Company, and Target. Through our highquality and innovative product portfolio, synergistic multichannel gotomarket strategy and unwavering focus on our consumers, we have experienced significant growth across channels: For the years 2019 and 2018, our net revenue was $439.3 million and $357.9 million, respectively, representing an increase of 22.7%. Our directtoconsumer revenue was $350.5 million in 2019, up 13.0% from 2018. Our revenue from retail partnerships was $88.8 million in 2019, up 86.0% from 2018. In the past five years, we have grown from being a strictly ecommerce business to developing into a multichannel business, operating 60 retail stores and working with 18 retail partners as of December 31, 2019. We have invested significantly in our sophisticated, integrated marketing strategy, with $154.6 million in marketing expenditure in 2019. Factors Affecting our Financial Condition and Results of Operations Our financial condition and results of operations have been, and will continue to be, affected by a number of important factors, including the following: Ability to Grow Our Brand Awareness. Our brand name and image are integral to the growth of our business and to the implementation of our strategies for expanding our business. We believe our brand sets us apart from our competitors, and is essential to our ability to engage and to stay connected with prospective and existing customers as they discover, evaluate, and purchase our suite of products and services. This continued customer engagement helps to inform and accelerate our culture of innovation and improves how we execute our vision of becoming the world's most loved and largest sleep company. In these ways, our brand directly contributes to and drives our growth. We believe that as brand awareness grows and deepens, we will continue to strengthen our ability to create and capture value across the Sleep Economy, enhancing our competitive advantages in a category that we believe no other single company understands better. We believe the consistency and quality of our messaging has helped [/INST] Negative. </s>

Beam Therapeutics 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 consolidated 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 Item 1A, Risk factors, in this Annual Report on Form 10-K. Overview We are a research stage biotechnology company committed to creating a new class of precision genetic medicines, based on our proprietary base editing technology, with a vision of providing life-long cures to patients suffering from serious diseases. Our proprietary base editing technology potentially enables an entirely new class of precision genetic medicines that targets a single base in the genome without making a double-stranded break in the DNA. This approach uses a chemical reaction designed to create precise, predictable and efficient genetic outcomes at the targeted sequence, which we believe will dramatically increase the impact of gene editing for a broad range of therapeutic applications. We believe we will be able to rapidly advance our portfolio of novel base editing programs by building on the significant recent advances in the field of genetic medicines. Our novel base editors have two principal components that are fused together to form a single protein: (i) a CRISPR protein bound to a guide RNA, that leverages the established DNA-targeting ability of CRISPR, but modified to not cause a double-stranded break, and (ii) a base editing enzyme, such as a deaminase, which carries out the desired chemical modification of the target DNA base. We have achieved proof-of-concept in vivo with long-term engraftment of ex vivo base edited human CD34 cells in mice for our Hereditary Persistence of Fetal Hemoglobin, or HPFH, program, and we have demonstrated base editing of cells in vitro at therapeutically relevant levels for the majority of our remaining programs. We have also successfully demonstrated feasibility of base editing with each of our three delivery modalities in relevant cell types (electroporation and AAV) and in vivo in mice (LNP). We expect to achieve additional preclinical proofs-of-concept in vivo for additional programs in 2020, which could include engraftment results for the Makassar precise correction sickle cell program, xenograft models for our CAR-T programs or in vivo based editing in our programs using LNP or AAV delivery. If successful, and provided the coronavirus disease of 2019, or COVID-19, does not cause our timelines to slip materially, this will allow us to initiate investigational new drug, or IND, enabling studies for multiple programs beginning in 2020. We expect to file an initial wave of IND filings beginning in 2021. Financial operations overview General We were incorporated on January 25, 2017 and commenced operations shortly thereafter. Since our inception, we have devoted substantially all of our resources to building our base editing platform and advancing development of our portfolio of programs, establishing and protecting our intellectual property, conducting research and development activities, organizing and staffing our company, business planning, raising capital and providing general and administrative support for these operations. To date, we have financed our operations primarily through the sales of our Series A-1 redeemable convertible preferred stock, or the Series A-1 Preferred Stock, Series A-2 redeemable convertible preferred stock, or the Series A-2 Preferred Stock, and Series B redeemable convertible preferred stock, or the Series B Preferred Stock and, together with the Series A-1 Preferred Stock and the Series A-2 Preferred Stock, the Preferred Stock, and through proceeds from our February 2020 IPO. Through December 31, 2019, we have raised an aggregate of $223.6 million from the sale of our Preferred Stock. On May 9, 2018, we entered into a merger option agreement with Blink Therapeutics Inc., or Blink. In September 2018, we exercised our option to acquire Blink, or the Blink Merger, and Blink thereafter became our wholly owned subsidiary. Blink held rights to certain intellectual property related to RNA-based editing. Pursuant to the Blink Merger, we issued two shares of our Series A-2 Preferred Stock for each share of redeemable convertible series A preferred stock of Blink, and we issued 0.446 shares of our common stock for each share of Blink common stock. We began consolidating Blink on May 9, 2018. We are a development stage company, and all of our programs are at a preclinical stage of development. To date, we have not generated any revenue from product sales and do not expect to generate revenue from the sale of products for the foreseeable future. Since inception we have incurred significant operating losses. Our net losses for the years ended December 31, 2019 and 2018 were $78.3 million and $116.7 million, respectively. As of December 31, 2019, we had an accumulated deficit of $203.0 million. Our total operating expenses were $75.2 million and $45.7 million for the years ended December 31, 2019 and 2018, respectively. We expect to continue to incur significant expenses and increasing operating losses in connection with ongoing development activities related to our portfolio of programs as we continue our preclinical development of product candidates; advance these product candidates toward clinical development; further develop our base editing platform; research activities as we seek to discover and develop additional product candidates; maintenance, expansion enforcement, defense, and protection of our intellectual property portfolio; and hiring research and development, clinical and commercial personnel. In addition, upon the closing of our IPO, we expect to incur additional costs associated with operating as a public company. As a result of these anticipated expenditures, we will need additional financing 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 licensing arrangements. We may be unable to raise additional funds or enter into such other agreements when needed on favorable terms or at all. Our inability to raise capital as and when needed would have a negative impact on our financial condition and our ability to pursue our business strategy. We can give no assurance that we will be able to secure such additional sources of funds to support our operations, or, if such funds are available to us, that such additional funding will be sufficient to meet our needs. Research and development expenses Research and development expenses consist of costs incurred in performing research and development activities, which include: • the cost to obtain licenses to intellectual property, such as those with Harvard University, or Harvard, Broad Institute of MIT and Harvard, or Broad Institute, and Editas Medicine, Inc, or Editas, and related future payments should certain success, development and regulatory milestones be achieved; • personnel-related expenses, including salaries, bonuses, benefits and stock-based compensation for employees engaged in research and development functions; • expenses incurred in connection with the discovery and preclinical development of our research programs, including under agreements with third parties, such as consultants, contractors and contract research organizations; • the cost of developing and validating our manufacturing process for use in our preclinical studies and future clinical trials; • laboratory supplies and research materials; and • facilities, depreciation and other expenses which include direct and allocated expenses. 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 benefits are consumed. In the early phases of development, our research and development costs are often devoted to product platform and proof-of-concept studies that are not necessarily allocable to a specific target, therefore, we have not yet begun tracking our expenses on a program-by-program basis. We expect that our research and development expenses will increase substantially in connection with our planned preclinical and future clinical development activities. 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, intellectual property, 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, and direct and allocated facility related expenses and other operating costs. We anticipate that our general and administrative expenses will increase in the future to support increased research and development activities. We also expect to incur increased costs associated with being a public company, including costs of accounting, audit, legal, regulatory and tax-related services associated with maintaining compliance with Nasdaq and SEC requirements, director and officer insurance costs, and investor and public relations costs. Other income and expenses Other income and expenses consist of the following items: • Change in fair value of derivative liabilities consists primarily of remeasurement gains or losses associated with changes in the anti-dilution issuance rights, finance milestone payment liabilities and success payment liabilities associated with our license agreement with Harvard, dated as of June 27, 2017, as amended, or the Harvard License Agreement, and the license agreement between Blink and Broad Institute, as amended, dated as of May 9, 2018, or the Broad License Agreement. Anti-dilution issuance rights were issued to Harvard and Broad Institute allowing Harvard and Broad Institute to maintain a defined ownership percentage in us on a fully diluted basis upon subsequent equity financings until we achieved a defined aggregate level of preferred stock financing. At the inception of the agreements, the liability for the anti-dilution right was recorded at fair value with cost recorded as research and development expense and was remeasured at each reporting period and at the termination of the right with changes recorded in other income (expense). Financing milestone payment liabilities are derived from future cash payments due to Harvard and Broad Institute upon the closing of additional rounds of Preferred Stock. At the inception of the agreements, the liabilities were recorded at fair value with cost recorded as research and development expense and were remeasured at each reporting period with changes recorded in other income (expense). Success payment liabilities are derived from future increases in the per share fair market value of the Series A-1 Preferred Stock and Series A-2 Preferred Stock at specified future dates. At inception of the agreements, the success payment liabilities were recorded at fair market value with cost recorded as research and development expense and were remeasured at each reporting period with changes recorded in other income (expense). Depending on our valuation, the success payment liabilities could fluctuate significantly from period to period. All anti-dilution issuance rights and finance milestone liabilities pursuant to our Harvard License Agreement and Broad License Agreement have been met as of December 31, 2018. Accordingly, we are no longer required to record liabilities for these rights. • Loss on issuance of preferred stock in connection with Blink Merger represents the expense recognized upon the consummation of the Blink Merger. Pursuant to the Blink Merger, we issued two shares of our Series A-2 Preferred Stock for each share of Blink and took a charge representing the excess of the fair value of our Series A-2 Preferred Stock issued to Blink shareholders over the value of the Blink preferred stock exchanged by Blink shareholders. • Loss on issuance of preferred stock to investors consists of a charge taken upon issuance of our Preferred Stock at a discount due to an increase in value above the sale price. • Change in fair value of preferred stock tranche liabilities consist primarily of remeasurement gains or losses associated with changes in the fair value of the tranche rights associated with our Series A-1 Preferred Stock and Series A-2 Preferred Stock. All obligations have been met at December 31, 2018 and therefore there will be no further remeasurement. 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, together with the change in dollars (in thousands): License revenue License revenue was $18,000 for the year ended December 31, 2019 representing Verve license revenue recorded under the Collaboration and License Agreement executed in April 2019. There was no revenue for the year ended December 31, 2018. Research and development expenses Research and development expenses were $54.6 million and $33.9 million for the years ended December 31, 2019 and 2018, respectively. The increase of $20.7 million was primarily due to the following: • Increases of $16.4 million in lab supplies and outsourced services, $10.7 million in personnel-related costs, and $4.6 million in facility-related costs, including depreciation. These increases were due to the growth in the number of research and development employees from 40 at December 31, 2018 to 97 at December 31, 2019, and their related activities, as well as the expense allocated to research and development related to our leased facilities. • A decrease of $1.7 million in stock compensation due to a one-time charge of $3.6 million for the year ended December 31, 2018 related to the Blink merger offset by an increase in stock compensation expense for additional stock option awards due to the increase in the number of research and development employees in 2019. • A decrease of $10.0 million in expenses related to technology licenses. For the year ended December 31, 2019, technology license expense was $3.4 million, which consisted primarily of option fees of $2.4 million related to a technology license agreement and $0.8 million, which consisted primarily of the license fee and fair value of Beam common stock provided to Bio Palette in conjunction with a license agreement executed in March 2019. For the year ended December 31, 2018, technology license expense was $13.3 million, which included: $5.3 million related to the Broad License Agreement for the initial value of anti-dilution rights, financing milestone payment liabilities, success payment liabilities, and the initial shares of common stock issued to Broad Institute, $3.7 million related to the issuance of 3,055,555 shares of Preferred Stock under a license agreement with Editas, $2.2 million for additional shares of stock issued to Broad Institute upon the Blink merger, and other technology license expenses of $2.0 million. Research and development expenses will continue to increase as we continue our current research programs, initiate new research programs, continue our preclinical development of product candidates and conduct future clinical trials for any of our product candidates. General and administrative expenses General and administrative expenses were $20.6 million and $11.9 million for the years ended December 31, 2019 and 2018, respectively. The increase of $8.7 million was primarily a result of a $4.4 million increase in personnel related costs due to an increase in general and administrative employees from eight employees as of December 31, 2018 to 21 employees as of December 31, 2019, a $1.7 million increase in stock-based compensation due to an increase in the number of general and administrative employees as well as an increase in the value of our common stock, a $1.2 million increase in outsourced services including audit services as well as consulting services to supplement our internal capabilities, a $1.1 million increase in other administrative expenses, and a $0.3 million increase in expense allocated to general and administrative expense related to our leased facilities, including depreciation, to support the growing organization. Change in fair value of derivative liabilities During the year ended December 31, 2018, the anti-dilution rights related to the Harvard License Agreement and the Broad License Agreement terminated and we issued 765,549 shares of our common stock to Harvard and Blink issued 920,000 shares of its common stock (which was converted into 410,320 shares of our common stock in connection with the Blink Merger) to Broad Institute. For the year ended December 31, 2018, we recorded a $1.3 million change in fair value expense related to these anti-dilution issuance rights. During the year ended December 31, 2018, we recorded a $9.7 million change in fair value expense related to financial milestone payments. All remaining financing milestone obligations were met in 2018. During the year ended December 31, 2019, we recorded a $5.4 million change in fair value expense related to the success payment liabilities as compared to a $0.7 million expense for the year ended December 31, 2018. The success payment obligations are still outstanding as of December 31, 2019 and will continue to be revalued at each reporting period. Loss on issuance of preferred stock in connection with Blink Merger Loss on issuance of preferred stock in connection with the Blink Merger of $49.5 million for the year ended December 31, 2018 represented the excess of the fair value of our Series A-2 Preferred Stock issued to Blink shareholders over the value of the Blink preferred stock exchanged by Blink shareholders at the time of the Blink Merger. Loss on issuance of preferred stock to investors Loss on issuance of preferred stock to investors of $5.7 million for the year ended December 31, 2018 resulted from issuance of our Series A-1 Preferred Stock at a fair value of the preferred stock in excess of the cash proceeds received. Change in fair value of preferred stock tranche liabilities We have determined that our obligation to issue and our investors’ obligation to purchase additional shares of Series A-1 Preferred Stock and Series A-2 Preferred Stock represented a freestanding financial instrument. The resulting preferred stock tranche liability was initially recorded at fair value, with gains and losses arising from changes in fair value recognized in the consolidated statement of operations at each period while such instruments were outstanding. As a result of the changes in fair value, we recognized other expense of $4.3 million for the year ended December 31, 2018. As of December 31, 2018, the tranche rights had been exercised and the liabilities have been reclassified to preferred stock. Interest income Interest income was $2.5 million for the year ended December 31, 2019 as compared to $0.3 million for the year ended December 31, 2018. We began actively investing our funds in 2019. Interest expense Interest expense of $0.2 million for the year ended December 31, 2019 was related to our equipment financing leases. There was no corresponding interest expense in 2018. Comparison of year ended December 31, 2018 and period ended December 31, 2017 Research and development expenses Research and development expenses were $33.9 million for the year ended December 31, 2018, compared to $5.9 million for the period from January 25, 2017 (Inception) to December 31, 2017. The increase of $28.0 million was primarily due to the following: • An $8.5 million increase in expenses related to technology licenses. In 2018, technology license expense included: $5.3 million related to the Broad License Agreement for the initial value of anti-dilution rights, financing milestone payment liabilities, success payment liabilities, and the initial shares of common stock issued to Broad Institute, $2.2 million related to the issuance of 410,320 additional shares of Beam common stock to Broad Institute in connection with the Blink Merger, $3.7 million related to the issuance of 3,055,555 shares of Preferred Stock under a license agreement with Editas; and other technology license expenses of $2.0 million. In 2017, technology license expenses included $4.8 million related to the Harvard License Agreement for the initial value of anti-dilution rights, financing milestone payment liabilities, success payment liabilities, and the initial shares of common stock issued to Harvard. These amounts were recorded as research and development expenses as they are considered compensation for the respective license agreements. • Increases of $5.9 million in lab supplies and outsourced services, $4.4 million in personnel-related costs, and $3.2 million in facility-related costs, including depreciation. These increases were due to the growth in the number of research and development employees from four at December 31, 2017 to 40 at December 31, 2018, and their related activities, as well as the expense allocated to research and development related to our new leased facility. • An increase of $5.7 million in stock compensation, including $3.6 million of expense representing the difference in value of the fully vested shares issued to the scientific founders of Blink and the value exchanged by the Blink shareholders at the time of the Blink Merger. The remainder of the increase was due to the increase in the number of research and development employees from December 31, 2017 to December 31, 2018. General and administrative expenses General and administrative expenses were $11.9 million for the year ended December 31, 2018, compared to $2.0 million for the period from January 25, 2017 (Inception) ended December 31, 2017. The increase of $9.8 million was primarily due to an increase in legal and patent costs of $4.3 million associated with establishing our patent portfolio, $1.7 million increase in personnel related costs due to an increase in general and administrative employees from one employee as of December 31, 2017 to eight employees as of December 31, 2018, $1.3 million increase in consulting services to supplement our internal capabilities, $1.1 million increase in stock-based compensation, and an increase in expense allocated to general and administrative expense related to our new leased facility, including depreciation of $0.7 million, to support the growing organization. Loss on issuance of preferred stock in connection with Blink Merger Loss on issuance of preferred stock in connection with the Blink Merger consists of a $49.5 million charge for the year ended December 31, 2018 related to the Blink Merger. This charge represented the excess of the fair value of our Series A-2 Preferred Stock issued to Blink shareholders over the value of the Blink preferred stock exchanged by Blink shareholders at the time of the Blink Merger. Loss on issuance of preferred stock to investors Loss on issuance of preferred stock to investors consisted of a $5.7 million discount for the year ended December 31, 2018, resulted from issuance of our Series A-2 Preferred Stock due to the fair value of the preferred stock issued being in excess of the cash proceeds received. Change in fair value of derivative liabilities During the year ended December 31, 2018, the anti-dilution rights related to the Harvard License Agreement and the Broad License Agreement have terminated and, during the year ended December 31, 2018 we issued 765,549 shares of our common stock and Blink issued 920,000 shares of its common stock (which was converted into 410,320 shares of our common stock in connection with the Blink Merger) to Harvard and Broad Institute, respectively. In 2018, we recorded a $1.3 million change in fair value expense related to the anti-dilution issuance right as compared to no change in fair value expense in 2017. In 2018, we recorded a $9.7 million change in fair value expense related to the financial milestone payment as compared to a $0.4 million expense in 2017. All remaining financing milestone obligations have been met in 2018, and we recorded a $13.8 million financing milestone liability for any unpaid balances on our consolidated balance sheets as of December 31, 2018. In 2018, we recorded a $0.7 million change in fair value expense related to the success payment liabilities as compared to a $0.1 million expense in 2017. The increase was a result of an increase in our valuation from December 31, 2017 to December 31, 2018. Change in fair value of preferred stock tranche liabilities We have determined that our obligation to issue and our investors’ obligation to purchase additional shares of Series A-1 Preferred Stock and Series A-2 Preferred Stock represented a freestanding financial instrument. The resulting preferred stock tranche liability was initially recorded at fair value, with gains and losses arising from changes in fair value recognized in the consolidated statement of operations at each period while such instruments were outstanding. As a result of the changes in fair value, we recognized other expense of $4.3 million for the year ended December 31, 2018, compared to $0.4 million in other income for the period from January 25, 2017 (Inception) to December 31, 2017. As of December 31, 2018, the tranche rights have been exercised and the liabilities have been reclassified to preferred stock. Interest income Interest income was $0.3 million in 2018 due our investment in money market funds. There were no investments in 2017. Liquidity and capital resources Since our inception in January 2017, we have incurred significant operating losses. We expect to incur significant expenses and operating losses for the foreseeable future as we advance the preclinical and, if successful, the clinical development of our programs. To date, we have funded our operations primarily with proceeds from the sales of Preferred Stock. Through December 31, 2019, we raised an aggregate of $223.6 million in gross proceeds from sales of our Preferred Stock. As of December 31, 2019, we had $91.8 million in cash, cash equivalents and marketable securities. On February 10, 2020, we completed our IPO in which we issued and sold 12,176,471 shares of our common stock, including 1,588,235 shares of common stock sold pursuant to the underwriters’ full exercise of their option to purchase additional shares, at a public offering price of $17.00 per share. We received net proceeds from our IPO of $188.3 million, after deducting underwriting discounts and estimated offering expenses payable by us. To date, we have not generated any revenue from product sales and do not expect to generate revenue from the sale of products for the foreseeable future. We anticipate the need for additional capital in order to continue to fund our research and development, including our plans for clinical and preclinical trials and new product development, as well as to fund general operations. As and if necessary, we will seek to raise these additional funds through various potential sources, such as equity and debt financings or through corporate collaboration and license agreements. Especially in light of COVID-19, we can give no assurances that we will be able to secure such additional sources of funds to support our operations, or, if such funds are available to us, that such additional financing will be sufficient to meet our needs For a more detailed discussion of risks related to our COVID-19, please see Item 1A., Risk factors-Risks related to our relationships with third parties, in this Annual Report on Form 10-K. Cash flows The following table summarizes our sources and uses of cash for the years ended December 31, 2019 and 2018 (in thousands): Operating activities Net cash used in operating activities for the year ended December 31, 2019 was $72.0 million, consisting primarily of our net loss of $78.3 million, a decrease in financing milestone liabilities of $13.8 million resulting from payment of these liabilities, a decrease in operating lease liabilities of $2.5 million, and an increase in prepaids and other assets of $1.9 million offset by cash provided by increases in accounts payable and accrued expenses of $7.7 million, and noncash charges consisting primarily of stock based compensation expense of $7.0 million, change in fair value of derivative liabilities of $5.4 million, depreciation of $3.5 million, and non-cash lease expense of $1.9 million, offset by amortization of investment premiums of $0.9 million. Net cash used in operating activities for the year ended December 31, 2018 was $20.3 million, consisting primarily of our net loss of $116.7 million offset by the following noncash charges: loss on issuance of preferred stock in connection with the Blink Merger of $49.5 million, change in fair value of derivatives consisting of anti-dilution rights, financial milestone payment liabilities and success payment liabilities of $11.7 million, non-cash research and development license expense of $7.4 million, loss on issuance of preferred stock to investors of $5.7 million, change in fair value of preferred stock tranche liabilities of $4.3 million, and stock-based compensation of $7.0 million, as well as increases in deferred rent liability of $7.6 million due to the lease of a new facility in 2018 and increases in accounts payable and accrued expenses of $4.0 million due to our growth. Net cash used in operating activities for the period from January 25, 2017 (Inception) to December 31, 2017 was $2.7 million, consisting primarily of our net loss of $8.0 million partially offset by non-cash charges of $4.6 million primarily consisting of a non-cash research and development license expense of $4.3 million associated with our Harvard License Agreement; and increases in accounts payable and accrued expenses of $0.9 million. Investing activities For the year ended December 31, 2019, cash used in investing activities was primarily the net result of purchases of marketable securities partially offset by maturities of marketable securities of $53.7 million, in addition to purchases of property and equipment of $12.5 million. For the year ended December 31, 2018 and period from January 25, 2017 (Inception) to December 31, 2017, cash used in investing activities consisted primarily of $13.1 million and $0.3 million of purchases of property and equipment, respectively. Financing activities Net cash provided by financing activities for the year ended December 31, 2019 consisted primarily of the net proceeds from the issuance of Series B Preferred Stock of $37.9 million, and net proceeds of $5.7 million from equipment financing, offset by an increase in equity issuance costs of $2.5 million. Net cash provided by financing activities for the year ended December 31, 2018 consisted primarily of the net proceeds from the issuance of Series A-1 Preferred Stock of $19.8 million, Series A-2 Preferred Stock of $48.5 million, Blink Series A Preferred Stock of $14.9 million, and Series B Preferred Stock of $96.5 million. Net cash provided by financing activities for the period from January 25, 2017 (Inception) to December 31, 2017 was $5.0 million consisting of net proceeds from the first tranche of the issuance of Series A-1 Preferred Stock. Funding requirements Our operating expenses are expected to increase substantially as we continue to advance our portfolio of programs. Specifically, our expenses will increase if and as we: • continue our current research programs and our preclinical development of product candidates from our current research programs; • seek to identify additional research programs and additional product candidates; • initiate preclinical testing and clinical trials for any product candidates we identify and develop; • maintain, expand, enforce, defend, and protect our intellectual property portfolio and provide reimbursement of third-party expenses related to our patent portfolio; • seek marketing approvals for any of our product candidates that successfully complete clinical trials; • ultimately establish a sales, marketing, and distribution infrastructure to commercialize any medicines for which we may obtain marketing approval; • further develop our base editing platform; • hire additional personnel including research and development, clinical and commercial personnel; • add operational, financial, and management information systems and personnel, including personnel to support our product development; • acquire or in-license products, intellectual property, medicines and technologies; • should we decide to do so, build and maintain a commercial-scale current Good Manufacturing Practices, or cGMP, manufacturing facility; and • operate as a public company. We expect that our cash, cash equivalents and marketable securities at December 31, 2019, together with the net proceeds from our February 2020 IPO, will enable us to fund our current and planned operating expenses and capital expenditures for at least the next 12 months. We have based these estimates on assumptions that may prove to be imprecise, and we may exhaust our available capital resources sooner that we currently expect. Because of the numerous risks and uncertainties associated with the development our programs, 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. Our future funding requirements will depend on many factors including: • the cost of continuing to build our base editing platform; • the costs of acquiring licenses for the delivery modalities that will be used with our product candidates; • the scope, progress, results, and costs of discovery, preclinical development, laboratory testing, manufacturing and clinical trials for the product candidates we may develop; • the costs of preparing, filing, and prosecuting patent applications, maintaining and enforcing our intellectual property and proprietary rights, and defending intellectual property-related claims; • the costs, timing, and outcome of regulatory review of the product candidates we may develop; • the costs of future activities, including product sales, medical affairs, marketing, manufacturing, distribution, coverage and reimbursement for any product candidates for which we receive regulatory approval; • the success of our license agreements and our collaborations; • our ability to establish and maintain additional collaborations on favorable terms, if at all; • the achievement of milestones or occurrence of other developments that trigger payments under any additional collaboration agreements we obtain; • the extent to which we acquire or in-license products, intellectual property, and technologies; and • the costs of operating as a public company. 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. We do not have any committed external source of funds. 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 we may have 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. We can give no assurance that we will be able to secure such additional sources of funds to support our operations, or, if such funds are available to us, that such additional funding will be sufficient to meet our needs. Contractual obligations The following is a summary of our significant contractual obligations as of December 31, 2019: (1) Represents future minimum lease payments under our operating leases for office and lab space in Cambridge, Massachusetts. The minimum lease payments above do not include any related common area maintenance charges or real estate taxes. The table above does not include our amended lease for additional laboratory space in Cambridge, Massachusetts, which commenced on March 1, 2020 and expires on March 31, 2023. The incremental increase in total amount as a result of the amended lease is approximately $3.2 million, which does not include the additional lease payments of $1.6 million we would incur if we were to exercise our option to extend the lease for one year. The table above also does not include potential milestone and success fees, sublicense fees, royalty fees, licensing maintenance fees, and reimbursement of patent maintenance costs that we may be required to pay under agreements we have entered into with certain institutions to license intellectual property. Our agreements to license intellectual property include potential milestone payments that are dependent upon the development of products using the intellectual property licensed under the agreements and contingent upon the achievement of development or regulatory approval milestones, as well as commercial and success payment milestones. We have not included such potential obligations in the table above because they are contingent upon the occurrence of future events and the timing and likelihood of such potential obligations are not known with certainty. Additionally, we enter into contracts in the normal course of business with contract research organizations and other vendors to assist in the performance of our research and development activities and other services and products for operating purposes. These contracts generally provide for termination on notice, and therefore are cancelable contracts and not included in the table of contractual obligations and commitments. 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. Critical accounting policies and significant judgements 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 U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, 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, Summary of significant accounting policies, to our consolidated financial statements 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 financial statements. Stock-based compensation We measure stock options and other stock-based awards granted to our employees, directors, consultants or founders based upon their fair value on the date of the grant and recognize stock-based compensation expense over the requisite service period, which is generally the vesting period of the respective award. We recognize forfeitures as they occur. The majority of our stock-based compensation awards are subject to either service- or performance-based vesting conditions. We apply the straight-line method of expense recognition to all awards with service-based vesting and recognize stock-based compensation for performance-based awards over the service period using the accelerated attribution method to the extent achievement of the of performance condition is probable. We estimate the fair value of each stock option grant on the date of grant using the Black-Scholes option-pricing model, which uses inputs such as the fair value of our common stock, 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. The fair value of our common stock is used to determine the fair value of restricted stock awards. Determination of the fair value of our common stock issued prior to our IPO Prior to our IPO in February 2020, there was no public market for our common stock. As a result, 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 option grant, 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 and which may have changed from the date of the most recent valuation through the date of the grant. Third party valuations were performed in accordance with the framework of the American Institute of Certified Public Accountants, Valuation of Privately-Held Company Equity Securities Issued as Compensation. Our common stock valuations were prepared using either an option pricing method, or OPM, or a hybrid method of the probability-weighted expected return method, or PWERM, both of which used market approaches to estimate our enterprise value. The OPM treats common stock and preferred stock 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 stock has value only if the funds available for distribution to stockholders exceeded the value of the preferred stock liquidation preferences at the time of the liquidity event, such as a strategic sale or a merger. The common stock is modeled as a call option on the underlying equity value at a predetermined exercise price. In the model, the exercise price is based on a comparison with the total equity value rather than, as in the case of a regular call option, a comparison with a per share stock price. Thus, common stock is considered to be a call option with a claim on the enterprise at an exercise price equal to the remaining value immediately after the preferred stock liquidation preference is paid. A discount for lack of marketability of the common stock is then applied to arrive at an indication of value for the common stock. The hybrid method is a probability-weighted expected return method, where the equity value in one or more scenarios is calculated using an OPM. The PWERM is a scenario-based methodology that estimates the fair value of our common stock based upon an analysis of future values, assuming various outcomes. The common stock value is based on the probability-weighted present value of expected future investment returns considering each of the possible outcomes available as well as the rights of each class of stock. The future value of the common stock under each outcome is discounted back to the valuation date at an appropriate risk-adjusted discount rate and probability weighted to arrive at an indication of value for the common stock. These third-party valuations were performed at various dates, which resulted in valuations of our common stock of $0.49 per share as of June 30, 2017, $0.67 per share as of March 26, 2018, $1.03 per share as of June 11, 2018, $4.22 per share as of December 1, 2018, $7.22 per share as of April 30, 2019, $11.88 per share as of July 22, 2019, and $13.68 per share as of August 27, 2019. In addition to considering the results of these third-party valuations, 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: • prices at which we sold shares of Preferred Stock and the superior rights and preferences of the Preferred Stock relative to our common stock at the time of each grant; • the progress of our research and development programs, including the status and results of preclinical studies for our product candidates; • our stage of development and our business strategy and the material risks related to our business and industry; • external market conditions affecting the biopharmaceutical industry and the material risks related to our business and industry; and trends within the biopharmaceutical 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 and our Preferred Stock; • the likelihood of achieving a liquidity event, such as an IPO or sale of our company in light of prevailing market conditions; and • the analysis of IPOs and the market performance of similar companies in the biopharmaceutical industry. The assumptions underlying these valuations represent management’s best estimates, which involve inherent uncertainties and the application of management judgement. As a result, if factors or expected outcomes change and we use significantly different assumptions or estimates, our stock-based compensation could be materially different. Following our IPO, the fair value of our common stock will be determined based on the quoted market price of our common stock. Variable interest entities We review each legal entity formed by parties related to us to determine whether or not 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 VIE based on a number of factors, including (i) which party has the power to direct the activities that most significantly affect the VIE’s economic performance, (ii) the parties’ contractual rights and responsibilities pursuant to any contractual agreements and (iii) which party has the obligation to absorb losses or the right to receive benefits from the VIE. If we determine that we are the primary beneficiary of a VIE, we consolidate the financial statements of the VIE into our consolidated financial statements at the time that determination is made. On a quarterly basis we evaluate whether we continue to be the primary beneficiary of any consolidated VIEs. If we determine that we are no longer the primary beneficiary of a consolidated VIE, or no longer have a variable interest in the VIE, we deconsolidate the VIE in the period that the determination is made. On March 22, 2018, certain of our investors, or the Primary Investors, formed Blink to hold certain intellectual property related to RNA base editing. On May 9, 2018, we entered into a merger option agreement, or the Option Agreement, with Blink. On the same date, Blink entered into the Broad License Agreement, issued 5,000,000 shares of Blink series A preferred stock to its investors at $1.00 per share, and issued restricted common stock to certain scientific founders. As of the date of the Option Agreement, Beam and Blink were both owned by members of the same group or Primary Investors, having over 75% ownership in each entity, which consisted primarily of our initial investors and scientific founders. Under the Option Agreement, Blink granted us an option, exercisable on the date that Blink issued an aggregate of 10,000,000 additional shares of Blink series A preferred stock and ending on the second anniversary of such date, to consummate a merger with Blink in exchange for a $121,000 option premium. In connection with the Blink Merger, we issued two shares of our Series A-2 Preferred Stock for each share of Blink series A preferred stock and issued 0.446 shares of our common stock for each share of Blink common stock. As of May 9, 2018, as a result of the design and purpose of Blink and the Option Agreement, we determined that Blink was a VIE and that we were the primary beneficiary, because we had both (1) the power to direct the activities of Blink that most significantly impacted Blink’s economic performance and (2) the right to receive benefits from Blink that could be significant to Blink. As a result, we began consolidating Blink on May 9, 2018. The operating activity of Blink from its formation on March 22, 2018 to May 9, 2018 was immaterial. In August 2018, Blink issued 10,000,000 shares of Blink series A preferred stock at $1.00 per share to the Primary Investors and we paid the $121,000 option premium to exercise our option to merge with Blink. On September 25, 2018, or the Merger Date, the merger was consummated, and Blink became a wholly owned subsidiary of Beam. We recognized expense for the excess in value of the Beam Series A-2 Preferred Stock and common stock exchanged for the Blink series A preferred stock and common stock, because the excess value was only transferred to certain investors of Beam and there were no other rights or privileges identified that require separate accounting as an asset. Fair value measurements Preferred stock tranche rights We have determined that our obligation to issue, and our investors’ obligation to purchase, additional shares of Series A-1 Preferred Stock pursuant to the second closing and Series A-2 Preferred Stock pursuant to the third closing represented a freestanding instrument. The resulting preferred stock tranche liability was initially recorded at fair value, with gains and losses arising from changes in fair value recognized in other income (expense) in the consolidated statement of operations. The preferred stock tranche liabilities were remeasured at each reporting period and upon the exercise or expiration of the obligation. The preferred stock tranche liabilities were valued using an option pricing model which utilized the fair value of the Preferred Stock, expected volatility, as well as the expected term. As of December 31, 2018, all redeemable convertible Series A-1 Preferred Stock and redeemable convertible Series A-2 Preferred Stock closings have occurred, and all tranche liabilities have been remeasured and reclassified to Preferred Stock. Anti-dilution issuance right Additional shares of common stock were issued to Harvard and Broad Institute upon equity financings allowing Harvard and Broad Institute to maintain a defined ownership percentage in us on a fully diluted basis until we achieved a defined aggregate level of preferred stock financing. These anti-dilution issuance rights were accounted for under ASC 815, Derivatives and Hedging, and were initially recorded at fair value with a corresponding charge to research and development expense. As such, we recorded this instrument as a liability at its fair value with a corresponding amount recorded as research and development expense and marked it to market at each reporting period, with changes in fair value recognized in other income (expense) in the consolidated statement of operations at each period-end while this instrument was outstanding. The liability was valued using a Monte Carlo simulation model, which models the value of the liability based on the change of several key variables, including the time to the capital raise, the probability of the capital raise, as well as the fair value of our common stock. During 2018, the anti-dilution rights were satisfied and there is no additional derivative liability accounting. Financing milestone payments We were required to make cash payments to Harvard and Broad Institute upon the achievement of future financing milestones tied to the closing of additional rounds of Preferred Stock. The financing milestone payments were accounted for under ASC 815, and were initially recorded at fair value with a corresponding charge to research and development expense. The liabilities were marked to market at each balance sheet date with all changes in value recognized in other income or expense in the consolidated statement of operations. We adjusted the liability for changes in fair value until the achievement of the financing milestones. To determine the estimated fair value of the financial milestone payments, we used a Monte Carlo simulation model, which models the value of the liability based on the change of several key variables, including time to capital raise, probabilities to capital raise, cost of debt, as well as the projected price per share upon issuance. As of December 31, 2018, all financing milestone payments have been achieved and were either paid in cash or are recorded in accrued expenses for actual amounts due. Success payments We are required to make success payments to Harvard and Broad Institute based on increases in the per share fair market value of our Series A-1 Preferred Stock and Series A-2 Preferred Stock, payable in cash. Subsequent to the February 2020 IPO, the amount of success payments will be based on the market value of our common stock. The success payments are accounted for under ASC 815 and are initially recorded at fair value with a corresponding charge to research and development expense. The liabilities are marked to market at each balance sheet date with all changes in value recognized in other income (expense) in the consolidated statement of operations. We will continue to adjust the liability for changes in fair value until the earlier of the achievement or expiration of the success payment obligation. To determine the estimated fair value of the success payments, we used a Monte Carlo simulation model, which models the value of the liability based on several key variables, including probability of event occurrence, timing of event occurrence, as well as the price per share at the time of success payment. Leases On January 1, 2019, we adopted ASU No. 2016-02, Leases (Topic 842), or ASC 842, which requires the recognition of the right-of-use assets and related operating and finance lease liabilities on the balance sheet. We adopted ASC 842 using a modified retrospective approach for all leases existing at January 1, 2019. The adoption of ASC 842 had a substantial impact on our consolidated balance sheet but did not have a material effect on the company’s consolidated statements of operations and other comprehensive loss, consolidated statements of redeemable convertible preferred stock and stockholders’ deficit. Upon adoption of ASC 842, we recorded $14.2 million and $21.7 million to operating lease right-of-use assets and the related lease liabilities, respectively. The operating lease liabilities are based on the present value of the remaining minimum lease payments discounted using our secured incremental borrowing rate at the effective date of January 1, 2019. For contracts entered into on or after the effective date, at the inception of a contract, we assess whether the contract is, or contains, a lease. The assessment is based on: (1) whether the contract involves the use of a distinct identified asset, (2) whether we obtain the right to substantially all the economic benefit from the use of the asset throughout the period, and (3) whether we have the right to direct the use of the asset. At inception of a lease, we allocate the consideration in the contract to each lease component based on its relative stand-alone price to determine the lease payments. Leases are classified as either finance leases or operating leases. A lease is classified as a finance lease if any one of the following criteria are met: the lease transfers ownership of the asset by the end of the lease term, the lease contains an option to purchase the asset that is reasonably certain to be exercised, the lease term is for a major part of the remaining useful life of the asset or the present value of the lease payments equals or exceeds substantially all of the fair value of the asset. A lease is classified as an operating lease if it does not meet any of these criteria. For all leases at the lease commencement date, a right-of-use asset and a lease liability are recognized. The right-of-use asset represents the right to use the leased asset for the lease term. The lease liability represents the present value of the lease payments under the lease. The right-of-use asset is initially measured at cost, which primarily comprises the initial amount of the lease liability, plus any initial direct costs incurred if any, less any lease incentives received. All right-of-use assets are reviewed for impairment. The lease liability is initially measured at the present value of the lease payments, discounted using the interest rate implicit in the lease or, if that rate cannot be readily determined, our secured incremental borrowing rate for the same term as the underlying lease. For real estate leases and other operating leases, we use its secured incremental borrowing rate. For finance leases, we use the rate implicit in the lease or its secured incremental borrowing rate if the implicit lease rate cannot be determined. Lease payments included in the measurement of the lease liability comprise the following: the fixed noncancelable lease payments, payments for optional renewal periods where it is reasonably certain the renewal period will be exercised, and payments for early termination options unless it is reasonably certain the lease will not be terminated early. Lease cost for operating leases consists of the lease payments plus any initial direct costs, primarily brokerage commissions, and is recognized on a straight-line basis over the lease term. Included in lease cost are any variable lease payments incurred in the period that are not included in the initial lease liability and lease payments incurred in the period for any leases with an initial term of 12 months or less. Lease cost for finance leases consists of the amortization of the right-of-use asset on a straight-line basis over the lease term and interest expense determined on an amortized cost basis. The lease payments are allocated between a reduction of the lease liability and interest expense. We made an accounting policy election to not recognize leases with an initial term of 12 months or less within our consolidated balance sheets and to recognize those lease payments on a straight-line basis in our consolidated statements of income over the lease term. JOBS Act We qualify as an “emerging growth company” as defined in the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. As an emerging growth company, we may take advantage of specified reduced disclosure and other requirements that are otherwise applicable generally to public companies, including reduced disclosure about our executive compensation arrangements, exemption from the requirements to hold non-binding advisory votes on executive compensation and golden parachute payments and exemption from the auditor attestation requirement in the assessment of our internal control over financial reporting. We may take advantage of these exemptions until December 31, 2025 or such earlier time that we are no longer an emerging growth company. We would cease to be an emerging growth company earlier 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. For so long as we remain an emerging growth company, we are permitted, and intend, to rely on exemptions from certain disclosure requirements that are applicable to other public companies that are not emerging growth companies. We may choose to take advantage of some, but not all, of the available exemptions. In addition, the JOBS Act provides that an emerging growth company can take advantage of an extended transition period for complying with new or revised accounting standards. This allows an emerging growth company to delay the adoption of certain accounting standards 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. Therefore, the reported results of operations contained in our consolidated financial statements may not be directly comparable to those of other public companies.

<s>[INST] Overview We are a research stage biotechnology company committed to creating a new class of precision genetic medicines, based on our proprietary base editing technology, with a vision of providing lifelong cures to patients suffering from serious diseases. Our proprietary base editing technology potentially enables an entirely new class of precision genetic medicines that targets a single base in the genome without making a doublestranded break in the DNA. This approach uses a chemical reaction designed to create precise, predictable and efficient genetic outcomes at the targeted sequence, which we believe will dramatically increase the impact of gene editing for a broad range of therapeutic applications. We believe we will be able to rapidly advance our portfolio of novel base editing programs by building on the significant recent advances in the field of genetic medicines. Our novel base editors have two principal components that are fused together to form a single protein: (i) a CRISPR protein bound to a guide RNA, that leverages the established DNAtargeting ability of CRISPR, but modified to not cause a doublestranded break, and (ii) a base editing enzyme, such as a deaminase, which carries out the desired chemical modification of the target DNA base. We have achieved proofofconcept in vivo with longterm engraftment of ex vivo base edited human CD34 cells in mice for our Hereditary Persistence of Fetal Hemoglobin, or HPFH, program, and we have demonstrated base editing of cells in vitro at therapeutically relevant levels for the majority of our remaining programs. We have also successfully demonstrated feasibility of base editing with each of our three delivery modalities in relevant cell types (electroporation and AAV) and in vivo in mice (LNP). We expect to achieve additional preclinical proofsofconcept in vivo for additional programs in 2020, which could include engraftment results for the Makassar precise correction sickle cell program, xenograft models for our CART programs or in vivo based editing in our programs using LNP or AAV delivery. If successful, and provided the coronavirus disease of 2019, or COVID19, does not cause our timelines to slip materially, this will allow us to initiate investigational new drug, or IND, enabling studies for multiple programs beginning in 2020. We expect to file an initial wave of IND filings beginning in 2021. Financial operations overview General We were incorporated on January 25, 2017 and commenced operations shortly thereafter. Since our inception, we have devoted substantially all of our resources to building our base editing platform and advancing development of our portfolio of programs, establishing and protecting our intellectual property, conducting research and development activities, organizing and staffing our company, business planning, raising capital and providing general and administrative support for these operations. To date, we have financed our operations primarily through the sales of our Series A1 redeemable convertible preferred stock, or the Series A1 Preferred Stock, Series A2 redeemable convertible preferred stock, or the Series A2 Preferred Stock, and Series B redeemable convertible preferred stock, or the Series B Preferred Stock and, together with the Series A1 Preferred Stock and the Series A2 Preferred Stock, the Preferred Stock, and through proceeds from our February 2020 IPO. Through December 31, 2019, we have raised an aggregate of $223.6 million from the sale of our Preferred Stock. On May 9, 2018, we entered into a merger option agreement with Blink Therapeutics Inc., or Blink. In September 2018, we exercised our option to acquire Blink, or the Blink Merger, and Blink thereafter became our wholly owned subsidiary. Blink held rights to certain intellectual property related to RNAbased editing. Pursuant to the Blink Merger, we issued two shares of our Series A2 Preferred Stock for each share of redeemable convertible series A preferred stock of Blink, and we issued 0.446 shares of our common stock for each share of Blink common stock. We began consolidating Blink on May 9, 2018. We are a development stage company, and all of our programs are at a preclinical stage of development. To date, we have not generated any [/INST] Negative. </s>

SITIME Corp

2020-03-02

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with the financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K. The MD&A contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act that involve risks and uncertainties, which are discussed under Item 1A. Overview We are a leading provider of silicon timing solutions. Our timing solutions are the heartbeat of our customers’ electronic systems, solving complex timing problems and enabling industry-leading products. We provide solutions that are differentiated by high performance and reliability, programmability, small size, and low power consumption. Our products have been designed into over 200 applications across our target markets, including enterprise and telecommunications infrastructure, automotive, industrial, IoT and mobile, and aerospace and defense. We commenced commercial shipments of our first oscillator products in 2006. Substantially all of our revenue to date has been derived from sales of oscillator systems across our target end markets. We intend to introduce products into the clock IC market, which we began sampling in the second quarter of 2019, and to focus on clock IC and timing sync solutions in the future. We seek to aggressively expand our presence in these two markets. We sell our products primarily through distributors and resellers, who in turn sell to our end customers. Based on sell-through information provided by these distributors, we believe the majority of our end customers are based in the U.S. We operate a fabless business model, allowing us to focus on the design, sales, and marketing of our products, quickly scale production, and significantly reduce our capital expenditures. We leverage our global network of distributors and resellers to address the broad set of end markets we serve. For our largest accounts, dedicated sales personnel work with the end customer to ensure that our solutions fully address the end customer’s timing needs. Our smaller customers work directly with our distributors to select the optimum timing solution for their needs. We were acquired by MegaChips in 2014 and were a wholly-owned subsidiary of MegaChips, a fabless semiconductor company based in Japan and traded on the Tokyo Stock Exchange, until November 25, 2019. On November 25, 2019, we completed the initial public offering of shares of our common stock. MegaChips continues to hold a majority controlling interest in our common stock. Key Factors Affecting Our Performance Customer Orders and Forecasts Because our sales are made pursuant to standard purchase orders, orders may be cancelled, reduced, or rescheduled with little or no notice and without penalty. Cancellations of orders could result in the loss of anticipated sales without allowing us sufficient time to reduce our inventory and operating expenses. In addition, changes in forecasts or the timing of orders from customers exposes us to the risks of inventory shortages or excess inventory. We may not be able to fulfill increased demand, at least in the short term, as we do not intend to acquire excess inventory to pre-build custom products. Design Wins with New and Existing Customers Our solutions enable our customers to differentiate their product offerings and position themselves to gain market share. We work closely with our customers to understand their product roadmaps and strategies. Our end customers continuously develop new products in existing and new application areas. We also consider design wins critical to our future success and anticipate being increasingly dependent on revenue from new design wins for our new higher-end products with higher average selling prices (“ASPs”). The selection process is typically lengthy and may require us to incur significant design and development expenditures in pursuit of a design win with no assurance that our solutions will be selected. As a result, the loss of any key design win or any significant delay in the ramp of volume production of the customer’s products into which our product is designed could adversely affect our business. Customer Demand and Product Life Cycles Once customers design our silicon timing systems solutions into their products, we closely monitor all aspects of their demand cycle, including the initial design phase, prototype production, volume production, and inventories, as well as end-market demand, including seasonality, cyclicality, and the competitive landscape. Given our customer relationships and the long-term aspects of our solutions, we benefit from visibility into customer demand. This in turn provides an opportunity for us to monitor and refine our business fundamentals. Product Adoption within New Markets and Applications As we evaluate new market opportunities and bring new products to market, we pay particular attention to forecasts by industry analysts and the adoption curve of technology. We also analyze in detail potential competing forces that could hinder such adoption. If we fail to anticipate or respond to technological shifts or market demands, or to timely develop new or enhanced products or technologies in response to the same, it could result in decreased revenue and the loss of our design wins to our competitors. Pricing, Product Cost, and Product Mix The ASPs of our products vary significantly. While the ASP of any individual product generally decreases over time, our average ASPs have remained relatively flat as we continue to introduce new higher-end products with higher ASPs. Our pricing and margins depend on the volumes and the features of the timing devices we provide to our customers. We continually monitor and work to reduce the cost of our products and improve the potential value our solutions provide to our customers as we target new design win opportunities and manage the product life cycles of our existing customer designs. Since we rely on third-party wafer foundries and assembly and test contractors to manufacture, assemble, and test our products, we maintain a close relationship with our suppliers to improve quality, increase yields, and lower manufacturing costs. Gross margin, or gross profit as a percentage of revenue, has been, and will continue to be, affected by a variety of factors, including ASPs, and product mix in a given period, material costs, yields, and manufacturing operations costs. We believe the primary driver of gross margin is the ASPs negotiated between us and our customers relative to material costs and yield improvement. As our products mature and unit volumes increase, we expect their ASPs to decline. These declines often coincide with improvements in manufacturing yields and lower wafer, assembly, and testing costs, which offset some or all of the margin reduction that results from lower ASPs. However, we expect our gross margin to fluctuate on a quarterly basis as a result of changes in ASPs due to new product introductions, existing product transitions into high-volume manufacturing, manufacturing costs, and our product mix. Cyclical Nature of the Semiconductor Industry The semiconductor industry is highly cyclical and is characterized by constant and rapid technological change, rapid product obsolescence, price erosion, evolving standards, short product life cycles, and wide fluctuations in product supply and demand. Downturns in the semiconductor industry, including the current downturn, have been characterized by diminished product demand, production overcapacity, high inventory levels, and accelerated erosion of average selling prices. The current downturn in the semiconductor industry has been attributed to a variety of factors, including the ongoing U.S.-China trade dispute, weakness in demand and pricing for semiconductors across applications, and excess inventory. While this downturn has not directly impacted our business to date, any prolonged or significant downturn in the semiconductor industry generally could adversely affect our business and reduce demand for our products and otherwise harm our financial condition and results of operations. Results of Operations The following table summarizes our results of operations for the periods presented. Revenue We derive revenue primarily from sales of silicon timing products to distributors and resellers who in turn sell to our end customers. We also sell products directly to end customers who integrate our products into their applications. Our sales are made pursuant to standard purchase orders which may be cancelled, reduced or rescheduled, with little or no notice. We recognize product revenue upon shipment when we satisfy our performance obligations as evidenced by the transfer of control of our products to customers. We measure revenue based on the amount of consideration we expect to be entitled to in exchange for products. Year Ended December 31, Change 2019 vs 2018 $ % (in thousands except percentage) Revenue $ 84,074 $ 85,214 $ (1,140 ) (1 %) Revenue decreased by $1.1 million, or 1%, for 2019 compared to 2018. This decrease was primarily due to a decrease of $5.5 million in revenue from our largest customer mainly resulting from a loss of design win for the 2018 design for one of its products. Such decrease in revenue from the largest customer was offset by an increase in revenue from other customers of $4.4 million mainly in Asia and due to higher demand of our timing products. The average selling price of our products remained flat year over year. Cost of Revenue, Gross Profit, and Gross Margin Cost of revenue consists of wafers acquired from third-party foundries, assembly, packaging, and test cost of our products paid to third-party contract manufacturers, and personnel and other costs associated with our manufacturing operations. Cost of revenue also includes depreciation of production equipment, inventory write-downs, amortization of internally developed software, shipping and handling costs, and allocation of overhead and facility costs. We also include credits for rebates received from foundries to cost of revenue. Gross profit increased by $3.4 million in the year ended December 31, 2019 compared to the same period in 2018. The year ended December 31, 2018 was negatively impacted by a net write-down of inventory of $5.0 million for that period. This written down inventory in 2018 was subsequently partially sold in the year ended December 31, 2019, which led to an increase in gross profit of $2.5 million for that period. This cumulative positive change in gross profit of $7.5 million period over period was partially offset by lower gross profit of $0.6 million resulting from lower sales volume and change in product mix that had lower margins. In addition, margin decreased by $3.5 million as a result of other overhead expense increases for the year ended December 31, 2019 compared to the same period in 2018. The inventory write-down in 2018 was related to inventory buildup of an anticipated order from our largest end customer that did not materialize. Gross margin was higher by 5% in the year ended December 31, 2019 compared to the same period in 2018 largely due to the inventory write-down recorded in the year ended December 31, 2018, which negatively impacted margin by 6%. This written down inventory was partially sold subsequently in the year ended December 31, 2019 which generated additional benefit to gross margin of 3%. This cumulative benefit of 9% was partially offset by 4% lower gross margin generated from lower sales volume, sale of lower margin products and other overhead expense increases for the year ended December 31, 2019 compared to the same period in 2018. Operating Expenses Our operating expenses consist of research and development, sales and marketing, and general and administrative expenses. Personnel costs are the most significant component of our operating expenses and consist of salaries, benefits, bonuses, stock-based compensation, and commissions. Our operating expenses also include consulting costs, allocated costs of facilities, information technology, and depreciation. We expect our operating expenses to fluctuate in absolute dollars and as a percentage of revenue over time. Research and Development Our research and development efforts are focused on the design and development of next-generation silicon timing systems solutions. Our research and development expense consists primarily of personnel costs, which include stock-based compensation, pre-production engineering mask costs, software license and intellectual property expenses, design tools and prototype-related expenses, facility costs, supplies, professional and consulting fees, and allocated overhead costs. We expense research and development costs as incurred. We believe that continued investment in our products and services is important for our future growth and acquisition of new customers and, as a result, we expect our research and development expenses to continue to increase in absolute dollars. However, we expect our research and development expense to fluctuate as a percentage of revenue from period to period depending on the timing of these expenses. Sales, General and Administrative Sales, general and administrative expense consists of personnel costs, including stock-based compensation, professional and consulting fees, accounting and audit fees, legal costs, field application engineering support, travel costs, advertising expenses, and allocated overhead costs. We expect sales, general and administrative expense to continue to increase in absolute dollars as we increase our personnel and grow our operations, although it may fluctuate as a percentage of revenue from period to period depending on the timing of these expenses. Research and development expense increased by $1.0 million, or 4%, for the year ended December 31, 2019 compared to the same period in 2018, primarily due to an increase in engineering tape-outs, supplies, and other expenses of $1.3 million. Additionally, capitalized labor costs for development of internal use software was lower by $1.0 million which led to lower capitalization of expense in the year ended December 31, 2019. The increase was partially offset by lower stock-based compensation expense of $1.3 million which was largely due to two-quarters of stock-based compensation expense incurred for the year ended December 31, 2018 compared to a partial quarter expense in 2019. This is due to the timing of grants of new employee awards upon completion of our initial public offering in November 2019. Selling, general and administrative expense decreased by $0.6 million, or 3%, for the year ended December 31, 2019 compared to the same period in 2018, primarily due to lower personnel costs of $1.3 million largely related to lower variable compensation tied to revenue. Additionally, stock-based compensation expenses decreased by $0.3 million for the year. These decreases were offset by higher legal expenses of $1.0 million year over year in connection with our patent litigation matter. Other Expense Other income (expense) consists primarily of interest expense on our outstanding debt, foreign exchange gains and losses, and asset dispositions. See Note 7 to our consolidated financial statements under Item 8 for more information about our debt. Other expense increased $0.2 million for the year ended December 31, 2019 compared to the same period in 2018, primarily as a result of higher interest rates on our outstanding revolving short-term debt during the year ended December 31, 2019 as compared to 2018. Income Tax Benefit (Expense) Income tax expense consists primarily of state income taxes and income taxes in certain foreign jurisdictions in which we conduct business. We have a full valuation allowance for deferred tax assets as the realization of the full amount of our deferred tax asset is uncertain, including NOL, carryforwards, and tax credits related primarily to research and development. We expect to maintain this full valuation allowance until realization of the deferred tax assets becomes more likely than not. At December 31, 2019 and 2018, we had NOL carryforwards of approximately $220.2 million and $224.6 million for U.S. federal and state income tax purposes, respectively, and had research and development tax credit carryforwards of approximately $7.5 million and $8.7 million for U.S. federal and state income tax purposes, respectively. Of the federal NOL carryforwards, approximately $148.3 million will expire in various years through 2036, if not utilized, and approximately $8.0 million will carry forward indefinitely. NOL carryforwards for state income tax purposes, if not utilized, will expire in various years through 2039. The research and development credit carryforwards for federal tax purposes will expire in various years through 2038, and state tax credits carry forward indefinitely. Year Ended December 31, Change 2019 vs 2018 $ % (in thousands except percentage) Income tax benefit $ $ $ (18 ) (69 %) Liquidity and Capital Resources Before our initial public offering in November 2019, we financed our operations primarily through cash generated from product sales and proceeds from our credit facilities, including proceeds from our loan agreement with MegaChips. As of December 31, 2019 and 2018, we had cash and cash equivalents of $63.4 million and $7.9 million, respectively. Our principal use of cash is to fund our operations to support growth. We believe that our existing cash and cash equivalents and funds available for borrowing under our credit facilities of an aggregate of approximately $59.0 million as of December 31, 2019, will be sufficient to meet our cash needs for at least the next 12 months. Over the longer term, our future capital requirements will depend on many factors, including our growth rate, the timing and extent of our sales and marketing and research and development expenditures, and the continuing market acceptance of our solutions. In the event that we need to borrow funds or issue additional equity, we cannot provide any assurance that any such additional financing will be available on terms acceptable to us, if at all. If we are unable to raise additional capital when we need it, it would harm our business, results of operations and financial condition. Cash Flows The following table summarizes our cash flows for the periods indicated: Operating Activities In 2019, cash provided by operating activities of $7.4 million was primarily due to a net loss of $6.6 million offset by non-cash expenses of $11.4 million and a decrease in operating assets and liabilities of $2.6 million. Non-cash expenses were mainly related to depreciation and amortization, stock-based compensation expense, inventory write-down and non-cash operating lease costs and other. Operating assets and liabilities decreased primarily due to a decrease in inventories as we managed our inventory levels and lower accounts receivable due to timing of shipments and collections, partially offset by higher prepaid expenses and other current assets related to advance payments to suppliers for inventory, lower accounts payable, accrued expenses and other liabilities including lease liabilities due to timing of payments. In 2018, cash used in operating activities of $1.0 million was primarily due to a net loss of $9.3 million and an increase in operating assets and liabilities of $9.1 million offset by non-cash expenses of $17.4 million. The increase in operating assets and liabilities was primarily due to increased inventories to support our future product sales and lower accounts payable offset by lower accounts receivable, decreased prepaid expenses and other current assets due to utilization of prepaid assets, and an increase in accrued expenses and other liabilities. Non-cash items included depreciation and amortization, stock-based compensation expense, and inventory write-down. Investing Activities Our investing activities consist primarily of capital expenditures for property and equipment purchases. Our capital expenditures for property and equipment have primarily been for general business purposes, including machinery and equipment, leasehold improvements, acquired software, internally developed software used in production and support of our products, computer equipment used internally, and production masks to manufacture our products. In 2019, cash used in investing activities was $3.2 million and consisted primarily of the purchase of production masks, internally developed software, and other property and equipment for general business purposes. In 2018, cash used in investing activities was approximately $5.0 million and consisted primarily of the purchase of production masks, internally developed software, and other property and equipment for general business purposes. Financing Activities Cash provided by financing activities includes proceeds from borrowings under our credit facilities and proceeds from issuance of shares. In 2019, cash provided by financing activities was $51.4 million, consisting of $56.4 million of proceeds from the initial public offering, net of issuance costs offset by repayments of $5.0 million under our short-term revolving line of credit. In 2018, cash provided by financing activities was $4.9 million, consisting of borrowings of $21.0 million under our short-term revolving line of credit and investment received from MegaChips of $1.9 million, partially offset by repayments of $18.0 million under our short-term revolving line of credit. During the year ended December 31, 2018, our outstanding balance on our short-term revolving lines of credit ranged from $40.0 million to $43.0 million and our borrowings from MegaChips were $3.0 million during the year. Debt Obligations The following summarizes principal loan balances for the years ended December 31, 2019 and 2018: As of December 31, 2019, remaining available credit line from MUFG was $9.0 million, SMBC was $20.0 million and MegaChips was $30.0 million. The following summarizes our total debt obligations as of December 31, 2019 and with further details on the term of the loans and interest payable on maturity: (1) Loan start date refers to the most recent renewal date. Refer to Note 7 of our consolidated financial statements under Item 8 for more information on our debt obligations. Contractual Obligations and Commitments Set forth below is information concerning our contractual commitments and obligations as of December 31, 2019: Obligations under contracts that we can cancel without a significant penalty are not included in the table above. The aggregate amount of our obligations under these contracts is approximately $16.3 million as of December 31, 2019. We signed an operating lease agreement for our corporate headquarters in Santa Clara, California that commenced on October 20, 2016 and will expire on December 31, 2026. The agreement provides for an option to renew for an additional five years and for rent payments through the term of the lease payment. We also lease office space in Michigan, Malaysia, Japan, the Netherlands, and Ukraine, and under all operating leases with various expiration dates through May 2021. We purchase components and wafers from a variety of suppliers and use several contract manufacturers to provide manufacturing services for its products. A significant portion of our reported purchase commitments arising from these agreements consists of firm, non-cancellable and unconditional purchase commitments once the production has started. In certain instances, these agreements allow us the option to cancel, reschedule, and adjust our requirements based on its business needs prior to firm orders being placed. Off-Balance Sheet Arrangements During the periods presented, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would 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 have been prepared in accordance with GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses, and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis. Actual results may differ from these estimates. To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected. The 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 We derive our revenue from product sales to distributors and resellers, who in turn sell to original equipment manufacturers or other end customers. We recognize product revenue, at a point in time, upon shipment when we satisfy our performance obligations as evidenced by the transfer of control of our products to customers. We measure revenue based on the amount of consideration we expect to be entitled to in exchange for products. Variable consideration is estimated and reflected as an adjustment to the transaction price. We determine variable consideration, which consists primarily of price adjustments and product returns by estimating the amount of consideration we expect to receive from our customers based on historical experience of price adjustments and product returns. Initial estimates of price adjustments and product returns are updated at the end of each reporting period if additional information becomes available. Changes to our estimated variable consideration were not material for the periods presented. Since our performance obligations relate to contracts with a duration of less than one year, we do not disclose the aggregate amount of the transaction price allocated to performance obligations that are unsatisfied or partially unsatisfied at the end of the reporting period. As a practical expedient, we record the incremental costs of obtaining a contract, consisting primarily of sales commissions, when incurred because the amortization period is one year or less. The costs are recorded within sales and marketing expenses. Our payment terms vary by contract type and type of customer and generally range from 30 to 60 days from shipment. We have also elected to recognize the cost for freight and shipping when control over the products sold passes to customers and revenue is recognized. We entered into a distribution agreement with MegaChips, whereby we appointed MegaChips as the exclusive distributor of our products in Japan. We recognize revenue derived from sales of products through MegaChips in the amount of expected payments from parties which purchased the products, as adjusted for estimated price concessions and product returns. Inventory Inventories consist of raw and processed wafers, work-in-process, and finished goods and are stated at the lower of standard cost or net realizable value. Standard costs approximate actual costs and are based on a first-in, first-out basis. We perform detailed reviews of the net realizable value of inventories, both on hand as well as for inventories that we are committed to purchase and write-down the inventory value for estimated deterioration, excess and obsolete and other factors based on management’s assessment of future demand and market conditions, and may require estimates that may include uncertain elements. Actual demand may differ from forecasted demand and such differences may have a material effect on recorded value of inventory. Once written-down, inventory write-downs are not reversed until the inventory is sold or scrapped. Stock-Based Compensation Stock-based compensation expense is measured at the grant date based on the fair value of the equity award and is recognized as expense over the requisite service period, which is generally the vesting period. We have elected to recognize forfeitures as they occur. Fair value of awards issued prior to initial public offering We had not issued stock-based awards since our acquisition by MegaChips in 2014, and did not have any outstanding equity awards prior to the initial public offering. However, MegaChips, in consultation with our management, had granted restricted stock units (“RSUs”), to certain of our employees. Compensation expense related to stock-based awards was measured and recognized in the financial statements at fair value. We estimated the fair value of each equity award on the date of grant using the trading price of the MegaChips stock in Japan and recognized the related stock-based compensation expense on a straight-line method. The MegaChips shares granted to the employees had a one-year holding period from the date of vesting. Due to the exercise restriction of one-year at the time of vesting, we had committed to advance cash to employees to pay for payroll taxes that were due on vesting instead of issuing the employees restricted shares. The liability associated with the cash expense paid to the employee in lieu of restricted shares was treated as liability based awards and was valued based on the estimate of the market price of the shares at the reporting date and the liability was adjusted accordingly. Fair value of awards issued after initial public offering Upon completion of its IPO in November 2019, we adopted the SiTime Corporation 2019 Stock Incentive Plan (the “2019 Plan”). Compensation expense for the RSUs granted under the 2019 Plan are measured and recognized in the financial statements at fair value. We estimate the fair value of each equity award on the date of grant using the closing market price of our common stock on the date of grant. Income Taxes Deferred tax liabilities and assets are recognized for the expected future tax consequences of temporary differences between financial statement carrying amounts and the tax basis of assets and liabilities and net operating loss and tax credit carryforwards. Valuation allowances are established when necessary to reduce deferred tax assets to a level which, more likely than not, will be realized. A tax position can be recognized only if it is more likely than not to be sustained based solely on its technical merits as of the reporting date and then only in an amount more likely than not to be sustained upon review by the tax authorities. We consider many factors when evaluating and estimating its tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes. Segment Reporting We operate as one reportable segment related to the design, development, and sale of silicon timing systems solutions. Our chief operating decision maker is our Chief Executive Officer. Our Chief Executive Officer reviews operating results on an aggregate basis and manages our operations as a whole for the purpose of evaluating financial performance and allocating resources. Accordingly, we have determined that we have a single reportable and operating segment structure. Substantially all of our long-lived assets were attributable to operations in the United States as of December 31, 2019. JOBS Act Transition Period The JOBS Act was enacted in April 2012. Section 107(b) of the JOBS Act provides that an emerging growth company can take advantage of an extended transition period for complying with new or revised accounting standards. Thus, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have 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. Recent Accounting Pronouncements See Note 2 to our consolidated financial statements under Item 8 for information regarding recently issued accounting pronouncements.

<s>[INST] Overview We are a leading provider of silicon timing solutions. Our timing solutions are the heartbeat of our customers’ electronic systems, solving complex timing problems and enabling industryleading products. We provide solutions that are differentiated by high performance and reliability, programmability, small size, and low power consumption. Our products have been designed into over 200 applications across our target markets, including enterprise and telecommunications infrastructure, automotive, industrial, IoT and mobile, and aerospace and defense. We commenced commercial shipments of our first oscillator products in 2006. Substantially all of our revenue to date has been derived from sales of oscillator systems across our target end markets. We intend to introduce products into the clock IC market, which we began sampling in the second quarter of 2019, and to focus on clock IC and timing sync solutions in the future. We seek to aggressively expand our presence in these two markets. We sell our products primarily through distributors and resellers, who in turn sell to our end customers. Based on sellthrough information provided by these distributors, we believe the majority of our end customers are based in the U.S. We operate a fabless business model, allowing us to focus on the design, sales, and marketing of our products, quickly scale production, and significantly reduce our capital expenditures. We leverage our global network of distributors and resellers to address the broad set of end markets we serve. For our largest accounts, dedicated sales personnel work with the end customer to ensure that our solutions fully address the end customer’s timing needs. Our smaller customers work directly with our distributors to select the optimum timing solution for their needs. We were acquired by MegaChips in 2014 and were a whollyowned subsidiary of MegaChips, a fabless semiconductor company based in Japan and traded on the Tokyo Stock Exchange, until November 25, 2019. On November 25, 2019, we completed the initial public offering of shares of our common stock. MegaChips continues to hold a majority controlling interest in our common stock. Key Factors Affecting Our Performance Customer Orders and Forecasts Because our sales are made pursuant to standard purchase orders, orders may be cancelled, reduced, or rescheduled with little or no notice and without penalty. Cancellations of orders could result in the loss of anticipated sales without allowing us sufficient time to reduce our inventory and operating expenses. In addition, changes in forecasts or the timing of orders from customers exposes us to the risks of inventory shortages or excess inventory. We may not be able to fulfill increased demand, at least in the short term, as we do not intend to acquire excess inventory to prebuild custom products. Design Wins with New and Existing Customers Our solutions enable our customers to differentiate their product offerings and position themselves to gain market share. We work closely with our customers to understand their product roadmaps and strategies. Our end customers continuously develop new products in existing and new application areas. We also consider design wins critical to our future success and anticipate being increasingly dependent on revenue from new design wins for our new higherend products with higher average selling prices (“ASPs”). The selection process is typically lengthy and may require us to incur significant design and development expenditures in pursuit of a design win with no assurance that our solutions will be selected. As a result, the loss of any key design win or any significant delay in the ramp of volume production of the customer’s products into which our product is designed could adversely affect our business. Customer Demand and Product Life Cycles Once customers design our silicon timing systems solutions into their products, we closely monitor all aspects of their demand cycle, including the initial design phase, prototype production, volume production, and inventories, as well as endmarket demand, including seasonality, cyclicality, and the competitive landscape. Given our customer relationships and the longterm aspects of our solutions, we benefit from visibility into customer demand. This in turn provides an opportunity for us to monitor and refine our business fundamentals. Product Adoption within New Markets and Applications As we evaluate new market opportunities and bring new products to market, we pay particular attention to forecasts by industry analysts and the adoption curve of technology. We also analyze in detail potential competing forces that could hinder such adoption. If we fail to anticipate or respond to technological shifts or market demands, [/INST] Positive. </s>

XPEL, Inc.

2020-03-16

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Executive Summary Set forth below is summary financial information for the years ended December 31, 2019 and 2018. This information is not necessarily indicative of results of future operations, and should be read in conjunction with Part I, Item 1A, “Risk Factors,” Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and accompanying notes thereto included in Part II, Item 8 of this Annual Report to fully understand factors that may affect the comparability of the information presented below. Full-Year 2019 compared to Full-Year 2018 • Consolidated revenue grew 18.2% to $129.9 million. • Gross margin grew 30.1% to $43.5 million. Gross margin percentage improved 3.1% to 33.5% of revenue. • Total operating expenses grew 22.1% to $26.4 million and represented 20.3% of total consolidated revenue. • Income tax expense grew 7.1% to $3.0 million. The effective income tax rate was 17.4%. • Net income grew 60.5% to $14.0 million and represented 10.8% of total revenue. Earnings per share was $0.51 compared with $0.32 in 2018. Key Business Metric - Non-GAAP Financial Measures Our management regularly monitors certain financial measures to track the progress of our business against internal goals and targets. We believe that the most important measure to the Company is Earnings Before Interest, Taxes, Depreciation, and Amortization (“EBITDA”). EBITDA is a non-GAAP financial measure. We believe EBITDA provides helpful information with respect to our operating performance as viewed by management, including a view of our business that is not dependent on (i) the impact of our capitalization structure and (ii) items that are not part of our day-to-day operations. Management uses EBITDA (1) to compare our operating performance on a consistent basis, (2) to calculate incentive compensation for our employees, (3) for planning purposes including the preparation of our internal annual operating budget, (4) to evaluate the performance and effectiveness of our operational strategies, and (5) to assess compliance with various metrics associated with the agreements governing our indebtedness. Accordingly, we believe that EBITDA provides useful information in understanding and evaluating our operating performance in the same manner as management. We define EBITDA as net income plus (a) total depreciation and amortization, (b) interest expense, net, and (c) income tax expense. The following table is a reconciliation of Net income to EBITDA for the years ended December 31, Use of Non-GAAP Financial Measures EBITDA should be considered in addition to, not as a substitute for, or superior to, financial measures calculated in accordance with GAAP. It is not a measurement of our financial performance under GAAP and should not be considered as alternatives to revenue or net income, as applicable, or any other performance measures derived in accordance with GAAP and may not be comparable to other similarly titled measures of other businesses. EBITDA has limitations as an analytical tool and you should not consider it in isolation or as a substitute for analysis of our operating results as reported under GAAP. EBITDA does not reflect the impact of certain cash charges resulting from matters we consider not to be indicative of ongoing operations; and other companies in our industry may calculate EBITDA differently than we do, limiting their usefulness as comparative measures. Results of Operations The following tables summarize revenue results for the years ended December 31, 2019 and 2018: Because many of our international customers require us to ship their orders to freight forwarders located in the United States, we cannot be certain about the ultimate destination of the product. The following table represents our estimate of sales by geographic regions based on our understanding of ultimate product destination based on customer interactions, customer locations and other factors for years ended December 31, 2019 and 2018: Product Revenue. Product revenue increased 17.5% for the year ended December 31, 2019 . Product revenue represented 86.4% of our total revenue for the year ended December 31, 2019. Within this category, revenue from our paint protection film product line increased 13.9% for the year ended December 31, 2019. Paint protection film sales represented 74.9% and 77.8% of our consolidated revenue for the years ended December 31, 2019 and 2018, respectively. Overall, this growth was due mainly to increases in the square footage of film product sold owing to increased demand for our products. This increase in demand was driven by both an increase in the number of customers and an increase in revenue to existing customers. Revenue from our window film product line grew 55.7% in the year ended December 31, 2019. Window film sales represented 8.8% and 6.7% of our consolidated revenue for the years ended December 31, 2019 and 2018, respectively. This growth was attributable to increased demand for our window film products commensurate with increased window film adoption within our distribution channels and an increase in new customers. Geographically, growth was strong in most of the regions in which we operate except for China. The decline in China in 2019 was primarily due to the need to sell through inventory built up in the region during 2018. This sell through of the 2018 inventory build occurred primarily during the first half of 2019 after which growth in sales to China resumed. Service revenue. Service revenue consists of revenue from fees for DAP software access, cutbank credit revenue which represents per-cut fees charged for the use of our DAP software, revenue from the labor portion of installation sales in our company-owned installation centers and revenue from training services provided to our customers. Service revenue grew 23.2% over the service revenue for the year ended December 31, 2018. Service revenue represented 13.6% and 13.1% of our total consolidated revenue from the years ended December 31, 2019 and 2018, respectively. Within the service revenue category, software revenue increased 27.1% from the year ended December 31, 2018. Software revenue represented 2.5% and 2.3% of our total consolidated revenue for the years ended December 31, 2019 and 2018, respectively. This increase was due primarily to increases in customers subscribing to our software. Cutbank credit revenue grew 17.0% from the year ended December 31, 2018. Cutbank sales represented 5.6% and 5.6% of our total consolidated revenue for the years ended December 31, 2019 and 2018, respectively. This increase was due primarily to the aforementioned increases in demand for our products and services. Installation labor revenue increased 27.0% from the year ended December 31, 2018, due mainly to the increase in demand for installation services. Training revenue increased 41.2% from the year ended December 31, 2018. This growth was due to continued strong interest in the Company’s training program coupled with increased training capacity added in 2019. Total installation revenue (labor and product combined) at our Company-owned installation centers for the year ended December 31, 2019 increased 27.0% over the year ended December 31, 2018. This represented 6.1% and 5.6% of our total consolidated revenue for the years ended December 31, 2019 and 2018, respectively. Adjusted product revenue, which combines the cutbank credit revenue service component with product revenue, increased by 17.4% from the year ended December 31, 2018 due mainly to the same factors described previously. Cost of Sales Cost of sales consists of product costs and the costs to provide our services. Product costs consist of material costs, personnel costs related to warehouse personnel, shipping costs, warranty costs and other related costs to provide products to our customers. Cost of service includes the labor costs associated with installation of product in our Company-owned facilities, costs of labor associated with pattern design for our cutting software and the costs incurred to provide training for our customers. Product costs in the year ended December 31, 2019 increased 11.7% over the year ended December 31, 2018 commensurate with the growth in product revenue. Cost of product sales represented 63.3% and 67.0% of total revenue in the years ended December 31, 2019 and 2018, respectively. Cost of service revenue grew 45.6% during the year ended December 31, 2019. The increase was due primarily to increases in labor installation costs commensurate with increased installation revenue and increases in design costs related to continued investments in DAP. Gross Margin Gross margin for the year ended December 31, 2019 grew approximately $10.1 million, or 30.1%. For the years ended December 31, 2019 and 2018, gross margin represented 33.5% and 30.4% of revenue, respectively. The following table summarizes gross margin for product and services for the years ended December 31, 2019 and 2018: Product gross margin for the year ended December 31, 2019 increased approximately $8.0 million, or 36.7%, over the year ended December 31, 2018 and represented 26.6% and 22.9% of total product revenue for the years ended December 31, 2019 and 2018, respectively. The increases in product gross margin percentages were primarily due to a lower percentage of sales to lower margin distributors (primarily our China Distributor) and improvements in product costs and operating leverage. Service gross margin increased approximately $2.0 million for the year ended December 31, 2019, and represented 76.8% and 80.4% of total service revenue for the years ended December 31, 2019 and 2018, respectively. The decrease in service gross margin percentage for these periods versus the prior year periods was primarily due to a higher percentage of lower margin installation labor costs relative to other higher margin service revenue components and increases in design costs related to continued investments in DAP. Operating Expenses Sales and marketing expenses for the year ended December 31, 2019 increased 11.5% compared to 2018. These expenses represented 5.8% and 6.2% of consolidated revenue for the years ended December 31, 2019 and 2018, respectively. This increase was primarily attributable to increases in sales staff and other marketing related expenses incurred to support the ongoing growth of the business. General and administrative expenses grew approximately $4.0 million, or 27.0%, during the year ended December 31, 2019. These costs represented 14.5% and 13.5% of total consolidated revenue for the years ended December 31, 2019 and 2018, respectively. The increase was due mainly to increases in personnel, occupancy costs, information technology costs and research and development costs to support the ongoing growth of the business and increases in professional fees due primarily to the ancillary costs associated with the preparation and filing of the Company’s registration statement on Form 10. Income Tax Expense Income tax expense for the year ended December 31, 2019 grew 7.1% to $3.0 million. On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax cuts and Jobs Act of Tax Reform Act. The Tax Reform Act made broad and complex changes to the U.S. tax code that affected the Company including, but not limited to, a permanent reduction of the U.S. corporate income tax rate from 34% to 21% effective January 1, 2018. The Company’s effective tax rate for the years ended December 31, 2019 and 2018 was 17.4% and 24.0%. The decrease in the effective rate was due primarily to 2018 return to provision adjustments and the impact of certain provisions of the Tax Reform Act. Net Income Net income for the year ended December 31, 2019 increased by $5.3 million from the prior year to $14.0 million due primarily to increased revenue and improved margins. Liquidity and Capital Resources The primary sources of liquidity for our business are cash and cash equivalents and cash flows provided by operations. As of December 31, 2019, we had cash and cash equivalents of $11.5 million We expect to continue to have cash requirements to support working capital needs, capital expenditures, and to pay interest and service debt, if applicable. We believe we have the ability and sufficient capacity to meet these cash requirements by using available cash and internally generated funds and borrowing under committed credit facilities. We are focused on continuing to generate positive operating cash to fund our operational and capital investment initiatives. We believe we have sufficient liquidity to operate for at least the next 12 months from the date of filing this report. Operating activities. Cash flows provided by operations totaled approximately $11.0 million for the year ended December 31, 2019, compared to $6.8 million for the year ended December 31, 2018. This increase was driven primarily by increased net income partially offset by increases in net working capital investments. Investing activities. Cash flows used in investing activities totaled approximately $2.3 million during the year ended December 31, 2019 compared $3.1 million during the year ended December 31, 2018. This decrease was due primarily to fewer acquisitions during the year ended December 31, 2019. Financing activities. Cash flows used in financing activities during the year ended December 31, 2019 totaled approximately $1.1 million compared to $3.1 million for the same period in 2018. The decrease in cash flows used in financing activities were due primarily to lower debt levels. Debt obligations as of December 31, 2019 and December 31, 2018 totaled approximately $0.8 million and $1.8 million, respectively. Credit Facilities Our credit facilities consist of an $8.5 million revolving line of credit agreement with The Bank of San Antonio and a revolving credit facility maintained by our Canadian subsidiary. The Bank of San Antonio facility is utilized to fund our working capital needs and is secured by a security interest in substantially all of our current and future assets. The line has a variable interest rate of the Wall Street Journal prime rate plus 0.75% with a floor of 4.25% and matures in May 2020. The interest rate as of December 31, 2019 and December 31, 2018 was 5.50% and 6.00%, respectively. As of December 31, 2019 and December 31, 2018, no balance was outstanding on this line. The credit agreement contains customary covenants including covenants relating to complying with applicable laws, delivery of financial statements, payment of taxes and maintaining insurance. The credit agreement also requires that XPEL must maintain debt service coverage (EBITDA divided by the current portion of long-term debt plus interest) of 1.25:1 and debt to tangible net worth of 4.0:1 on a rolling four quarter basis. The credit agreement also contains customary events of default including the failure to make payments of principal and interests, the breach of any covenants, the occurrence of a material adverse change, and certain bankruptcy and insolvency events. As of December 31, 2019, the Company was in compliance with all covenants. During 2018, XPEL Canada Corp., a wholly-owned subsidiary of XPEL, Inc., entered into a Canadian Dollar (“CAD”) $4.5 million revolving credit facility through HSBC Bank Canada. This facility is utilized to fund our working capital needs in Canada. This facility bears interest at HSBC Canada Bank’s prime rate plus .25% per annum and is guaranteed by the parent company. As of December 31, 2019 and December 31, 2018, no balance was outstanding on this facility. Contractual Obligations The Company has contractual obligations to purchase stated quantities of inventory from its primary supplier through March 2020. The agreement in place requires that the Company use commercially reasonable efforts to purchase $5,000,000 worth of products from this supplier on a quarterly basis and includes an annual purchase requirement of $20,000,000. This Supply Agreement will renew on March 21, 2020 for an additional two-year term. The Company also has annual contractual obligations for operating leases according to the details discussed more fully in Footnote 15, Leases, to the Company’s audited consolidated financial statements included in Item 8. Critical Accounting Policies We have adopted various accounting policies to prepare the consolidated financial statements in accordance with U.S. GAAP. Certain of our accounting policies require the application of significant judgment by management in selecting the appropriate assumptions for calculating financial estimates. We identified the critical accounting policies which affect our more significant estimates and assumptions used in preparing our consolidated financial statements. Certain of the most critical estimates that require significant judgment are as follows: Allowance for Doubtful Accounts When evaluating the adequacy of the allowance for doubtful accounts, we analyze accounts receivable, historical write-offs of bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in customer payment terms. We maintain an allowance for doubtful accounts at an amount estimated to be sufficient to provide adequate protection against losses resulting from collecting less than full payment on outstanding accounts receivable. An amount of judgment is required when assessing the ability to realize accounts receivable, including assessing the probability of collection and the current credit-worthiness of each customer. If the financial condition of our customers was to deteriorate, resulting in an impairment of their ability to make payments, an additional provision for uncollectible accounts may be required. This allowance was $0.2 million and $0.1 million as of December 31, 2019 and 2018, respectively. Based on our analysis, we believe the reserve is adequate for any exposure to credit losses. Inventory Reserves Inventory reserves are maintained for the estimated value of the inventory that may have a lower value than stated or quantities in excess of future production needs. We have an evaluation process to assess the value of the inventory that is slow moving, excess or obsolete on a quarterly basis. We evaluate our inventory based on current usage and the latest forecasts of product demand and production requirements from our customers. This reserve was $0.1 million and $0.2 million as of December 31, 2019 and 2018, respectively. Based on our evaluation, we believe the reserve to be adequate. Recoverability of Long-Lived Assets The Company reviews its long-lived assets whenever events or changes in circumstances indicate the carrying amount of the assets may not be recoverable and determines potential impairment by comparing the carrying value of the assets with expected net cash flows expected to be provided by operating activities of the business or related products. If the sum of the expected undiscounted future net cash flows were less than the carrying value, we would determine whether an impairment loss should be recognized. An impairment loss would be measured by comparing the amount by which the carrying value exceeds the fair value of the asset. No impairment losses were recorded in any year presented. Goodwill and Intangible Assets Goodwill represents the excess purchase price over the fair value of tangible net assets acquired in business combinations after amounts have been allocated to intangible assets. Goodwill is not amortized, but is reviewed for impairment during the last quarter of each year, or whenever events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount, using a discounted cash flow model and comparable market values of each reporting unit. Measuring the fair value of reporting units is a Level 3 measurement under the fair value hierarchy. See Note 12, Fair Value Measurements, for a discussion of levels. Intangible assets primarily consist of capitalized software, customer relationships, trademarks and non-compete agreements. These assets are amortized on a straight-line basis over the period of time in which their expected benefits will be realized. Revenue Recognition Our revenue is comprised primarily of product and services sales where we act as principal to the transaction. All revenue is recognized when the Company satisfies its performance obligation(s) by transferring the promised product or service to our customer when our customer obtains control of the product or service, with the majority of our revenue being recognized at a point in time. A performance obligation is a promise in a contract to transfer a distinct product or service to a customer. A contract’s transaction price is allocated to each distinct performance obligation. Revenue is recorded net of returns, allowances. Sales, value add, and other taxes collected from customers and remitted to governmental authorities are accounted for on a net (excluded from revenues) basis. Shipping and handling costs are accounted for as a fulfillment obligation, on a net basis, and are included in cost of sales. Business Combinations Identifiable assets acquired and liabilities and contingent liabilities assumed in a business combination are measured initially at their fair values at the acquisition date, irrespective of the extent of any non-controlling interest. The excess of the fair value of the consideration transferred including the recognized amount of any non-controlling interest in the acquiree, over the fair value of the Company’s share of the identifiable net assets acquired is recorded as goodwill. Acquisition-related expenses are recognized separately from the business combination and are recognized as general and administrative expense as incurred. There have been no other material changes to our critical accounting policies and estimates from those previously disclosed in our consolidated financial statements. Recent Accounting Pronouncements Not Yet Adopted In June 2016, the FASB issued ASU 2016-13, “Financial Instruments - Measurement of Credit Losses on Financial Instruments”, which requires measurement and recognition of expected credit losses for financial assets held. As a smaller reporting company, ASU 2016-13 is effective for the Company beginning January 1, 2023 and is required to be applied prospectively. We are currently evaluating the impact that ASU 2016-13 will have on our consolidated financial statements. Related Party Relationships There are no family relationships between or among any of our directors or executive officers. There are no arrangements or understandings between any two or more of our directors or executive officers, and there is no arrangement, plan or understanding as to whether non-management stockholders will exercise their voting rights to continue to elect the current Board. There are also no arrangements, agreements or understandings between non-management stockholders that may directly or indirectly participate in or influence the management of our affairs. Off-Balance Sheet Arrangements As of December 31, 2019 and December 31, 2018, we did not have any relationships with unconsolidated organizations or special purpose entities, that were established for the purpose of facilitating off-balance sheet arrangements. We do not engage in off-balance sheet financing arrangements. In addition, we do not engage in trading activities involving non-exchange contracts.

<s>[INST] Set forth below is summary financial information for the years ended December 31, 2019 and 2018. This information is not necessarily indicative of results of future operations, and should be read in conjunction with Part I, Item 1A, “Risk Factors,” Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and accompanying notes thereto included in Part II, Item 8 of this Annual Report to fully understand factors that may affect the comparability of the information presented below. FullYear 2019 compared to FullYear 2018 Consolidated revenue grew 18.2% to $129.9 million. Gross margin grew 30.1% to $43.5 million. Gross margin percentage improved 3.1% to 33.5% of revenue. Total operating expenses grew 22.1% to $26.4 million and represented 20.3% of total consolidated revenue. Income tax expense grew 7.1% to $3.0 million. The effective income tax rate was 17.4%. Net income grew 60.5% to $14.0 million and represented 10.8% of total revenue. Earnings per share was $0.51 compared with $0.32 in 2018. Key Business Metric NonGAAP Financial Measures Our management regularly monitors certain financial measures to track the progress of our business against internal goals and targets. We believe that the most important measure to the Company is Earnings Before Interest, Taxes, Depreciation, and Amortization (“EBITDA”). EBITDA is a nonGAAP financial measure. We believe EBITDA provides helpful information with respect to our operating performance as viewed by management, including a view of our business that is not dependent on (i) the impact of our capitalization structure and (ii) items that are not part of our daytoday operations. Management uses EBITDA (1) to compare our operating performance on a consistent basis, (2) to calculate incentive compensation for our employees, (3) for planning purposes including the preparation of our internal annual operating budget, (4) to evaluate the performance and effectiveness of our operational strategies, and (5) to assess compliance with various metrics associated with the agreements governing our indebtedness. Accordingly, we believe that EBITDA provides useful information in understanding and evaluating our operating performance in the same manner as management. We define EBITDA as net income plus (a) total depreciation and amortization, (b) interest expense, net, and (c) income tax expense. The following table is a reconciliation of Net income to EBITDA for the years ended December 31, Use of NonGAAP Financial Measures EBITDA should be considered in addition to, not as a substitute for, or superior to, financial measures calculated in accordance with GAAP. It is not a measurement of our financial performance under GAAP and should not be considered as alternatives to revenue or net income, as applicable, or any other performance measures derived in accordance with GAAP and may not be comparable to other similarly titled measures of other businesses. EBITDA has limitations as an analytical tool and you should not consider it in isolation or as a substitute for analysis of our operating results as reported under GAAP. EBITDA does not reflect the impact of certain cash charges resulting from matters we consider not to be indicative of ongoing operations; and other companies in our industry may calculate EBITDA differently than we do, limiting their usefulness as comparative measures. Results of Operations The following tables summarize revenue results for the years ended December 31, 2019 and 2018: Because many of our international customers require us to ship their orders to freight forwarders located in the United States, we cannot be certain about the ultimate destination of the product. The following table represents our estimate of sales by geographic regions based on our understanding of ultimate product destination based on customer interactions, customer locations and other factors for years ended December 31, 2019 and 2018: Product Revenue. Product revenue increased 17.5% for the year ended December 31, 2019 . Product revenue represented [/INST] Positive. </s>

Applied Therapeutics Inc.

2020-03-13

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 financial statements and the related notes included elsewhere in this Annual Report. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report, 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, our actual results could differ materially from the results described in or implied by these forward-looking statements. Overview We are a clinical-stage biopharmaceutical company developing a pipeline of novel product candidates against validated molecular targets in indications of high unmet medical need. We focus on molecules and pathways whose role in the disease process is well known based on prior research, but have previously failed to yield successful products due to poor efficacy and tolerability. Our unique approach to drug development leverages recent technological advances to design improved drugs, employs early use of biomarkers to confirm biological activity and focuses on potential use of expedited regulatory pathways. Our first molecular target is aldose reductase, or AR, an enzyme that converts glucose to sorbitol under oxidative stress conditions, and is implicated in multiple diseases. Prior attempts to inhibit this enzyme were hindered by nonselective, nonspecific inhibition, which resulted in limited efficacy and significant off-target safety effects. The detrimental consequences of AR activation have been well established by decades of prior research. Our AR program currently includes three small molecules, which are all potent and selective inhibitors of AR, but are engineered to have unique tissue permeability profiles to target different disease states, including diabetic complications, heart disease and a rare pediatric metabolic disease. Using similar strategies to our AR inhibitors, or ARI, program, we have also developed a program targeting selective inhibition of phosphatidylinositol 3-kinase, or PI3K, subunits that produced an early-stage oncology pipeline. The result of this unique multifaceted approach to drug development is a portfolio of highly specific and selective product candidates that we believe are significantly de-risked and can move quickly through the development process. We plan to initiate our clinical program in these indications in 2020. AT-007 is a novel central nervous system, or CNS, penetrant ARI that we are developing for the treatment of galactosemia, a devastating rare pediatric metabolic disease that affects how the body processes a simple sugar called galactose, and for which there is no known cure or approved treatment available. In May 2019, the U.S. Food and Drug Administration, or FDA, granted orphan drug designation to AT-007 for the treatment of galactosemia. We initiated a Phase 1/2 study of AT-007 in galactosemia in June 2019. The study is a double-blind placebo-controlled trial evaluating safety and pharmacokinetics of AT-007 in healthy volunteers, as well as safety, pharmacokinetics and biomarker effects in adult galactosemia patients over 28 days of once daily oral dosing. The key biomarker outcome of the study was reduction in galactitol, an aberrant toxic metabolite of galactose, formed by AR in galactosemia patients. In January 2020, we announced positive topline results. AT-007 treatment resulted in a statistically significant and robust reduction in plasma galactitol versus placebo in adult galactosemia patients. Reductions in galactitol were dose dependent, with higher concentrations of AT-007 resulting in a greater magnitude of reduction in galactitol. At the highest dose tested (20mg/kg), AT-007 significantly reduced plasma galactitol 45-54% from baseline versus placebo (with a p value of less than 0.01). Galactitol reduction was rapid and sustained over time. No substantial change from baseline was observed in placebo treated patients. AT-007 was well tolerated, with no drug-related adverse events noted to date in galactosemia patients or in the 72 healthy volunteers treated in Part 1 of the trial. We will continue to characterize AT-007 long-term safety in adult galactosemia patients and intend to initiate a pediatric study. AT-001 is a novel ARI with broad systemic exposure and peripheral nerve permeability that we are developing for the treatment of diabetic cardiomyopathy, or DbCM, a fatal fibrosis of the heart, for which no treatments are available. We completed a Phase 1/2 clinical trial evaluating AT-001 in approximately 120 patients with type 2 diabetes, in which no drug-related adverse effects or tolerability issues were observed. In September 2019, we announced the initiation of a Phase 3 registrational trial for AT-001 in DbCM. The study, called ARISE-HF, will investigate AT-001’s ability to improve or prevent the decline of functional capacity in patients with DbCM at high risk of progression to overt heart failure. Since inception in 2016, our operations have focused on developing our product candidates, organizing and staffing our company, business planning, raising capital, establishing our intellectual property portfolio and conducting clinical trials. We do not have any product candidates approved for sale and have not generated any revenue. Initial Public Offering On May 16, 2019, we completed the IPO, in which we issued and sold 4,000,000 shares of our common stock at a public offering price of $10.00 per share, for aggregate gross proceeds of $40.0 million. We received approximately $34.6 million in net proceeds after deducting underwriting discounts and commissions and estimated offering costs. The shares began trading on The Nasdaq Global Market on May 14, 2019. Upon completion of the IPO, all of our outstanding shares of convertible preferred stock, converted into 7,538,671 shares of our common stock. Prior to the completion of the IPO, we primarily funded our operations with proceeds from the sale of convertible preferred stock. We have incurred significant operating losses since inception in 2016. Our ability to generate product revenue sufficient to achieve profitability depends on the successful development and commercialization of one or more of our product candidates. Our net loss was $45.6 million for the twelve months ended December 31, 2019. As of December 31, 2019, we had an accumulated deficit of $66.8 million. We expect to continue to incur significant expenses and increasing operating losses for the foreseeable future in connection with our ongoing activities. Furthermore, we expect to continue to incur additional costs associated with operating as a public company, including significant legal, accounting, investor relations and other expenses. As of December 31, 2019, we had cash and cash equivalents and short-term investments of $38.9 million. November 2019 Private Placement On November 7, 2019, we entered into a securities purchase agreement for the Private Placement with the Purchasers. Pursuant to the securities purchase agreement, the Purchasers purchased 1,380,344 shares of our common stock. The purchase price for each share was $14.50, with net proceeds of approximately $18 million. The closing of the purchase and sale of the securities occurred on November 12, 2019. January 2020 Secondary Public Offering In January 2020, we issued and sold 2,741,489 shares of our common stock at a public offering price of $45.50 per share, with an additional 411,223 shares sold pursuant to the underwriters’ full exercise of their option to purchase additional shares in the Secondary Public Offering. We received aggregate net proceeds, net of underwriting discounts and commissions and estimated offering expenses of $134.8 million. Components of Our Results of Operations Revenue Since inception, we have not generated any revenue 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 if we enter into collaboration or license agreements with third parties, we may generate revenue in the future from a combination of product sales or payments from collaboration or license agreements. Operating Expenses 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: · employee-related expenses, including salaries, related benefits 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; and · costs related to compliance with regulatory requirements. We expense research and development costs as incurred. Costs for external development activities are recognized based on an evaluation of the progress to completion of specific tasks using information provided to us by our vendors. Payments for these activities are based on the terms of the individual agreements, which may differ from the pattern of costs incurred, and are reflected in our financial statements as prepaid or accrued research and development expenses. Research and development activities are central to our business model. We expect that our research and development expenses will continue to increase for the foreseeable future as we continue clinical development for our product candidates and continue to discover and develop additional product candidates. If any of our product candidates enter into later stages of clinical development, they will 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. Historically, we have incurred research and development expenses that primarily relate to the development of AT-001, AT-007 and our ARI program. As we advance our product candidates, we expect to allocate our direct external research and development costs across each of the indications or product candidates. 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 and finance functions. General and administrative expenses also include professional fees for legal, accounting, auditing, tax and consulting services; travel expenses; and facility-related expenses, which include 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 general and administrative headcount to support our continued research and development and potential commercialization of 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 compliance services; director and officer insurance costs; and investor and public relations costs. Other Income (Expense), Net Other income (expense), net consists of interest income (expense), net, loss on extinguishment of debt and other expenses. Interest income (expense), net consists primarily of our interest income on our cash and cash equivalents and marketable securities and interest expense related to the convertible promissory notes. Loss on extinguishment of debt consists of a loss on extinguishment related to the conversion of convertible promissory notes into Series B Preferred Stock. Other expense consists of adjustments to the fair value of embedded derivatives associated with certain conversion features of the convertible promissory notes and adjustments to the fair value of the warrant liability in connection with the convertible promissory notes. Results of Operations The following table summarizes our results of operations: Research and Development Expenses The following table summarizes our research and development expenses: Research and development expenses for the year ended December 31, 2019 were $32.4 million, compared to $11.5 million for the year ended December 31, 2018. The increase of approximately $20.9 million was primarily related to increased activity on our clinical trials, including an increase in clinical and pre-clinical expenses of $12.4 million and drug manufacturing and formulation expenses of $4.1 million, personnel expenses of $4.6 million due to an increase in the chief executive officer salary, for which a portion was allocated to research and development, the hiring of research and development personnel, including the chief medical officer, share-based compensation and employee bonuses, and offset by a decrease of regulatory and other expenses of $0.2 million. General and Administrative Expenses The following table summarizes our general and administrative expenses: General and administrative expenses were $13.2 million for the year ended December 31, 2019, compared to $2.0 million for the year ended December 31, 2019. The increase of approximately $11.2 million was primarily related to the increase of personnel expenses of $4.4 million due to an increase in the chief executive officer salary, for which a portion was allocated to general and administrative and the hiring of other personnel, including the chief financial officer, and an increase in professional and legal fees of $3.5 million due to the closing of multiple financings and increased IP work, and an increase in other expenses of $3.2 million, primarily due to recruiting efforts for the chief medical officer and rent. Other Income (Expense), Net Other income (expense), net was income of approximately $69,000 for the year ended December 31, 2019, compared to expense of $3.0 million for the year ended December 31, 2018. The change from expense to income was primarily related to a the conversion of promissory notes in 2018, resulting in a decrease in non-cash interest expense on convertible promissory notes of $1.6 million, a loss on extinguishment related to the conversion of convertible promissory notes into Series B Preferred Stock of $0.2 million and the removal of the associated fair value of the derivative liability of $1.0 million and warrant liability of $0.2 million related to the promissory notes. Additionally, there was interest income earned on marketable securities of $93,000 in 2019. Liquidity and Capital Resources Since our inception through December 31, 2019, we have not generated any revenue and have incurred significant operating losses and negative cash flows from our operations. We expect our existing cash and cash equivalents and short-term investments of $38.9 million as of December 31, 2019, together with the net proceeds from the Secondary Public Offering of approximately $134.8 million, net of underwriting discounts and commissions and estimated offering expenses subsequent to December 31, 2019, will be sufficient to fund our operating expenses and capital expenditure requirements for at least one year from the date of this Annual Report on Form 10-K. Cash Flows The following table summarizes our cash flows for each of the periods presented: Operating Activities During the year ended December 31, 2019, operating activities used cash of $36.3 million, primarily comprising cash research and development spending, related to increased clinical and pre-clinical activities, drug manufacturing and formulation development. During the year ended December 31, 2018, operating activities used cash of $11.2 million of cash, primarily comprising cash research and development spending related to increased clinical and pre-clinical activities, drug manufacturing and formulation development. Investing Activities Net cash used in investing activities for the year ended December 21, 3019 was $20.0 million relating to our investment in marketable securities for $20.0 million. For the year ended December 31, 2018, there were no investing activities. Financing Activities During the year ended December 31, 2019, net cash provided by financing activities was $56.4 million, primarily from the cash proceeds from the IPO of $37.2 million, net of underwriting costs, and from the issuance of Series B Preferred Stock resulting in $3.1 million cash proceeds, as well as $18.4 million of cash proceeds from the Private Placement. During the year ended December 31, 2018, net cash provided by financing activities was $26.7 million. Cash proceeds, net of cash issuance costs, from the sale of our Series B Preferred Stock was $21.2 million and cash proceeds, net of cash issuance costs, from the sale of convertible promissory notes was $5.6 million. Cash proceeds from the exercise of stock options were approximately $47,000. The net cash provided by financing activities was partially offset by the payment of deferred financing costs related to the IPO of $0.1 million. 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. We expect that our expenses will increase significantly if and as we: · continue the ongoing and planned development of our product candidates; · initiate, conduct and complete any ongoing, anticipated or future preclinical studies and clinical trials for our current and future product candidates; · seek marketing approvals for any product candidates that successfully complete clinical trials; · establish a sales, marketing, manufacturing and distribution infrastructure to commercialize any current or future product candidate for which we may obtain marketing approval; · seek to discover and develop additional product candidates; · continue to build a portfolio of product candidates through the acquisition or in-license of drugs, product candidates or technologies; · maintain, protect and expand our intellectual property portfolio; · hire additional clinical, regulatory and scientific personnel; and · add operational, financial and management information systems and personnel, including personnel to support our product development and planned future commercialization efforts. 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. Due to the numerous risks and uncertainties associated with the development of our product candidates and programs, and because the extent to which we may enter into collaborations with third parties for development of our product candidates is unknown, we are unable to estimate the timing and amounts of increased capital outlays and operating expenses associated with completing the research and development of our product candidates. Our future funding requirements, both near and long-term, will depend on many factors, including: · the initiation, scope, progress, timing, costs and results of our ongoing and planned clinical trials for our product candidates; · the outcome, timing and cost of meeting regulatory requirements established by the FDA and other comparable foreign regulatory authorities; · the cost of filing, prosecuting, defending and enforcing our patent claims and other intellectual property rights; · the cost of defending potential intellectual property disputes, including patent infringement actions; · the achievement of milestones or occurrence of other developments that trigger payments under the Columbia Agreements or other agreements we may enter into; · the extent to which we are obligated to reimburse, or entitled to reimbursement of, clinical trial costs under future collaboration agreements, if any; · the effect of competing technological and market developments; · the cost and timing of completion of clinical or commercial-scale manufacturing activities; · the costs of operating as a public company; · the extent to which we in-license or acquire other products and technologies; · our ability to establish and maintain collaborations on favorable terms, if at all; · the cost of establishing sales, marketing and distribution capabilities for our product candidates in regions where we choose to commercialize our product candidates, if approved; and · the initiation, progress, timing and results of the commercialization our product candidates, if approved, for commercial sale. 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. Until such time, if ever, that we can generate product revenue sufficient to achieve profitability, we expect to finance our cash needs through offerings of securities, private equity financing, debt financings, collaborations or other strategic transactions. The terms of financing may adversely affect the holdings or the rights of our stockholders. If we are unable to obtain funding, we may be required to delay, limit, reduce or terminate some or all of our research and product development, product portfolio expansion or future commercialization efforts. 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. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2019: (1) Represents future minimum lease payments under our operating lease for office space. Except as disclosed in the table above, we have no long-term debt or capital leases and no material non-cancelable purchase commitments with service providers, as we have generally contracted on a cancelable, purchase-order basis. 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. These contracts are cancelable by us upon prior 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 preceding table as the amount and timing of such payments are not known. We may incur potential contingent payments upon our achievement of clinical, regulatory and commercial milestones, as applicable, or royalty payments that we may be required to make under the 2016 and 2019 Columbia Agreements pursuant to which we have in-licensed certain intellectual property. Due to the uncertainty of the achievement and timing of the events requiring payment under this agreement, the amounts to be paid by us are not fixed or determinable at this time and are excluded from the table above. See the section titled “Business-Exclusive License Agreement with Columbia University.” Critical Accounting Policies and Significant Judgments and Estimates Our management’s discussion and analysis of financial condition and results of operations is based on our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles, or U.S. GAAP. The preparation of our 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 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 greater detail in Note 1 to our financial statements appearing elsewhere in this Annual Report, 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 We expense all costs incurred in performing research and development activities. Research and development expenses include materials and supplies, preclinical expenses, manufacturing expenses, contract services and other outside expenses. As part of the process of preparing our financial statements, we are required to estimate our accrued research and development expenses. We make estimates of our accrued expenses as of each balance sheet date in the financial statements based on facts and circumstances known to us at that time. 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, 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. Nonrefundable advance payments for goods or services to be received in the future for use in research and development activities are deferred and capitalized. The capitalized amounts are expensed as the related goods are delivered or the services are performed. Stock-Based Compensation We account for our stock-based compensation as expense in the statements of operations based on the awards’ grant date fair values. We account for forfeitures as they occur by reversing any expense recognized for unvested awards. We estimate the fair value of options granted using the Black-Scholes option pricing model. The Black-Scholes option pricing model requires inputs based on certain subjective assumptions, including (a) the expected stock price volatility, (b) the calculation of expected term of the award, (c) the risk-free interest rate and (d) expected dividends. Due to the lack of a public market for 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 computation of expected volatility is based on the historical volatility of a representative group of companies with similar characteristics to us, including stage of product development and life science industry focus. We use the simplified method as allowed by the SEC Staff Accounting Bulletin No. 107, Share-Based Payment, to calculate the expected term for options granted 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. The expected dividend yield is assumed to be zero as we have never paid dividends and have no current plans to pay any dividends on our common stock. The fair value of stock-based payments is recognized as expense over the requisite service period which is generally the vesting period. Determination of the Fair Value of Common Stock As there was no public market for our common stock prior to the IPO on May 16, 2019, the estimated fair value of our common stock prior to May 16, 2019 had been determined by our board of directors, 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 option 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. In addition to considering the results of these third party valuations, 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 prices at which we sold shares of preferred stock and the superior rights and preferences of the preferred stock relative to our common stock at the time of each grant; · the progress of our research and development programs, including the status and results of preclinical studies for our product candidates; · our stage of development and commercialization and our business strategy; · 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 and our preferred stock; · the likelihood of achieving a liquidity event, such as an initial public offering, or sale of our company in light of prevailing market conditions; and · the analysis of initial public offerings and the market performance of similar companies in the biotechnology industry. The assumptions underlying these valuations represented management’s best estimate, which involved inherent uncertainties and the application of management’s judgment. As a result, if we had used different assumptions or estimates, the fair value of our common stock and our stock-based compensation expense could have been materially different. Options Granted The intrinsic value of all outstanding options as of December 31, 2019 was $83.5 million, based on the fair value of our common stock of $27.28 per share, of which approximately $34.9 million related to vested options and approximately $48.6 million related to unvested options. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements and do not have any holdings in variable interest entities. 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 1 to our financial statements appearing elsewhere in this Annual Report. Quantitative and Qualitative Disclosures about Market Risks We are exposed to market risks in the ordinary course of our business. These risks primarily include interest rate sensitivities. As of December 31, 2019, we had cash, cash equivalents and investments of $38.9 million. Our exposure to interest rate sensitivity is impacted by changes in the underlying U.S. bank interest rates. Our surplus cash has been invested in interest-bearing savings accounts from time to time. We have not entered into investments for trading or speculative purposes. We do not believe an immediate one percentage point change in interest rates would have a material effect on the fair market value of our portfolio, and therefore we do not expect our operating results or cash flows to be significantly affected by changes in market interest rates. As of December 31, 2019, we had no outstanding debt and are therefore not subject to interest rate risk related to debt. 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] Overview We are a clinicalstage biopharmaceutical company developing a pipeline of novel product candidates against validated molecular targets in indications of high unmet medical need. We focus on molecules and pathways whose role in the disease process is well known based on prior research, but have previously failed to yield successful products due to poor efficacy and tolerability. Our unique approach to drug development leverages recent technological advances to design improved drugs, employs early use of biomarkers to confirm biological activity and focuses on potential use of expedited regulatory pathways. Our first molecular target is aldose reductase, or AR, an enzyme that converts glucose to sorbitol under oxidative stress conditions, and is implicated in multiple diseases. Prior attempts to inhibit this enzyme were hindered by nonselective, nonspecific inhibition, which resulted in limited efficacy and significant offtarget safety effects. The detrimental consequences of AR activation have been well established by decades of prior research. Our AR program currently includes three small molecules, which are all potent and selective inhibitors of AR, but are engineered to have unique tissue permeability profiles to target different disease states, including diabetic complications, heart disease and a rare pediatric metabolic disease. Using similar strategies to our AR inhibitors, or ARI, program, we have also developed a program targeting selective inhibition of phosphatidylinositol 3kinase, or PI3K, subunits that produced an earlystage oncology pipeline. The result of this unique multifaceted approach to drug development is a portfolio of highly specific and selective product candidates that we believe are significantly derisked and can move quickly through the development process. We plan to initiate our clinical program in these indications in 2020. AT007 is a novel central nervous system, or CNS, penetrant ARI that we are developing for the treatment of galactosemia, a devastating rare pediatric metabolic disease that affects how the body processes a simple sugar called galactose, and for which there is no known cure or approved treatment available. In May 2019, the U.S. Food and Drug Administration, or FDA, granted orphan drug designation to AT007 for the treatment of galactosemia. We initiated a Phase 1/2 study of AT007 in galactosemia in June 2019. The study is a doubleblind placebocontrolled trial evaluating safety and pharmacokinetics of AT007 in healthy volunteers, as well as safety, pharmacokinetics and biomarker effects in adult galactosemia patients over 28 days of once daily oral dosing. The key biomarker outcome of the study was reduction in galactitol, an aberrant toxic metabolite of galactose, formed by AR in galactosemia patients. In January 2020, we announced positive topline results. AT007 treatment resulted in a statistically significant and robust reduction in plasma galactitol versus placebo in adult galactosemia patients. Reductions in galactitol were dose dependent, with higher concentrations of AT007 resulting in a greater magnitude of reduction in galactitol. At the highest dose tested (20mg/kg), AT007 significantly reduced plasma galactitol 4554% from baseline versus placebo (with a p value of less than 0.01). Galactitol reduction was rapid and sustained over time. No substantial change from baseline was observed in placebo treated patients. AT007 was well tolerated, with no drugrelated adverse events noted to date in galactosemia patients or in the 72 healthy volunteers treated in Part 1 of the trial. We will continue to characterize AT007 longterm safety in adult galactosemia patients and intend to initiate a pediatric study. AT001 is a novel ARI with broad systemic exposure and peripheral nerve permeability that we are developing for the treatment of diabetic cardiomyopathy, or DbCM, a fatal fibrosis of the heart, for which no treatments are available. We completed a Phase 1/2 clinical trial evaluating AT001 in approximately 120 [/INST] Negative. </s>

Union Acquisition Corp. II

2019-12-30

2019-09-30

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 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. Certain information contained in the discussion and analysis 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 “Special Note Regarding Forward-Looking Statements,” “Item 1A. Risk Factors” and elsewhere in this Annual Report on Form 10-K. Overview We are a blank check company formed on December 6, 2018 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. We intend to effectuate our initial business combination using cash from the proceeds of the IPO and the sale of the Private Placement Warrants, our capital stock, debt or a combination of cash, stock and debt. We have neither engaged in any operations nor generated any revenues to date. Our entire activity since inception has been to prepare for our IPO, which was consummated on October 22, 2019. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities from inception to September 30, 2019 were organizational activities, those necessary to prepare for the IPO, described below, and, subsequent to the IPO, 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 after the IPO. We are incurring 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 December 6, 2018 (inception) through September 30, 2019, we had a net loss of $15,175, which consisted of operating and formation costs. Liquidity and Capital Resources As of September 30, 2019, we had $27,831 in cash. Until the consummation of the IPO, our liquidity needs were satisfied through the receipt of $25,000 from our sale of the founder shares, and unsecured loans from one of our shareholders. On October 22, 2019, we consummated the IPO of 20,000,000 Units, which includes a partial exercise by the underwriters of their over-allotment option in the amount of 2,500,000 Units, at a price of $10.00 per Unit, generating gross proceeds of $200,000,000. Simultaneously with the closing of the IPO, we consummated the sale of 6,250,000 Private Placement Warrants to two of our shareholders at a price of $1.00 per warrant, generating gross proceeds of $6,250,000. Following the IPO and the sale of the Private Placement Warrants, a total of $200,000,000 was placed in the trust account and, following the payment of certain transaction expenses, we had $1,888,753 of cash held outside of the trust account and available for working capital purposes. We incurred $4,529,222 in IPO related costs, including $4,000,000 of underwriting fees and $529,222 of other costs. For the period from December 6, 2018 (inception) through September 30, 2019, cash used in operating activities was $15,175, resulting primarily from net loss of $15,175. We intend to use substantially all of the funds held in the trust account, including any amounts representing interest earned on the trust account to complete our business combination. To the extent that our shares 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. In order to fund working capital deficiencies or finance transaction costs in connection with a business combination, our officers, directors or their affiliates 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 warrants at a price of $1.00 per warrant 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 undertaking in-depth due diligence and negotiating a business combination is 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 consummate 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. 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 Arrangements; Commitments and Contractual Obligations We have no obligations, assets or liabilities which would be considered off-balance sheet arrangements as of September 30, 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. We do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities other than an agreement to pay UCG International Corp., an affiliate of Juan Sartori, a monthly fee of $10,000 for office space, utilities and administrative support provided to the Company. We began incurring these fees on October 17, 2019 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 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. Recent Accounting Pronouncements In July 2017, the FASB issued Accounting Standards Update (“ASU”) 2017-11, Earnings Per Share (Topic 260), Distinguishing Liabilities from Equity (Topic 480) and Derivatives and Hedging (Topic 815): Part I. Accounting for Certain Financial Instruments with Down Round Features; Part II. Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception. Part I of this update addresses the complexity of accounting for certain financial instruments with down round features. Down round features are features of certain equity-linked instruments (or embedded features) that result in the strike price being reduced on the basis of the pricing of future equity offerings. Also, entities must adjust their basic Earnings Per Share (“EPS”) calculation for the effect of the down round provision when triggered (that is, when the exercise price of the related equity-linked financial instrument is adjusted downward because of the down round feature). That effect is treated as a dividend and as a reduction of income available to common stockholders in basic EPS. An entity will also recognize the effect of the trigger within equity. The guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. We adopted this guidance during the period ended September 30, 2019. The adoption of this guidance enabled us to record the warrants as equity instruments and is not expected to have a material impact on our financial position, results of operations, cash flows or disclosures moving forward until a trigger event occurs. Part II of this update addresses the difficulty of navigating Topic 480, Distinguishing Liabilities from Equity, because of the existence of extensive pending content in the FASB Accounting Standards Codification. This pending content is the result of the indefinite deferral of accounting requirements about mandatorily redeemable financial instruments of certain nonpublic entities and certain mandatorily redeemable noncontrolling interests. The amendments in Part II of this update are not expected to have an impact on the Company. 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] Overview We are a blank check company formed on December 6, 2018 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. We intend to effectuate our initial business combination using cash from the proceeds of the IPO and the sale of the Private Placement Warrants, our capital stock, debt or a combination of cash, stock and debt. We have neither engaged in any operations nor generated any revenues to date. Our entire activity since inception has been to prepare for our IPO, which was consummated on October 22, 2019. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities from inception to September 30, 2019 were organizational activities, those necessary to prepare for the IPO, described below, and, subsequent to the IPO, 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 nonoperating income in the form of interest income on marketable securities held after the IPO. We are incurring 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 December 6, 2018 (inception) through September 30, 2019, we had a net loss of $15,175, which consisted of operating and formation costs. Liquidity and Capital Resources As of September 30, 2019, we had $27,831 in cash. Until the consummation of the IPO, our liquidity needs were satisfied through the receipt of $25,000 from our sale of the founder shares, and unsecured loans from one of our shareholders. On October 22, 2019, we consummated the IPO of 20,000,000 Units, which includes a partial exercise by the underwriters of their overallotment option in the amount of 2,500,000 Units, at a price of $10.00 per Unit, generating gross proceeds of $200,000,000. Simultaneously with the closing of the IPO, we consummated the sale of 6,250,000 Private Placement Warrants to two of our shareholders at a price of $1.00 per warrant, generating gross proceeds of $6,250,000. Following the IPO and the sale of the Private Placement Warrants, a total of $200,000,000 was placed in the trust account and, following the payment of certain transaction expenses, we had $1,888,753 of cash held outside of the trust account and available for working capital purposes. We incurred $4,529,222 in IPO related costs, including $4,000,000 of underwriting fees and $529,222 of other costs. For the period from December 6, 2018 (inception) through September 30, 2019, cash used in operating activities was $15,175, resulting primarily from net loss of $15,175. We intend to use substantially all of the funds held in the trust account, including any amounts representing interest earned on the trust account to complete our business combination. To the extent that our shares 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. In order to fund working capital deficiencies or finance transaction costs in connection with a business combination, our officers, directors or their affiliates 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 [/INST] Positive. </s>

PACIFIC DRILLING S.A.

2020-03-12

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with Item 1A. “Risk Factors,” Item 6. “Selected Financial Data” and the financial statements in Item 8, “Financial Statements.” Predecessor and Successor Reporting On November 2, 2018, the Bankruptcy Court issued the Confirmation Order approving the Plan of Reorganization and on November 19, 2018, the Plan of Reorganization became effective pursuant to its terms and we emerged from our Chapter 11 bankruptcy proceedings. We had filed the Plan of Reorganization with the Bankruptcy Court in connection with our voluntary petitions for relief under Chapter 11 of Title 11 of the United States Code, initially filed on November 12, 2017, which were jointly administered under the caption In re Pacific Drilling S.A., et al., Case No. 17-13193 (MEW). On the Plan Effective Date, we adopted and applied the relevant guidance with respect to the accounting and financial reporting for entities that have emerged from bankruptcy proceedings, or “Fresh Start Accounting.” Under Fresh Start Accounting, our balance sheet on the Plan Effective Date reflects all of our assets and liabilities at fair value. Our emergence from bankruptcy and the adoption of Fresh Start Accounting resulted in a new reporting entity, referred to herein as the “Successor,” for financial reporting purposes. To facilitate discussion and analysis of our financial condition and results of operations herein, we refer to the reorganized Debtors as the Successor for periods subsequent to November 19, 2018 and as the “Predecessor” for periods on or prior to November 19, 2018. As a result of the adoption of Fresh Start Accounting and the effects of the implementation of the Plan, our consolidated financial statements subsequent to November 19, 2018 may not be comparable to our consolidated financial statements on or prior to November 19, 2018, and as such, “black-line” financial statements are presented to distinguish between the Predecessor and Successor companies. Market Outlook Historically, operating results in the offshore contract drilling industry have been cyclical and directly related to the demand for and the available supply of capable drilling rigs, which are influenced by various factors. Although dayrates and utilization for high-specification drillships have in the past been less sensitive to short-term oil price movements than those of older or less capable drilling rigs, the sustained decline in oil prices from 2014 levels rendered many deepwater projects less attractive to our clients. This decline, coupled with investor pressure on our clients to be free cash flow positive, has significantly impacted the number of projects available for high-specification drillships. However, over the period from 2015 to today, our clients have managed to reduce their total well construction costs thereby allowing them economic success at lower oil prices and making deepwater projects more attractive. Drilling Rig Supply We estimate that there are currently 107 high-specification drillships across the industry. There has been one order placed since April 2014 to build an additional high-specification drillship, and within the last year, there have been several delays in delivery dates for new drillships. We estimate that there are approximately 12 high-specification drillships in late stages of construction still to be delivered with only one having a firm contract announced. However, as a result of significantly reduced contracting activity, a significant number of floating rigs have been removed from the actively marketed fleet through cold stacking or scrapping since early 2014. Despite this reduction in supply, the excess supply of high-specification drillships is expected to continue in 2020. Although we have visibility into the maximum number of high-specification drillships that could be available, we cannot accurately predict how many of those rigs will be actively marketed or how many of those rigs may be temporarily or permanently removed from the market. Drilling Rig Demand Demand for our drillships is a function of the worldwide levels of deepwater exploration and development spending by oil and gas companies, which has decreased or been delayed significantly as a result of the sustained weakness in oil prices. The type of projects that modern drillships undertake are generally located in deeper water, in more remote locations, and can be more capital intensive or require more time to first oil than competing alternatives. The drilling programs of oil and gas companies are also affected by the global economic and political climate, access to quality drilling prospects, exploration success, perceived future availability and lead time requirements for drilling equipment, advances in drilling technology, and emphasis on deepwater and high-specification exploration and production versus other areas. We have recently seen some increases in the capital expenditure budgets for many exploration and production companies from the lows of the market downturn. Overall, 2019 saw an improving pace for high-specification drillship contracting activity with about 40 rig years contracted, compared to 32 rig years in 2018. There is currently a total demand for 70 high-specification drillships. We expect contracting activity to continue to improve; however, no assurances can be given as to the scope, pace or duration of any recovery. Supply and Demand Balance Since 2014, the imbalance of supply and demand has resulted in significantly lower dayrates. While recent scrapping and cold stacking of floating assets have lowered the total rig supply, supply of deepwater drilling rigs continues to exceed demand. However, we believe that, if oil prices at March 6, 2020 levels are sustained, reduction in rig supply continues and breakeven costs for deepwater projects remain competitive, utilization of high-specification floating rigs should improve in 2020 and over the next few years. Fleet Status The status of our fleet as of March 6, 2020 and certain historical fleet information for the periods covered by the financial statements included in this annual report follows: · The Pacific Bora operated under a contract with Folawiyo AJE Services Limited in Nigeria from February 9, 2017 to May 16, 2017. From August 1, 2017 to October 3, 2017 and from November 2017 to February 2018, the Pacific Bora operated under a contract with Erin Energy Corporation in Nigeria. In November 2018, the Pacific Bora commenced operations with Eni to operate in Nigeria for two wells which it completed in July 2019. The Pacific Bora is currently working offshore Oman under a contract with Eni that started in February 2020 for one firm well and one option well. · The Pacific Mistral is currently idle in Las Palmas while actively seeking a contract. · The Pacific Scirocco is currently idle in Las Palmas while actively seeking a contract. · The Pacific Santa Ana operated in Mauritania under a contract with Petronas to perform integrated services under Phase I of a two-phased plug and abandonment project from December 2017 to May 2018. From April to September 2019, the Pacific Santa Ana operated under a contract with Total for one well in Senegal and one well in Mauritania. This contract also provides for two option wells that would follow the Petronas Phase II work. The Pacific Santa Ana is currently working on Phase II of the plug and abandonment project under the contract with Petronas in Mauritania, which started in December 2019 with an estimated 360 days of work. · The Pacific Khamsin is currently working in the U.S. Gulf of Mexico under a contract with Equinor/Total that started in December 2019 for three firm wells and one option well. · The Pacific Sharav operated under a five-year contract with a subsidiary of Chevron through August 27, 2019. The Pacific Sharav is currently operating under an extension of the contract with Chevron in the U.S. Gulf of Mexico through May 2020. On February 25, 2020, the Pacific Sharav entered into a contract with Murphy in Mexico for two firm wells and one option well, expected to start in the fourth quarter of 2020. · The Pacific Meltem is currently mobilizing to the U.S. Gulf of Mexico. From time to time, we are awarded letters of intent or receive letters of award for our drillships. Certain of those letters remain subject to negotiation and execution of definitive contracts and other customary conditions. No assurance can be given as to the terms of any such arrangement, such as the applicable duration or dayrate, until a definitive contract is entered into by the parties, if we are able to finalize a contract at all. Factors Affecting our Results of Operations The primary factors that have affected our historical operating results and are expected to impact our future operating results include: · energy market conditions, including oil prices; · our clients’ capital expenditure budgets; · the number of drillships in our fleet; · dayrates earned by our drillships; · utilization rates of drillships industry-wide; · operating expenses of our drillships; · administrative expenses; · interest and other financial items; and · tax expenses. Our revenues are derived primarily from the operation of our drillships at fixed daily rates, which depend principally upon the number and availability of our drillships, the dayrates received and the number of days utilized. We recognize revenues from drilling contracts as services are performed upon and after contract commencement. Additionally, we may receive revenues for preparation and mobilization of equipment and personnel or for capital improvements to rigs. Revenues earned directly related to contract preparation and mobilization are deferred and recognized over the primary term of the drilling contract. We may also receive fees upon completion of a drilling contract that are conditional based on the occurrence of an event, such as demobilization of a rig. Our expenses consist primarily of operating expenses, depreciation, administrative expenses, interest and other financial expenses and tax expenses. Operating expenses include the remuneration of offshore crews, repairs and maintenance, as well as expenses for shore-based support offices and onshore operations support staff. Depreciation expense is based on the historical cost or, upon the adoption of Fresh Start Accounting, fair value of our drillships and other property and equipment and recorded on a straight-line basis over the estimated useful lives of each class of assets. Upon the adoption of Fresh Start Accounting, the estimated useful lives of our drillships and their related equipment generally range from 8 to 33 years. General and administrative expenses include the costs of management and administration of our Company, such as the labor costs of our corporate employees, remuneration of our directors and legal and advisory expenses. Interest expense primarily depends on our overall level of indebtedness and interest rates. Tax expenses reflect current and deferred tax expenses. Our income tax expense generally results from the taxable income on our drillship operations. We also incur withholding taxes on cross border intercompany payments, such as services or bareboat charter fees, and we sometimes operate in jurisdictions that levy income taxes on a deemed profit or gross income basis. Results of Operations References to the year ended December 31, 2018 relate to the combined Successor and Predecessor periods for the year ended December 31, 2018. Year ended December 31, 2019 compared to Year ended December 31, 2018 The following table provides a comparison of our consolidated results of operations for the years ended December 31, 2019 and 2018: Revenues. The decrease in revenues of $35.1 million for the year ended December 31, 2019, as compared to the revenues of $264.9 million for the year ended December 31, 2018 resulted primarily from lower operating revenues from the Pacific Sharav completing its legacy Chevron five-year contract in late August 2019 and rolling over to continue working for Chevron at a lower current market dayrate, and lower amortization of deferred revenue. This decrease in revenue was partially offset by increased fleet utilization. During the year ended December 31, 2019, we achieved fleet utilization of 30.0% compared to 21.6% during the year ended December 31, 2018. Fleet utilization is defined as the total number of contracted operating days divided by the total number of rig calendar days in the measurement period. Revenue for the years ended December 31, 2019 and 2018 included amortization of deferred revenue of $1.9 million and $20.2 million, respectively, and reimbursable revenues of $12.0 million and $6.5 million, respectively. The decrease in the amortization of deferred revenue was due to elimination of deferred revenue upon the adoption of Fresh Start Accounting in November 2018. During the year ended December 31, 2019, we achieved an average revenue efficiency of 97.4%, compared to 97.8% during the year ended December 31, 2018. Revenue efficiency is defined as actual contractual dayrate revenue (excluding mobilization fees, upgrade reimbursements and other revenue sources) divided by the maximum amount of contractual dayrate revenue that could have been earned during such period. Operating expenses. The following table summarizes operating expenses: The increase in direct rig related operating expenses for the year ended December 31, 2019, as compared to the year ended December 31, 2018, resulted primarily from the Pacific Khamsin incurring ramp-up costs for its contract with Equinor. The increase was also due to the Pacific Santa Ana operating at a higher level of costs while performing drilling service for Total in 2019, compared to the costs incurred under the contract with Petronas to perform integrated services under Phase I of the plug and abandonment project in 2018. The increase was partially offset by lower costs of maintaining our idle rigs together in Las Palmas. Integrated services for the year ended December 31, 2019 represent costs incurred by the Pacific Khamsin and the Pacific Santa Ana for subcontractors to perform integrated services as part of the contract with Equinor and Phase II of the plug and abandonment project with Petronas, respectively, both of which commenced in December 2019. Integrated services for the year ended December 31, 2018 represent costs incurred by the Pacific Santa Ana for Phase I of the plug and abandonment project with Petronas that was completed in May 2018. Reimbursable costs are not included under the scope of the drilling contract’s initial dayrate but are subject to reimbursement from our clients. Reimbursable costs can be highly variable between quarters. Because the reimbursement of these costs by our clients is recorded as additional revenue, the expense does not negatively affect our profit in general. The increase in shore-based and other support costs for the year ended December 31, 2019, as compared to the year ended December 31, 2018, was primarily due to the classification of health and safety and supply chain costs within operating support costs upon the adoption of Fresh Start Accounting in November 2018, compared to being classified within general and administrative expenses in the Predecessor period in 2018. The increase was partially offset by the impact of cost control and process optimization initiatives implemented during the first quarter of 2019. The decrease in amortization of deferred costs for the year ended December 31, 2019, as compared to the year ended December 31, 2018, was primarily due to the elimination of deferred costs upon the adoption of Fresh Start Accounting in November 2018. General and administrative expenses. The decrease in general and administrative expenses for the year ended December 31, 2019, as compared to the year ended December 31, 2018, was primarily due to the classification of health and safety and supply chain costs in shore-based and other support costs as discussed above, lower legal costs associated with the arbitration proceeding related to the Pacific Zonda and the impact of cost control and process optimization initiatives implemented during the first quarter of 2019. Depreciation and amortization expense. The decrease in depreciation and amortization expense for the year ended December 31, 2019, as compared to the year ended December 31, 2018, resulted from the fair value adjustment of our property and equipment upon the adoption of Fresh Start Accounting in November 2018, partially offset by the amortization expense of our client-related intangible asset. Loss from unconsolidated subsidiaries. For the year ended December 31, 2019, we recognized a loss of $216.7 million, recorded in loss from unconsolidated subsidiaries, due to the write-off of the $204.7 million receivable related to the Zonda Arbitration and other asset balances associated with the Zonda Debtors. See Note 16 to our consolidated financial statements. Interest expense. The decrease in interest expense for the year ended December 31, 2019, as compared to the year ended December 31, 2018, was primarily due to less interest expense incurred on lower outstanding debt balances. The decrease was also due to default interest incurred on the 2013 Revolving Credit Facility and SSCF in accordance with the Plan of Reorganization in 2018. Reorganization items. We classified all income, expenses, gains or losses that were incurred or realized subsequent to the Petition Date and as a result of the Chapter 11 proceedings as reorganization items, which primarily consisted of professional fees. See Note 3 to our consolidated financial statements. Income taxes. During the year ended December 31, 2019, income tax expense was $12.4 million, compared to an income tax benefit of $9.1 million for the year ended December 31, 2018. The income tax benefit for the year ended December 31, 2018 was primarily the result of internal restructuring in 2018 allowing recognition of the tax benefits of net operating losses. Tax expense from ongoing operations for the year ended December 31, 2019 increased primarily from profitable operations in certain jurisdictions. The relationship between our provision for or benefit from income taxes and our pre-tax book income can vary significantly from period to period considering, among other factors, (a) the overall level of pre-tax book income, (b) changes in the blend of income that is taxed based on gross revenues or at high effective tax rates versus pre-tax book income or at low effective tax rates and (c) our rig operating structures. Consequently, our income tax expense does not necessarily change proportionally with our pre-tax book income. Significant decreases in our pre-tax book income typically result in higher effective tax rates, while significant increases in pre-tax book income can lead to lower effective tax rates, subject to the other factors impacting income tax expense noted above. Additionally, pre-tax book losses typically result in negative effective tax rates due to withholding taxes, local taxation on profitable operations, and deemed profit tax based on revenue even while reporting operational losses. During the years ended December 31, 2019 and 2018, our effective tax rate was (2.3)% and 0.4%, respectively. Year ended December 31, 2018 compared to Year ended December 31, 2017 The following table provides a comparison of our consolidated results of operations for the years ended December 31, 2018 and 2017: Revenues. During the year ended December 31, 2018, revenues were $264.9 million. The decrease in revenues for the year ended December 31, 2018, as compared to the year ended December 31, 2017 resulted primarily from lower operating revenues from the Pacific Bora working for only a part of the year, the Pacific Scirocco being offhire for the entire year and lower amortization of deferred revenue for the Pacific Santa Ana. During the year ended December 31, 2018, we achieved an average revenue efficiency of 97.8%, as compared to 98.3% during the year ended December 31, 2017. Contract drilling revenue for the years ended December 31, 2018 and 2017 also included amortization of deferred revenue of $20.2 million and $46.8 million, respectively, and reimbursable revenues of $6.5 million and $6.0 million, respectively. The decrease in the amortization of deferred revenue was primarily due to lower amortization resulting from the Pacific Santa Ana completing its contract with Chevron in January 2017. Operating expenses. The following table summarizes operating expenses: During the year ended December 31, 2018, direct rig related operating expenses were $153.8 million. The decrease in direct rig related operating expenses resulted primarily from the Pacific Scirocco being idle in the year ended December 31, 2018 as compared to the year ended December 31, 2017 when the rig incurred higher costs while on standby and then operating for a client. Integrated services represent costs incurred by the Pacific Santa Ana for subcontractors to perform integrated services for Phase I of the plug and abandonment project with Petronas that was completed on May 7, 2018. The decrease in shore-based and other support costs per day for the year ended December 31, 2018, as compared to the year ended December 31, 2017, was primarily due to lower headcount. General and administrative expenses. The decrease in general and administrative expenses for the year ended December 31, 2018, as compared to the year ended December 31, 2017, was primarily due to the classification of legal and advisory expenses related to our debt restructuring efforts as reorganization items subsequent to the Petition Date and lower accruals for employee incentive programs. Depreciation and amortization expense. The decrease in depreciation and amortization expense for the year ended December 31, 2018, as compared to the year ended December 31, 2017, was primarily due to Fresh Start Accounting. Interest expense. The decrease in interest expense for the year ended December 31, 2018, as compared to the year ended December 31, 2017, was primarily due to no interest accruing on the 2017 Notes, the 2020 Notes and the Term Loan B during the Chapter 11 proceedings as well as the elimination of amortization of deferred financing costs beginning in the fourth quarter of 2017. The decrease was partially offset by accrued default interest on the 2013 Revolving Credit Facility and SSCF that was paid in accordance with our Plan of Reorganization. Write-off of deferred financing costs. During the year ended December 31, 2017, we expensed $30.8 million of deferred financing costs previously recorded within our consolidated balance sheets as a result of the filing of the Bankruptcy Petitions. Reorganization items. During 2017 after the Petition Date and through the 2018 Predecessor period, we classified all income, expenses, gains or losses that were incurred or realized subsequent to the Petition Date and as a result of the Chapter 11 proceedings as reorganization items. See Note 2 to our consolidated financial statements. Other expense. During the year ended December 31, 2017, we recognized an other-than-temporary impairment in our Hyperdynamics available-for-sale securities of $6.8 million. The remaining change was due to currency exchange fluctuations. Income taxes. During the year ended December 31, 2018, income tax benefit was $9.1 million, compared to an income tax expense of $12.9 million for the year ended December 31, 2017. The income tax benefit for the year ended December 31, 2018 was primarily the result of internal restructuring in 2018 allowing recognition of the tax benefits of net operating losses. Tax expense from ongoing operations for the year ended December 31, 2018 decreased due to a lower level of drilling operations. The relationship between our provision for or benefit from income taxes and our pre-tax book income can vary significantly from period to period considering, among other factors, (a) the overall level of pre-tax book income, (b) changes in the blend of income that is taxed based on gross revenues or at high effective tax rates versus pre-tax book income or at low effective tax rates and (c) our rig operating structures. Consequently, our income tax expense does not necessarily change proportionally with our pre-tax book income. Significant decreases in our pre-tax book income typically result in higher effective tax rates, while significant increases in pre-tax book income can lead to lower effective tax rates, subject to the other factors impacting income tax expense noted above. Additionally, pre-tax book losses typically result in negative effective tax rates due to withholding taxes, local taxation on profitable operations, and deemed profit tax based on revenue even while reporting operational losses. During the years ended December 31, 2018 and 2017, our effective tax rate was 0.4% and (2.5)%, respectively. Liquidity and Capital Resources We centrally manage our funding and treasury activities in accordance with corporate policies that have objectives of ensuring appropriate levels of liquidity, maintaining adequate levels of insurance and balancing exposures to market risks. Cash and cash equivalents are held mainly in United States dollars. Most of our contract drilling revenues are received monthly in arrears in United States dollars and most of our operating costs are paid on a monthly basis. Sources and Uses of Cash Year ended December 31, 2019 compared to Year ended December 31, 2018 The following table presents our net cash used in operating activities for the years ended December 31, 2019 and 2018: The reduction in net cash used in operating activities for the year ended December 31, 2019 resulted primarily from lower payments for reorganization items, lower cash interest, the release of cash collateral held as credit support for customs bonds and bank guarantees, cost savings from headcount and other spending reductions and lower legal and advisory costs related to our Chapter 11 proceedings and the arbitration proceedings related to the Pacific Zonda. The following table presents our net cash used in investing activities for the years ended December 31, 2019 and 2018: The increase in capital expenditures for the year ended December 31, 2019 primarily resulted from purchases related to rig enhancement equipment, including a managed pressure drilling system. The following table presents our net cash provided by (used in) financing activities for the years ended December 31, 2019 and 2018: During the year ended December 31, 2019, we paid the remaining professional fees related to the issuance of the First Lien Notes and Second Lien PIK Notes prior to our emergence from bankruptcy. During the year ended December 31, 2018, we drew $50.0 million from debtor-in-possession financing and issued $750.0 million of First Lien Notes and $273.6 million of Second Lien PIK Notes. We also issued $500.0 million of common shares in an equity rights offering and private placement. In connection with the above transactions, we paid $42.9 million in financing costs in 2018. Upon our emergence from bankruptcy, we repaid in full the 2013 Revolving Credit Facility of $475.0 million, the SSCF of $661.5 million and debtor-in-possessing financing of $50.0 million. Year ended December 31, 2018 compared to Year ended December 31, 2017 The following table presents our net cash used in operating activities for the years ended December 31, 2018 and 2017: The reduction in net cash used in operating activities for the year ended December 31, 2018 resulted primarily from cash collections in 2017 on the Pacific Scirocco subsequent to completing its contract with Total in December 2016. In addition, the decrease was due to higher legal and advisory costs in 2018 related to our emergence from Chapter 11 proceedings and subcontractor payments made in 2018 in connection with the Pacific Santa Ana to perform Phase I of the integrated services project with Petronas. The following table presents our net cash used in investing activities for the years ended December 31, 2018 and 2017: The decrease in capital expenditures for the year ended December 31, 2018 primarily resulted from a final milestone payment of $16.3 million for a fleet spare blowout preventer in 2017. As a result of deconsolidation of the Zonda Debtors, consolidated cash balances decreased by $4.9 million. In addition, the change in net cash from investing activities resulted from the $6.0 million purchase of available-for-sale securities in the prior period. The following table presents our net cash provided by (used in) financing activities for the years ended December 31, 2018 and 2017: During the year ended December 31, 2018, we drew $50.0 million from debtor-in-possession financing and issued $750.0 million of First Lien Notes and $273.6 million of Second Lien PIK Notes. We also issued $500.0 million of common shares in an equity rights offering and private placement. In connection with the above transactions, we paid $42.9 million in financing costs in 2018. Upon our emergence from bankruptcy, we repaid in full the 2013 Revolving Credit Facility of $475.0 million, the SSCF of $661.5 million and debtor-in-possessing financing of $50.0 million. During the year ended December 31, 2017, (i) we made a $76.0 million prepayment of the SSCF in accordance with our obligation to maintain the loan to rig value covenant in the facility, (ii) we applied cash collateral of $31.7 million to the principal installments due in May 2017 under the SSCF and (iii) we permanently repaid $25.0 million under the 2013 Revolving Credit Facility. Liquidity Our liquidity fluctuates depending on a number of factors, including, among others, our contract backlog, our revenue efficiency and the timing of accounts receivable collection as well as payments for operating costs and other obligations. Market conditions in the offshore drilling industry in recent years have led to materially lower levels of spending for offshore exploration and development by our current and potential clients on a global basis, which in turn has negatively affected our revenue, profitability and cash flows. Primary sources of funds for our short-term liquidity needs are expected to be our existing cash and cash equivalents and availability under our $50.0 million, first lien superpriority Revolving Credit Facility. See Note 23 to our consolidated financial statements in this annual report. As of March 6, 2020, we had $248.3 million of cash and cash equivalents and $6.1 million of restricted cash. Based on our cash flow forecast, we expect to generate aggregate negative cash flows for 2020. We believe that our sources of cash, including our ability to draw on the Revolving Credit Facility, will provide sufficient liquidity over at least the next 12 months to fund our cash needs. The first scheduled principal payment due on our outstanding long-term debt is October 1, 2023, when our First Lien Notes mature. Our Second Lien Notes mature April 1, 2024, and we may pay interest in kind. Our ability to continue to meet our anticipated obligations and pay or refinance our long-term debt at maturity will depend on market conditions, our operating performance and cash flow. Share Repurchase Program On February 22, 2019, our shareholders approved a share repurchase program for a total expenditure of up to $15.0 million for a two-year period. We may purchase shares in one or several transactions on the open market or otherwise; however, we are not obligated to repurchase any specific number or dollar value of our common shares under the program. We anticipate that future repurchases, if any, will be funded with cash on hand. As of March 6, 2020, we have repurchased a total of 44,710 of our common shares on the open market with the last repurchase occurring in May 2019 and had approximately $14.3 million remaining available under the program. Capital Expenditures We have no material commitments for capital expenditures related to the construction of a newbuild drillship. We do, however, expect to incur capital expenditures for purchases in the ordinary course of business. Such capital expenditure commitments are included in purchase obligations presented in Item 7 “Contractual Obligations.” Description of Indebtedness See Notes 7 and 23 to our consolidated financial statements for additional information. Bank Guarantee As of December 31, 2019, we were contingently liable under a certain bank guarantee totaling approximately $5.4 million issued as security in the normal course of our business. Derivative Instruments and Hedging Activities We may enter into derivative instruments from time to time to manage our exposure to fluctuations in interest rates and foreign exchange rates. We do not enter into derivative transactions for speculative purposes; however, for accounting purposes, certain transactions may not meet the criteria for hedge accounting. See Note 14 to our consolidated financial statements. Off-Balance Sheet Arrangements As of March 6, 2020, we do not have any off-balance sheet arrangements. Contractual Obligations The table below sets forth our contractual obligations as of December 31, 2019: (a) Amounts are based on the aggregate outstanding principal balances of the First Lien Notes and the original principal amount of the Second Lien PIK Notes. (b) Interest payments are based on our outstanding borrowings under the First Lien Notes and the Second Lien PIK Notes at their respective interest rates of 8.375% and 12.0%, which assumes the interest on the Second Lien PIK Notes will be paid in-kind. Accrued paid in-kind interest is assumed to be settled in cash at the date of maturity of the Second Lien PIK Notes. The original principal amount of the Second Lien PIK Notes was $273.6 million, and we project that if no cash interest is paid on the Second Lien PIK Notes throughout their term, the total amount we would owe the holders of such notes upon maturity on the notes on April 1, 2024 is approximately $520.2 million. (c) Purchase obligations are agreements to purchase goods and services that are enforceable and legally binding, that specify all significant terms, including the quantities to be purchased, price provisions and the approximate timing of the transactions, which includes our purchase orders for goods and services entered into in the normal course of business. (d) Contractual obligations do not include approximately $43.5 million of liabilities from unrecognized tax benefits related to uncertain tax positions, inclusive of interest and penalties, included on our consolidated balance sheets as of December 31, 2019. We are unable to specify with certainty the future periods in which we may be obligated to settle such amounts. Some of the figures included in the table above are based on estimates and assumptions about these obligations, including their duration and other factors. The contractual obligations we will actually pay in future periods may vary from those reflected in the tables. Critical Accounting Estimates and Policies The preparation of consolidated financial statements in conformity with GAAP requires management to make certain estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities, the disclosures of contingent assets and liabilities at the balance sheet date and the amounts of revenues and expenses recognized during the reporting period. On an ongoing basis, we evaluate our estimates and assumptions, including those related to allowance for doubtful accounts, financial instruments, obsolescence for materials and supplies, depreciation of property and equipment, deferred costs, impairment of long-lived assets, income taxes, share-based compensation and contingencies. We base our estimates and assumptions on historical experience and on various other factors 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 could differ from such estimates. Our critical accounting estimates are important to the portrayal of both our financial position and results of operations and require us to make difficult, subjective or complex assumptions or estimates about matters that are uncertain. We would report different amounts in our consolidated financial statements, which could be material, if we used different assumptions or estimates. We have discussed the development and selection of our critical accounting estimates with our board of directors and the board of directors has reviewed the disclosure presented below. During the past three fiscal years, we have not made any material changes in accounting methodology. We believe that the following is a summary of the critical accounting policies used in the preparation of our consolidated financial statements. Fresh start accounting. On the Plan Effective Date, we adopted and applied the relevant guidance with respect to the accounting and financial reporting for entities that have emerged from bankruptcy proceedings, or “Fresh Start Accounting.” Under Fresh Start Accounting, our balance sheet on the Plan Effective Date reflects all of our assets and liabilities at fair value. Our emergence from bankruptcy and the adoption of Fresh Start Accounting resulted in a new reporting entity, referred to herein as the “Successor,” for financial reporting purposes. To facilitate discussion and analysis of our financial condition and results of operations herein, we refer to the reorganized Debtors as the Successor for periods subsequent to November 19, 2018 and as the “Predecessor” for periods on or prior to November 19, 2018. As a result of the adoption of Fresh Start Accounting and the effects of the implementation of the Plan of Reorganization, our consolidated financial statements subsequent to November 19, 2018 may not be comparable to our consolidated financial statements on or prior to November 19, 2018, and as such, “black-line” financial statements are presented to distinguish between the Predecessor and Successor companies. Revenues from contracts with clients. Contract drilling revenues are recognized consistent with the contractual rate invoiced for the services provided during the period. In connection with drilling contracts, we may receive fees for preparation and mobilization of equipment and personnel or for capital improvements to rigs. We record a contract liability for upfront fees received for mobilization, contract preparation and capital upgrade, which are amortized ratably to contract drilling revenue as services are rendered over the initial term of the related drilling contract. Demobilization revenue expected to be received upon contract completion is estimated as part of the overall transaction price at contract inception. We record demobilization revenue in earnings ratably over the expected term of the contract with an offset to an accretive contract asset. We record reimbursable revenue at the gross amount billed to the client in the period the corresponding goods and services are to be provided. Property and equipment. As of December 31, 2019, property and equipment was $1.8 billion, which represented 81.7% of our total assets. The carrying value of our property and equipment consisted primarily of our high-specification drillships that were recorded at cost less accumulated depreciation. We estimate useful lives and salvage values by applying judgments and assumptions that reflect both historical experience and expectations regarding future operations and asset performance. Upon the adoption of Fresh Start Accounting, the estimated useful lives of our drillships and their related equipment generally range from 8 to 32 years. Applying different judgments and assumptions to useful lives and salvage values would likely result in materially different net carrying amounts and depreciation expense for our drillships. We review property and equipment for impairment when events or changes in circumstances indicate that the carrying amounts of our assets held and used may not be recoverable. Potential impairment indicators include steep declines in commodity prices and related market conditions, significant actual or expected declines in rig utilization, increases in idle time or substantial damage to the property and equipment that adversely affects the extent and manner of its use. We assess impairment using estimated undiscounted cash flows for the property and equipment being evaluated by applying assumptions regarding future operations, market conditions, dayrates, utilization and idle time. An impairment loss is recorded in the period if the carrying amount of the asset is not recoverable. During the Successor periods in 2019 and 2018 and the Predecessor periods in 2018 and 2017, there were no long-lived asset impairments. Contingencies. We record liabilities for estimated loss contingencies when we believe a loss is probable and the amount of the probable loss can be reasonably estimated. Once established, we adjust the estimated contingency loss accrual for changes in facts and circumstances that alter our previous assumptions with respect to the likelihood or amount of loss. Income taxes. Income taxes are provided based upon our interpretation of the tax laws and rates in the countries in which our subsidiaries are registered and where their operations are conducted and income and expenses are earned and incurred, respectively. This requires significant judgment and the use of estimates and assumptions regarding future events, such as the amount, timing and character of income, deductions and tax credits. Our tax liability in any given year could be affected by changes in tax laws, regulations, agreements, and treaties or our level of operations or profitability in each jurisdiction. Although our annual tax provision is based on the best information available at the time, a number of years may elapse before the ultimate tax liabilities in the various jurisdictions are determined. We recognize deferred tax assets and liabilities for the anticipated future tax effects of temporary differences between the financial statement basis and the tax basis of our assets and liabilities using the applicable enacted tax rates in effect in the year in which the asset is realized or the liability is settled. Estimates, judgments and assumptions are required in determining whether deferred tax assets will be fully or partially realized. When it is estimated to be more likely than not that all or some portion of certain deferred tax assets, such as net operating loss carryforwards, will not be realized, we establish a valuation allowance for the amount of the deferred tax assets that is considered to be unrealizable. We recognize tax benefits from an uncertain tax position only if it is more likely than not that the position will be sustained upon examination by taxing authorities based on the technical merits of the position. The amount recognized is the largest benefit that we believe has greater than a 50% likelihood of being realized upon settlement. In determining if a tax position is likely to be sustained upon examination, we analyze relevant tax laws and regulations, case law, and administrative practices. Actual income taxes paid may vary from estimates depending upon various factors, including changes in income tax laws, settlement of audits with taxing authorities, or expiration of statutes of limitations. Recently Issued Accounting Pronouncements Please refer to Note 2 to our consolidated financial statements in this annual report for a discussion of recent accounting pronouncements and their anticipated impact.

<s>[INST] Predecessor and Successor Reporting On November 2, 2018, the Bankruptcy Court issued the Confirmation Order approving the Plan of Reorganization and on November 19, 2018, the Plan of Reorganization became effective pursuant to its terms and we emerged from our Chapter 11 bankruptcy proceedings. We had filed the Plan of Reorganization with the Bankruptcy Court in connection with our voluntary petitions for relief under Chapter 11 of Title 11 of the United States Code, initially filed on November 12, 2017, which were jointly administered under the caption In re Pacific Drilling S.A., et al., Case No. 1713193 (MEW). On the Plan Effective Date, we adopted and applied the relevant guidance with respect to the accounting and financial reporting for entities that have emerged from bankruptcy proceedings, or “Fresh Start Accounting.” Under Fresh Start Accounting, our balance sheet on the Plan Effective Date reflects all of our assets and liabilities at fair value. Our emergence from bankruptcy and the adoption of Fresh Start Accounting resulted in a new reporting entity, referred to herein as the “Successor,” for financial reporting purposes. To facilitate discussion and analysis of our financial condition and results of operations herein, we refer to the reorganized Debtors as the Successor for periods subsequent to November 19, 2018 and as the “Predecessor” for periods on or prior to November 19, 2018. As a result of the adoption of Fresh Start Accounting and the effects of the implementation of the Plan, our consolidated financial statements subsequent to November 19, 2018 may not be comparable to our consolidated financial statements on or prior to November 19, 2018, and as such, “blackline” financial statements are presented to distinguish between the Predecessor and Successor companies. Market Outlook Historically, operating results in the offshore contract drilling industry have been cyclical and directly related to the demand for and the available supply of capable drilling rigs, which are influenced by various factors. Although dayrates and utilization for highspecification drillships have in the past been less sensitive to shortterm oil price movements than those of older or less capable drilling rigs, the sustained decline in oil prices from 2014 levels rendered many deepwater projects less attractive to our clients. This decline, coupled with investor pressure on our clients to be free cash flow positive, has significantly impacted the number of projects available for highspecification drillships. However, over the period from 2015 to today, our clients have managed to reduce their total well construction costs thereby allowing them economic success at lower oil prices and making deepwater projects more attractive. Drilling Rig Supply We estimate that there are currently 107 highspecification drillships across the industry. There has been one order placed since April 2014 to build an additional highspecification drillship, and within the last year, there have been several delays in delivery dates for new drillships. We estimate that there are approximately 12 highspecification drillships in late stages of construction still to be delivered with only one having a firm contract announced. However, as a result of significantly reduced contracting activity, a significant number of floating rigs have been removed from the actively marketed fleet through cold stacking or scrapping since early 2014. Despite this reduction in supply, the excess supply of highspecification drillships is expected to continue in 2020. Although we have visibility into the maximum number of highspecification drillships that could be available, we cannot accurately predict how many of those rigs will be actively marketed or how many of those rigs may be temporarily or permanently removed from the market. Drilling Rig Demand Demand for our drillships is a function of the worldwide levels of deepwater exploration and development spending by oil and gas companies, which has decreased or been delayed significantly as a result of the sustained weakness in oil prices. The type of projects that modern drillships undertake are generally located in deeper water, in more remote locations, and can be more capital intensive or require more time to first oil than competing alternatives. The drilling programs of oil and gas companies are also affected by [/INST] Positive. </s>

BridgeBio Pharma, Inc.

2020-03-03

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 “Item 6. Selected Financial Data” and the financial statements and related notes included elsewhere in 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 Act and Section 21E of the Securities Exchange Act of 1934, as amended, (the “Exchange Act”). In some cases, you can identify these statements by forward-looking words such as “may,” “will,” “expect,” “believe,” “anticipate,” “intend,” “could,” “should,” “estimate,” or “continue,” and similar expressions or variations. Such forward-looking statements are subject to risks, uncertainties and other factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled “Risk Factors” included in this Annual Report on Form 10-K. The forward-looking statements in this Annual Report on Form 10-K represent our views as of the date of this Annual Report on Form 10-K. Except as may be required by law, we assume no obligation to update these forward-looking statements or the reasons that results could differ from these forward-looking statements. You should, therefore, not rely on these forward-looking statements as representing our views as of any date subsequent to the date of this Annual Report on Form 10-K. Overview We are a team of experienced drug discoverers, developers, and innovators working to create life-altering medicines that target well-characterized genetic diseases at their source. We founded BridgeBio in 2015 to identify and advance transformative medicines to treat patients who suffer from Mendelian diseases, which are diseases that arise from defects in a single gene, and cancers with clear genetic drivers. Our pipeline of over 20 development programs includes product candidates ranging from early discovery to late-stage development. Several of our programs target indications that we believe present the potential for our product candidate, if approved, to target portions of market opportunities of at least $1.0 billion in annual sales. We have initiated a rolling NDA submission for one of our product candidates, and have three product candidates in clinical trials that, if positive, we believe could support the filing of an application for marketing authorization. We focus on genetic diseases because they exist at the intersection of high unmet patient need and tractable biology. Our approach is to translate research pioneered at academic laboratories and leading medical institutions into products that we hope will ultimately reach patients. We are able to realize this opportunity through a confluence of scientific advances: (i) identification of the genetic underpinnings of disease as more cost-efficient genome and exome sequencing becomes available; (ii) progress in molecular biology; and (iii) the development and maturation of longitudinal data and retrospective studies that enable the linkage of genes to diseases. We believe that this early-stage innovation represents one of the greatest practical sources for new drug creation. Since our inception in 2015, we have focused substantially all of our efforts and financial resources on acquiring and developing product and technology rights, building our intellectual property portfolio and conducting research and development activities for our product candidates within our wholly-owned subsidiaries and controlled entities, including partially-owned subsidiaries and subsidiaries we consolidate based on our deemed majority control of such entities as determined using either the variable interest entity, or VIE model, or the voting interest entity, or VOE model. To support these activities, we and our wholly-owned subsidiary, BridgeBio Services, Inc., (i) identify and secure new programs, (ii) set up new wholly-owned subsidiaries and controlled entities, (iii) recruit key management team members, (iv) raise and allocate capital across the portfolio and (v) provide certain shared services, including accounting and human resources, as well as workspaces. 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 our equity securities and, to a lesser extent, debt borrowings. On July 1, 2019, immediately prior to the completion of the initial public offering of our common stock (the IPO), we engaged in a series of transactions whereby BridgeBio Pharma LLC, or BBP LLC, became a wholly-owned subsidiary of BridgeBio Pharma, Inc., or BBP Inc., collectively with BBP LLC, BridgeBio. As part of the transactions, holders of Preferred Units, Founder Units, Common Units and Management Incentive Units of BBP LLC exchanged all outstanding units for an aggregate of 99,999,967 shares of common stock of BBP Inc. On July 1, 2019, we completed the IPO. As part of the IPO, we issued and sold 23,575,000 shares of our common stock, which included 3,075,000 shares sold pursuant to the exercise of the underwriters’ over-allotment option, at a public offering price of $17.00 per share. In July 2019, we received net proceeds of approximately $366.2 million from the IPO, after deducting underwriters’ discounts and commissions of $28.1 million and offering costs of $6.5 million. As of December 31, 2019, we had cash, cash equivalents and marketable securities of $577.1 million or $385.9 million excluding Eidos. Since our inception, we have incurred significant operating losses. For the years ended December 31, 2019, 2018 and 2017, we incurred net losses of $288.6 million, $169.5 million and $43.8 million, respectively. Our ability to generate product revenue sufficient to achieve profitability will depend heavily on the successful development and eventual commercialization of our product candidates at our wholly-owned subsidiaries and controlled entities. We expect to continue to incur significant expenses and increasing operating losses for at least the next several years. Financial Highlights The following table summarizes our financial results: License revenue increased by $40.6 million in 2019 due mainly to the upfront payment received by Eidos upon execution of the Alexion License Agreement. Total operating expenses and loss from operations increased by $123.1 million and $82.6 million, respectively, in 2019 and $139.8 million in 2018 mainly attributed to increase in external-related costs to support the progression in our research and development programs, which also contributed primarily to the increase in net loss and net loss attributable to common stockholders of BridgeBio. During 2019, we received net proceeds of $366.2 million from the BridgeBio IPO, $36.9 million from term loans and $23.9 million from Eidos’ at-the-market issuance of shares. In 2018, we received total net proceeds of $487.0 million from the Eidos IPO, issuances of our convertible preferred units and availment of term loans. As of December 31, 2019, we had cash, cash equivalents and marketable securities of $385.9 million excluding Eidos. Basis of Presentation and Consolidation Since our inception, we have created wholly-owned subsidiaries or made investments in certain controlled entities, including partially-owned subsidiaries for which we have majority voting interest under the VOE model or for which we are the primary beneficiary under the VIE model, which we refer to collectively as our consolidated entities. Ownership interests in entities over which we have significant influence, but not a controlling financial interest, are accounted for as cost and equity method investments. Ownership interests in consolidated entities that are held by entities other than us are reported as redeemable convertible noncontrolling interests and noncontrolling interests in our consolidated balance sheets. Losses attributed to redeemable convertible noncontrolling interests and noncontrolling interests are reported separately in our consolidated statements of operations. We have either created or made investments in entities that are either wholly or partially-owned subsidiaries and VIEs. Refer to Note 2 to our consolidated financial statements for a list of our VIEs. Factors Affecting Comparability Our historical financial condition and results of operations for the periods presented may not be comparable, either between periods or going forward due to the factors described below. Eidos Therapeutics, Inc. Transactions: In February 2018, we entered into a note and warrant purchase agreement with Eidos pursuant to which Eidos issued a convertible promissory note, or the Eidos Note, with the principal amount of $10.0 million and a warrant to purchase a number of shares of preferred stock equal to $4.0 million at the price paid by investors in the next equity financing, or the Eidos Warrant. In March 2018, we transferred 10% or $1.0 million of our interest in the Eidos Note and the Eidos Warrant to a minority stockholder of Eidos. In March 2018, the Eidos Note was redeemed into shares of Series B redeemable convertible preferred stock of Eidos at a 30% discount to the price paid by other investors. In conjunction with these transactions, Eidos recognized a preferred stock warrant liability, tranche liability and an embedded derivative, which were recorded at fair value at inception and remeasured to fair value at each subsequent reporting date until the instruments were settled. For the year ended December 31, 2018, we recorded $1.3 million in other income (expense), net in the consolidated statements of operations related to these 2018 Eidos financing transactions. All of these Eidos financial instruments were settled during 2018. In June 2018, Eidos completed its initial public offering, or the Eidos IPO. All redeemable convertible preferred stock of Eidos was converted into common stock at the closing of the Eidos IPO. As part of the Eidos IPO, we purchased common stock in the amount of $17.0 million. The Eidos Warrant was also net exercised upon the completion of the Eidos IPO. We previously determined that Eidos was a controlled VIE as of December 31, 2017 and through its initial public offering in June 2018, at which time we determined that Eidos is no longer a VIE. In May 2019, we purchased 1,103,848 shares of Eidos common stock from an existing Eidos stockholder for $28.6 million in a private purchase transaction. In July 2019, we purchased 882,353 shares of Eidos common stock from an existing Eidos investor for $26.4 million in a private purchase transaction. Subsequent to the Eidos IPO and through December 31, 2019, we held a majority voting interest in Eidos and consolidate Eidos under the VOE model. PellePharm, Inc. Transactions: PellePharm entered into a series of agreements, or the LEO Agreement, with LEO Pharma A/S, or LEO, in November 2018. As part of the LEO Agreement, we granted LEO an exclusive, irrevocable option, or the LEO Call Option, to acquire all of PellePharm’s shares held by us. The LEO Call Option is exercisable by LEO on or before the occurrence of certain events relating to PellePharm’s clinical development programs and no later than July 30, 2021. We account for the LEO Call Option as a current liability in our consolidated financial statements because we are obligated to sell our shares in PellePharm to LEO at a pre-determined price, if the option is exercised. The fair value of the LEO Call Option on issuance in November 2018 was $1.9 million and increased to $3.0 million as of December 31, 2018 and to $4.1 million as of December 31, 2019. We will remeasure the LEO Call Option to fair value at each subsequent balance sheet date until the LEO Call Option is either exercised or expires. We previously determined that we were the primary beneficiary of PellePharm, as of December 31, 2017 and through the date of execution of the LEO Agreement in November 2018. At the time of execution, we concluded that we are no longer the primary beneficiary of, and thus deconsolidated, PellePharm. Subsequent to the LEO Agreement, we account for our retained investment in common and preferred stock of PellePharm under the equity method and cost method, respectively. Upon adoption ASU 2016-01 in 2019 (see Note 2 to our consolidated financial statements), we concluded that our investment in preferred stock of PellePharm did not have a readily available fair value. As a result we started to measure the adjusted cost basis of our retained investment in PellePharm’s preferred stock of PellePharm at cost less impairment plus or minus observable price changes. Since our investment in common stock was reduced to zero during the first quarter of 2019 as a result of applying the equity method, we subsequently adjusted the cost basis of our preferred stock investment by recording our percentage of net losses consistent with our preferred stock ownership percentage of 61.9% until the adjusted cost basis was also reduced to zero during the remaining period of 2019. Results of Operations License Revenue License revenue includes the recognition of upfront payments received in connection with our license agreements. The level of license revenue to be recognized depends in part upon the estimated recognition period of the upfront payments allocated to continuing performance obligations, the achievement of milestones and other contingent events, the amount of research and development work, and entering into new collaboration agreements, if any. License revenue for 2019 was $40.6 million arising primarily from the recognition of the upfront payment received by Eidos upon execution of the Alexion License Agreement. Eidos determined that the exclusive license granted to Alexion was a distinct performance obligation and, as of the effective date, Eidos had provided all necessary information to Alexion to benefit from the license and the license term had begun. There were no revenues in 2018 and 2017. Operating Expenses Cost of License Revenue Cost of license revenue represents sublicensing fees payable under the Stanford License in connection with the Alexion License Agreement and was $2.5 million in 2019. There were no costs of license revenue in 2018 and 2017. Research and Development Expenses Research and development costs consist primarily of external costs, such as fees paid to consultants, contractors, CMOs and CROs in connection with our preclinical and clinical development activities and are tracked on a program-by-program basis. License fees and other costs incurred after a product candidate has been designated and that are directly related to the product candidate are included in the specific program expense. License fees and other costs incurred prior to designating a product candidate are included in early stage research programs. The following table summarizes our research and development expenses by program incurred for the following periods: (1) Amounts presented above may differ from the financial statements of Eidos due to intercompany income and expenses, which are eliminated in the consolidated financial statements of BridgeBio for all periods presented. (2) Results for PellePharm are not included in our research and development expenses subsequent to the deconsolidation date in November 2018. Research and development expense increased by $69.9 million in 2019 and $109.5 million in 2018 primarily due to increase in external-related costs to support progression in our research and development programs including increasing research pipeline. General and Administrative Expenses General and administrative expenses increased by $50.8 million in 2019 and $30.3 million in 2018 due to increase in headcount to support the growth of our operations and external-related costs incurred as a result of preparation for the SEC listing and continuing compliance as a public company. General and administrative expenses increased by $30.3 million in 2018 mainly due to increase in professional and consulting services largely due to our expanding operations. Other Income (Expense), Net Interest Income Interest income consists of interest income earned on our cash equivalents and marketable securities and the increase of $6.9 million in 2019 and $2.0 million in 2018 was attributed primarily to the additional income earned from higher investment balances following the initial public and debt offerings. Interest Expense Interest expense consists primarily of interest expense incurred under our term loans with Hercules Capital, Inc., or Hercules and the increase of $6.2 million in 2019 and $2.5 million in 2018 was primarily attributed to increase in term loan amounts. (Loss) Gain from Equity Investments Loss from equity investments increased by $20.6 million in 2019 and $0.3 million in 2018 primarily due to our share of losses from our investment in PellePharm totaling $17.1 million in 2019 and $0.3 million in 2018. We recognize our share of losses from the PellePharm equity method investment as incurred. After our equity method investment was reduced to zero during the three months ended March 31, 2019, we recognized our percentage of net losses consistent with our preferred stock ownership percentage until the investment was also reduced to zero during the remaining period of 2019. In 2018, after the execution of the LEO Agreement, we concluded that PellePharm should be deconsolidated and we recorded our retained interest in PellePharm at fair value, resulting in a gain of $19.3 million being recognized during the year ended December 31, 2018. There were no such transactions in 2017. Other Expense Other expense consists mainly of changes in fair value of the LEO Call Option liability. We account for the LEO Call Option as a current liability as we have the obligation to sell our PellePharm shares to LEO at a pre-determined price if the LEO Call Option is exercised. The LEO Call Option can be exercised at any time through the maturity date. The LEO Call Option was recorded at fair value on the date the option agreement was entered into with LEO in November 2018. The LEO Call Option is subject to remeasurement to fair value at each balance sheet date until the LEO Call Option is either exercised or expires. The LEO call option expense decrease of $1.9 million in 2019 was due to change in fair value. The increase of $3.0 million in 2018 was due to initial recognition and change in fair value. Other expense in 2018 consists primarily of the change in fair value of the Eidos financial instruments issued and settled in 2018 and other miscellaneous expenses unrelated to our core operations. Income Taxes Prior to the tax-free reorganization, BBP LLC was treated as a pass-through entity for U.S. federal income tax purposes, and as such, was generally not subject to U.S. federal income tax at the entity level. Rather, the tax liability with respect to its taxable income was passed through to its unitholders. Therefore, no provision or liability for federal income tax has been included in our consolidated financial statements prior to the reorganization. For our consolidated entities, income taxes are accounted for under the asset and liability method as described below. Upon the Reorganization on July 1, 2019, we became subject to typical corporate U.S. federal and state income taxation. To the extent we incur operating losses in the periods in which we are treated as a corporation for tax purposes, net operating loss carryforwards may generally be used by us to offset cash taxes on future taxable income, subject to applicable tax laws. As of December 31, 2019, we had net operating losses of approximately $393.4 million and $160.0 million for federal and state income tax purposes, respectively, available to reduce future taxable income, if any. The federal net operating losses generated prior to 2018 will begin to expire in 2037 and losses generated after 2018 will carryover indefinitely. State net operating losses will generally begin to expire in 2037. As of December 31, 2019, we had federal research and development credit carryforwards of $17.6 million, which will expire beginning in 2037 if not utilized. As of December 31, 2019, we had state research and development credit carryforwards of $2.6 million. The state research and development tax credits have no expiration date. A valuation allowance is provided for deferred tax assets where the recoverability of the assets is uncertain. The determination to provide a valuation allowance is dependent upon the assessment of whether it is more likely than not that sufficient future taxable income will be generated to utilize the deferred tax assets. Based on the weight of the available evidence, which includes our consolidated entities’ historical operating losses and forecast of future losses, we have provided a full valuation allowance against the deferred tax assets resulting from the tax loss and credits carried forward. Utilization of the net operating loss and credit carryforwards may be subject to a substantial annual limitation due to an ownership change limitation as provided by section 382 of the Code, and similar state provisions. The annual limitation may result in the expiration of net operating losses and credits before utilization. In the event that we have a change of ownership, utilization of the net operating loss and tax credit carryforwards may be restricted. Net Loss Attributable to Redeemable Convertible Noncontrolling Interests and Noncontrolling Interests Net loss attributable to redeemable convertible noncontrolling interests and noncontrolling interests in our consolidated statements of operations consists of the portion of the net loss of those consolidated entities that is not allocated to us. Changes in the amount of net loss attributable to noncontrolling interests are directly impacted by changes in the net loss of our consolidated entities and are the result of ownership percentage changes. Refer to Note 7 to our consolidated financial statements. Net loss attributable to redeemable convertible noncontrolling interests and noncontrolling interests was $28.0 million in 2019, compared to $38.7 million in 2018 and $13.3 million in 2017. Liquidity and Capital Resources We have historically financed our operations primarily through the sale of our equity securities, debt borrowings and revenue from collaboration arrangements. As of December 31, 2019, we had cash, cash equivalents and marketable securities of $577.1 million or $385.9 million excluding Eidos. The funds that were held by our wholly-owned subsidiaries and controlled entities are available for specific entity usage, except in limited circumstances. The cash, cash equivalents and marketable securities of $191.2 million as of December 31, 2019 belonging to Eidos may only be used solely by Eidos or its subsidiaries, if any. As of December 31, 2019, our outstanding debt was $91.8 million, net of debt issuance costs and accretion or $75.7 million excluding Eidos. Since our inception, we have incurred significant operating losses. For the years ended December 31, 2019, 2018 and 2017, we incurred net losses of $288.6 million, $169.5 million and $43.8 million, respectively. We had an accumulated deficit as of December 31, 2019 of $440.0 million. We expect to continue to incur net losses over the next several years as we continue our drug discovery efforts and incur significant preclinical and clinical development costs related to our current research and development programs as well as costs related to commercial launch readiness. In particular, to the extent we advance our programs into and through later-stage clinical studies without a partner, we will incur substantial expenses. Our current business plan is also subject to significant uncertainties and risks as a result of, among other factors, our ability to generate product revenue sufficient to achieve profitability will depend heavily on the successful development and eventual commercialization of our product candidates at our consolidated entities. We expect our cash and cash equivalents and marketable securities will fund our operations for at least the next 12 months based on current operating plans and financial forecasts. If our current operating plans or financial forecasts change, we may require additional funding sooner in the form of public or private equity offerings, debt financings or additional collaborations and licensing arrangements. However, future financing may not be available in amounts or on terms acceptable to us, if at all. Sources of Liquidity Initial public offerings In June 2018, our controlled subsidiary, Eidos, completed its U.S. initial public offering of its common stock of which net proceeds received were $95.5 million. As of December 31, 2019, we held 24,575,501 shares of common stock of Eidos. All cash and cash equivalents held by Eidos are restricted and can be applied solely to fund the operations of Eidos. On July 1, 2019, we completed the IPO of our common stock. As part of the IPO, we issued and sold 23,575,000 shares of our common stock, which included 3,075,000 shares sold pursuant to the exercise of the underwriters’ over-allotment option, at a public offering price of $17.00 per share. We received net proceeds of approximately $366.2 million from the IPO, after deducting underwriters’ discounts and commissions of $28.1 million and offering costs of $6.5 million. Term Loans Hercules Loan and Security Agreement In June 2018, we executed a Loan and Security Agreement with Hercules Capital, Inc. (“Hercules”), under which we borrowed $35.0 million (“Tranche I”). The term of the loan was approximately 42 months, with a maturity date of January 1, 2022 (the “Maturity Date”). No principal payments were due during an interest-only period, commencing on the initial borrowing date and continuing through July 1, 2020 (the “Amortization Date”). The outstanding balance of the loan was to be repaid monthly beginning on the Amortization Date and extending through the Maturity Date. The term loan bears interest at a floating rate equal to the greater of: (i) the prime rate as reported in the Wall Street Journal plus 4.35% and (ii) 9.35% (9.85% as of December 31, 2018 based on the prime rate as of that date), payable monthly. In December 2018, we executed the First Amendment to the Loan and Security Agreement, whereby we borrowed an additional $20.0 million (“Tranche II”) to increase the total principal balance outstanding to $55.0 million. Upon draw of the additional $20.0 million, the interest-only period on the entire facility was extended until January 1, 2021 (the “Amended Amortization Date”). The outstanding balance of the original loan of $35.0 million and the additional borrowing of $20.0 million is to be repaid monthly beginning on the Amended Amortization Date and extending through July 1, 2022 (the “Amended Maturity Date”). The additional $20.0 million loan bears interest at a floating rate equal to the greater of: (i) the prime rate as reported in the Wall Street Journal plus 3.35% and (ii) 9.10% (9.10% as of December 31, 2018), payable monthly. On the earliest to occur of (i) the Amended Maturity Date, (ii) the date we prepay the outstanding principal amount of the Amended Hercules Term Loan or (iii) the date the outstanding principal amount of the Amended Hercules Term Loan otherwise becomes due, we will owe Hercules an end of term charge equal to 6.35% of the principal amount of the original $35.0 million term loan, or $2.2 million, and 5.75% of the principal amount of the incremental $20.0 million term loan, or $1.2 million. These amounts will be accrued over the term of the loan using the effective-interest method. In May 2019, we executed the Second Amendment to the Loan and Security Agreement (the “Amended Hercules Term Loan”) whereby we borrowed an additional $20.0 million (“Tranche III”) to increase the total principal balance outstanding to $75.0 million. In July 2019, the completion of our IPO triggered certain provisions of the Amended Hercules Term Loan. We received an option to pay up to 1.5% of scheduled cash pay interest on the entire facility as payment in kind, or PIK Interest, with such cash pay interest paid as PIK Interest at a 1:1.2 ratio. The interest-only period will continue through July 1, 2021 (the “Amended Amortization Date”) and the entire facility received a maturity date of January 1, 2023 (the “Amended Maturity Date”). The outstanding balance of the Amended Hercules Term Loan is to be repaid by us on a monthly basis beginning on the Amended Amortization Date and extending through the Amended Maturity Date. The interest rate for the Amended Hercules Term Loan was established as follows: (1) Tranche I bears interest at a floating rate equal to the greater of: (i) the prime rate as reported in the Wall Street Journal plus 3.85% and (ii) 8.85% (8.85% as of December 31, 2019 based on the prime rate as of that date), payable monthly; (2) Tranche II bears interest at a floating rate equal to the greater of: (i) the prime rate as reported in the Wall Street Journal plus 2.85% and (ii) 8.60% (8.60% as of December 31, 2019), payable monthly; and (3) Tranche III bears interest at a floating rate equal to the greater of: (i) the prime rate as reported in the Wall Street Journal plus 3.10% and (ii) 9.10% (9.10% as of December 31, 2019), payable monthly. The Amended Hercules Term Loan contains customary representations and warranties, events of default, and affirmative and negative covenants for a term loan facility of this size and type. However, Hercules imposes no liquidity covenants on us and Hercules cannot limit or restrict our ability to dispose of assets, make investments, or make acquisitions. As pledged collateral for our obligations under the Amended Hercules Term Loan, we granted Hercules a security interest in all our assets or personal property , including all equity interests owned or hereafter acquired by us. Further, at Hercules’ sole discretion we must make a mandatory prepayment equal to 75% of net cash proceeds received from the sale or licensing of any pledged or collateral assets, including intellectual property, of a consolidated entity owned by us, or the repurchase or redemption of any pledged collateral by certain specified operating companies. None of our consolidated entities are a party to, nor provide any credit support or other security in connection with the Amended Hercules Term Loan. Silicon Valley Bank (SVB) and Hercules Loan Agreement On November 13, 2019, Eidos entered into the SVB and Hercules Loan Agreement. The SVB and Hercules Loan Agreement provides for up to $55.0 million in term loans to be drawn in three tranches as follows: (i) Tranche A loan of $17.5 million, (ii) Tranche B loan of up to $22.5 million which is available to be drawn until October 31, 2020, and (iii) Tranche C loan of up to $15.0 million available to be drawn upon a clinical trial milestone. The Tranche C loan is available to be drawn until September 30, 2021. The Tranche A loan of $17.5 million was drawn on November 13, 2019. There have not been any additional draws on the other tranches as of December 31, 2019. The Tranche A loan bears interest at a fixed rate equal to the greater of either (i) 8.50% or (ii) 3.25% plus the prime rate as reported in The Wall Street Journal (8.50% as of December 31, 2019). The Tranche A loan repayment schedule provides for interest only payments until November 1, 2021, followed by consecutive equal monthly payments of principal and interest commencing on this date continuing through the maturity date of October 2, 2023. The Tranche A loan also provides for a $0.3 million commitment fee that was paid at closing and a final payment charge equal to 5.95% multiplied by the amount funded to be paid when the loan becomes due or upon prepayment of the facility. If Eidos elects to prepay the Tranche A loan, there is also a prepayment fee of between 0.75% and 2.50% of the principal amount being prepaid depending on the timing and circumstances of prepayment. The Tranche A loan is secured by substantially all of Eidos’ assets, except Eidos’ intellectual property, which is the subject of a negative pledge. Cash Flows The following table summarizes our cash flows during the periods indicated: Net Cash Flows Used in Operating Activities Net cash used in operating activities was $253.6 million in 2019, consisting primarily of net loss of $288.6 million, adjusted for non-cash items such as $21.4 million in stock-based compensation expense and $20.9 million for our share of losses of our equity method investments as well as net cash outflow of $10.9 million related to changes in operating assets and liabilities. The $10.9 million net cash outflow related to changes in operating assets and liabilities was attributed mainly to an increase of $16.9 million in other assets, an increase of $13.5 million in prepaid expenses and other assets and a decrease of $4.7 million in accounts payable mostly due to payments of CROs’ and CMOs’ expenses for increased research activities, offset by changes in liabilities primarily due to an increase in accrued research and development liabilities of $12.0 million and an increase in accrued compensation and benefits of $9.3 million. Net cash used in operating activities was $136.6 million in 2018, consisting primarily of net loss of $169.5 million, adjusted for non-cash charges such as $19.3 million gain on the deconsolidation of PellePharm, $17.9 million acquired in-process research and development assets, $6.1 million stock-based compensation expense and $3.0 million of expense related to the LEO Call Option as well as net cash inflow of $22.5 million related to changes in operating assets and liabilities. The $22.5 million net cash inflow related to changes in operating assets and liabilities was primarily due to an increase of $16.7 million in accounts payable and an increase of $5.8 million in accrued research and development liabilities as a result of increased research and development activities and timing of payments to vendors. Net cash used in operating activities was $40.5 million in 2017, consisting primarily of net loss of $43.8 million, adjusted for non-cash charges of $1.8 million stock-based compensation expense and net cash inflow of $1.2 million related to changes in operating assets and liabilities. Net Cash Flows Used in Investing Activities Net cash used in investing activities was $217.3 million in 2019, consisting primarily of $212.9 million used to purchase marketable securities, $2.6 million related to purchase of property and equipment and $2.5 million paid for in-progress research and development assets acquired in connection with asset acquisitions. Net cash used in investing activities was $21.0 million in 2018, consisting primarily of $16.0 million paid for in-progress research and development assets acquired through asset acquisitions, $2.2 million related to purchase of property and equipment and $2.9 million decrease in cash and cash equivalents resulting from the deconsolidation of PellePharm. Net cash used in investing activities was $0.5 million in 2017 due to purchases of property and equipment. Net Cash Flows Provided by Financing Activities Net cash provided by financing activities was $398.8 million in 2019, consisting primarily of the net proceeds from our IPO of $366.2 million, availment of term loans of $36.9 million, at-the-market issuance of noncontrolling interest by Eidos of $23.9 million, issuance of noncontrolling interest in Eidos to Alexion of $23.3 million and stock option exercises of $1.8 million, offset by $55.0 million payment in relation to our purchase of common stock of Eidos from a noncontrolling interest holder. Net cash provided by financing activities was $501.5 million in 2018, consisting primarily of the net proceeds from the issuance of our redeemable convertible preferred units of $335.0 million, the issuance of common stock in connection with the Eidos IPO of $95.5 million, third-party investors redeemable noncontrolling interests of $58.4 million and term loans of $56.4 million, offset by our purchase of a noncontrolling interest in Eidos for $44.2 million. The net cash proceeds from the Eidos IPO may only be used solely by Eidos or its subsidiaries, if any. Net cash provided by financing activities was $113.0 million in 2017, consisting primarily of the net proceeds from the issuance of our redeemable convertible preferred units of $107.0 million and issuance of promissory notes of $4.0 million. Contractual Obligations The following table summarizes our contractual obligations as of December 31, 2019: In March 2019, Eidos entered into an amendment to its office lease. The amended lease commenced in August 2019 and Eidos increased its rentable facilities to 10,552 square feet. The amended lease is for 87 months and has $6.4 million of payments under this lease. In May 2019, we executed the Second Amendment to the Loan and Security Agreement (the “Amended Hercules Term Loan”) whereby we borrowed an additional $20.0 million (“Tranche III”) to increase the total principal balance outstanding to $75.0 million. In July 2019, the completion of our IPO triggered certain provisions of the Amended Hercules Term Loan. The outstanding balance of the Amended Hercules Term Loan is to be repaid by us monthly beginning on July 1, 2021 and extending through January 1, 2023. Immediately prior to completion of our IPO, these dates were January 1, 2021 and July 1, 2022, respectively. In November 2019, Eidos entered into the SVB and Hercules Loan Agreement. The SVB and Hercules Loan Agreement provides for up to $55.0 million in term loans to be drawn in three tranches. The Tranche A loan of $17.5 million was drawn on November 13, 2019. There have not been any additional draws on the other tranches as of December 31, 2019. We have performance-based milestone compensation arrangements with certain employees, whose vesting is contingent upon meeting various regulatory and development milestones, with fixed monetary amounts known at inception that can be settled in the form of cash or fully vested common stock of the Company at our sole election, upon achievement of each contingent milestones. As of December 31, 2019, the potential milestone compensation amount is up to $34.0 million. Since the timing of the payments is contingent on the occurrence of these performance-based milestones, these payments are not included in the contractual obligations above. In December 2019, we entered into a manufacturing agreement in which we agreed to pay a one-time fee of $10.0 million for a dedicated manufacturing suite. The amount included in the table above as ‘Build-to-suit lease obligation’ pertains to the unpaid portion of as of December 31, 2019. We have certain payment obligations under various license and collaboration agreements. Under these agreements we are required to make milestone payments upon successful completion and achievement of certain intellectual property, clinical, regulatory and sales milestones. The payment obligations under the license and collaboration agreements are contingent upon future events such as our achievement of specified development, clinical, regulatory and commercial milestones, and we will be required to make development milestone payments and royalty payments in connection with the sale of products developed under these agreements. As the achievement and timing of these future milestone payments are not probable or estimable, such amounts have not been included in our consolidated balance sheet as of December 31, 2019, or in the contractual obligations table above. In addition, we enter into agreements in the normal course of business with contract research organizations and other vendors 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 the contractual obligations table above. Off-Balance Sheet Arrangements During the periods presented, we did not have any off-balance sheet arrangements. While we have investments classified as VIEs, their purpose is not to provide off-balance sheet financing. Critical Accounting Polices and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with United States generally accepted accounting principles. 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 consolidated financial statements, as well as 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 following accounting policies are those most critical to the judgments and estimates used in the preparation of our consolidated financial statements for the periods in this report. Licensing Arrangements When we enter into licensing agreements with pharmaceutical and biotechnology partners, we assess whether the arrangements fall within the scope of Accounting Standards Codification (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 partner fall within the scope of other accounting literature. If we conclude that payments from the 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 partner is not a customer for certain activities and associated payments, such as for certain collaborative research, development, manufacturing and commercial activities, we record such payments as a reduction of research and development expense or general and administrative expense, based on where we record the underlying expense. Revenue Recognition We recognize license revenue based on the facts and circumstances of each contractual agreement and includes recognition of upfront fees and milestone payments. At the inception of each agreement, we determine which promises represent distinct performance obligations, for which management must use significant judgment. Additionally, at inception and at each reporting date thereafter, we must determine and update, as appropriate, the transaction price, which includes variable consideration such as development milestones. We must use judgment to determine when to include variable consideration in the transaction price such that inclusion of such variable consideration will not result in a significant reversal of revenue recognized when the contingency surrounding the variable consideration is resolved. We must also allocate the arrangement consideration to performance obligations based on their relative standalone selling prices, which we generally base on our best estimates and which require significant judgment. For example, in estimating the standalone selling prices for granting licenses for our drug candidate, our estimates may include revenue forecasts, clinical development timelines and costs, discount rates and probabilities of clinical and regulatory success. For performance obligations satisfied over time, we recognize revenue based on our estimates of expected future costs or other measures of progress. Research and Development Expenses Research and development costs are expensed as incurred. Research and development costs consist of salaries, benefits, and other personnel related costs, including stock-based compensation expense, laboratory supplies, preclinical studies, clinical trials and related clinical manufacturing costs, costs related to manufacturing preparations, fees paid to other entities to conduct certain research and development activities on our behalf, and allocated facility and other related costs. Non-refundable advance payments for goods or services that will be used or rendered for future research and development activities are deferred and capitalized as either prepaid expenses or other noncurrent assets depending on the timing of delivery of the goods or performance of the services. Accrued Research and Development Liabilities We record accruals for estimated costs of research and development activities conducted by third-party service providers, which include the conduct of preclinical studies and clinical trials, 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 accrued research and development liabilities in the consolidated balance sheet and within research and development expense in the consolidated statements of operations. These costs are a significant component of our research and development expenses. Examples of estimated research and development expenses that we accrue include: • fees paid to CROs in connection with preclinical and toxicology studies and clinical studies; • fees paid to investigative sites in connection with clinical studies; • fees paid to CMOs in connection with the production of product and clinical study materials; and • professional service fees for consulting and related services. We base our expense accruals related to clinical studies on our estimates of the services received and efforts expended pursuant to contracts with multiple research institutions and CROs that conduct and manage clinical studies on our behalf. The financial terms of these agreements vary from contract to contract and may result in uneven payment flows. Payments under some of these contracts depend on factors, such as the successful enrollment of patients and the completion of clinical study milestones. Our service providers generally invoice us monthly in arrears for services performed. 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 we do not identify costs that we have begun to incur or if we underestimate or overestimate the level of services performed or the costs of these services, our actual expenses could differ from our estimates. We record advance payments to service providers as prepaid assets. We record accruals for the estimated costs of our contract manufacturing activities performed by third parties. The financial terms of these agreements are subject to negotiation, vary from contract to contract and may result in uneven payment flows to our vendors. Payments under the contracts include upfront payments and milestone payments, which depend on factors such as the achievement of the completion of certain stages of the manufacturing process. For purposes of recognizing expense, we assess whether we consider the production process sufficiently defined to be considered the delivery of a good or the delivery of a service, where processes and yields are developing and less certain. If we consider the process to be the delivery of a good, we recognize expense when the drug product is delivered, or we otherwise bear risk of loss. If we consider the process to be the delivery of a service, we recognize expense based on our best estimates of the contract manufacturer’s progress towards completion of the stages in the contract. We base our estimates on the best information available at the time. However, additional information may become available to us which may allow us to make a more accurate estimate in future periods. In this event, we may be required to record adjustments to research and development expenses in future periods when the actual level of activity becomes more certain. Any increases or decreases in cost are generally considered to be changes in estimates and will be reflected in research and development expenses in the period identified. To date, we have not experienced significant changes in our estimates of accrued research and development liabilities after a reporting period. However, due to the nature of estimates, there is no assurance that we will not make changes to our estimates in the future as we become aware of additional information about the status or conduct of our clinical studies and other research activities. VIE and VOE We consolidate those entities in which we have a direct or indirect controlling financial interest based on either the VIE model or the VOE model. VIEs are entities that, by design, either: (i) lack sufficient equity to permit the entity to finance its activities without additional support from other parties; or (ii) have equity holders that do not have the ability to make significant decisions relating to the entity’s operations through voting rights, or do not have the obligation to absorb the expected losses, or do not have the right to receive the residual returns of the entity. The primary beneficiary of a VIE is required to consolidate the assets and liabilities of the VIE. The primary beneficiary is the party that has both the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance and the obligation to absorb losses or the right to receive benefits from the VIE that could potentially be significant to the VIE through its interest in the VIE. To assess whether we have the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance, we consider all of the facts and circumstances, including our role in establishing the VIE and our ongoing rights and responsibilities. Our assessment includes identifying the activities that most significantly impact the VIE’s economic performance and identifying which party, if any, has power over those activities. In general, the parties that make the most significant decisions affecting the VIE (management and representation on the board of directors) and have the right to unilaterally remove those decision-makers are deemed to have the power to direct the activities of a VIE. To assess whether we have the obligation to absorb losses of the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE, we consider all of our economic interests, which primarily include equity investments in preferred and common stock and issuance of notes that are convertible into preferred stock, that are deemed to be variable interests in the VIE. This assessment requires us to apply judgment in determining whether these interests, in the aggregate, are considered potentially significant to the VIE. Factors considered in assessing the significance include: the design of the VIE, including its capitalization structure; subordination of interests; payment priority; relative share of interests held across various classes within the VIE’s capital structure; and the reasons why the interests are held by us. At the VIE inception, we determine whether we are the primary beneficiary and if the VIE should be consolidated based on the facts and circumstances. We then perform ongoing reassessments at each reporting period on whether changes in the facts and circumstances regarding our involvement with the VIE results in a change to our consolidation conclusion. Entities that do not qualify as a VIE are assessed for consolidation under the VOE model. Under the VOE model, we consolidate an entity if we determine that we, directly or indirectly, have greater than 50% of the voting shares and that other equity holders in such entities do not have substantive voting, participating or liquidation rights. Stock-Based Compensation Prior to the IPO, because there was no public market for our units as we were a private company, our board of managers determined the fair value of management incentive units and common units by considering a number of objective and subjective factors, including having contemporaneous and retrospective valuations of our equity performed by a third-party valuation specialist, valuations of comparable peer public companies, sales of our redeemable convertible preferred units, operating and financial performance, the lack of liquidity of our units, and general and industry-specific economic outlook. The fair value of our management incentive unit and common unit were determined by our board of managers until the IPO. Following our IPO, the closing sale price per share of our common stock as reported on the Nasdaq Global Select Market on the date of grant is used to determine the exercise price per share of our stock-based awards to purchase common stock. Stock-based compensation is measured at the grant date for all stock-based awards made to employees and non-employees based on the fair value of the awards and is recognized as an expense on a straight-line basis over the requisite service period, which is generally the vesting period. We have elected to recognize the actual forfeitures by reducing the stock-based compensation in the same period as the forfeitures occur. Stock-based compensation for awards made to non-employees was measured as per ASC 505-50 until we early adopted Accounting Standards Update, or ASU, 2018-07 Compensation-Stock Compensation (Topic 718) on January 1, 2017. We remeasured our equity-classified non-employee awards for which a measurement date had not been established at their adoption-based fair-value based measurement (January 1, 2017), and determined there was no cumulative-effect adjustment to our opening accumulated deficit. Subsequent to the adoption of ASU 2018-07, we account for non-employee awards similar to employee awards. Prior to the IPO, we granted management incentive units and common units to employees and non-employees. These awards generally have only a service condition and vest over a period of up to five years. The awards have accelerated vesting upon a fundamental transaction, which is defined as (i) a merger, recapitalization or other business combination, (ii) a sale, transfer, exclusive license or disposition of BBP LLC or (iii) a final liquidation, dissolution, winding-up or termination of BBP LLC. Our consolidated entities have granted stock options that are exercisable in the underlying entity’s equity and have issued restricted stock awards in the underlying entity’s equity to employees and non-employees. None of the awards issued by the consolidated entities are issued for BBP LLC members’ capital. These awards generally have only a service condition and generally vest over a period of up to four years. On June 22, 2019, we adopted the 2019 Stock Option and Incentive Plan (the “2019 Plan”), which became effective on June 25, 2019. The 2019 Plan provides for the grant of stock-based incentive awards, including common stock options and other stock-based awards. On November 13, 2019, we adopted the 2019 Inducement Equity Plan (the “2019 Inducement Plan”). The 2019 Inducement Plan provides for the grant stock-based awards to induce highly-qualified prospective officers and employees who are not currently employed by BridgeBio or its Subsidiaries to accept employment and to provide them with a proprietary interest in the Company, including common stock options and other stock-based awards. We were authorized to issue 1,000,000 shares of common stock for inducement awards under the 2019 Inducement Plan, which may be allocated among stock options, awards of restricted common stock, restricted common units and other stock-based awards. Milestone Compensation Arrangements with Employees We have performance-based milestone compensation arrangements with certain employees, whose vesting is contingent upon meeting various regulatory and development milestones, with fixed monetary amounts known at inception that can be settled in the form of cash or fully vested common stock of the Company at our sole election, upon achievement of each contingent milestones. Compensation expense arising from each milestone is recognized when the specific contingent milestone is probable of achievement and is measured at each reporting period. Under ASC 718, Compensation - Stock Compensation, we will classify the milestone compensation arrangements as liability-classified awards when it is probable of achievement because of the possible fixed monetary amounts settlement outcomes. The arrangements would also result in settlement with a variable number of shares based on the then-current stock price at grant date should we elect to settle in equity. Income Taxes Prior to the tax-free reorganization, BBP LLC was treated as a pass-through entity for U.S. federal income tax purposes, and as such, was generally not subject to U.S. federal income tax at the entity level. Rather, the tax liability with respect to its taxable income was passed through to its unitholders. Therefore, no provision or liability for federal income tax has been included in our consolidated financial statements prior to the reorganization. For our consolidated entities, income taxes are accounted for under the asset and liability method as described below. Upon the Reorganization on July 1, 2019, we became subject to typical corporate U.S. federal and state income taxation. To the extent we incur operating losses in the periods in which we are treated as a corporation for tax purposes, net operating loss carryforwards may generally be used by us to offset cash taxes on future taxable income, subject to applicable tax laws. Income taxes are accounted for under the asset and liability method. 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 base and net operating loss and tax credit carryforwards. Deferred tax assets and liabilities are determined based upon the difference between the consolidated financial statement carrying amounts and the tax basis of assets and liabilities and are measured using the enacted tax rate expected to apply to taxable income in the years in which the differences are expected to be reversed. Deferred tax assets are reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax asset will not be realized. For U.S. federal income tax purposes, we are required to file separate U.S. federal income tax returns for the consolidated entities. We are required to assess stand-alone valuation allowances separately in each entity even though we consolidate their financial results in our consolidated financial statements. We continue to file combined state tax returns in most jurisdictions. As a result, we continue to assess the state portion of our valuation allowance for those jurisdictions on a consolidated basis. We evaluate our deferred tax assets regularly to determine whether adjustments to the valuation allowance are appropriate due to changes in facts or circumstances, such as changes in expected future pre-tax earnings, tax law, interactions with taxing authorities and developments in case law. In making this evaluation, we rely on our recent history of pre-tax earnings. Our material assumptions are our forecasts of future pre-tax earnings and the nature and timing of future deductions and income represented by the deferred tax assets and liabilities, all of which involve the exercise of significant judgment. Although we believe our estimates are reasonable, we are required to use significant judgment in determining the appropriate amount of valuation allowance recorded against our deferred tax assets. We recognize uncertain income tax positions at the largest amount that is more likely than not to be sustained upon audit by the relevant taxing authority. Changes in recognition or measurement are reflected in the period in which judgment occurs. BridgeBio’s consolidated entities’ policy is to recognize interest and penalties related to the underpayment of income taxes as a component of the provision for income taxes. To date, there have been no interest or penalties recorded in relation to unrecognized tax benefits. JOBS Act and Emerging Growth Company Status We are an emerging growth company, as defined in 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 the 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 that (i) we are no longer an emerging growth company or (ii) we affirmatively and irrevocably opt out of the extended transition period provided in the JOBS Act. As a result, our consolidated financial statements may not be comparable to companies that comply with the new or revised accounting pronouncements as of public company effective dates. We will remain an emerging growth company until the earliest of (i) December 31, 2024, (ii) the last day of our first fiscal year in which we have total annual gross revenues of $1.07 billion or more, (iii) the date on which we have issued more than $1.0 billion of non-convertible debt instruments during the previous three fiscal years, or (iv) the date on which we are deemed a “large accelerated filer” under the rules of the SEC with at least $700.0 million of outstanding equity securities held by non-affiliates as of the immediately preceding June 30. Recent Accounting Pronouncements See Note 2, “Summary of Significant Accounting Policies-Recently Adopted Accounting Pronouncements” to our consolidated financial statements appearing under Part II, Item 8 for more information.

<s>[INST] This Annual Report on Form 10K contains “forwardlooking statements” within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act of 1934, as amended, (the “Exchange Act”). In some cases, you can identify these statements by forwardlooking words such as “may,” “will,” “expect,” “believe,” “anticipate,” “intend,” “could,” “should,” “estimate,” or “continue,” and similar expressions or variations. Such forwardlooking statements are subject to risks, uncertainties and other factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forwardlooking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled “Risk Factors” included in this Annual Report on Form 10K. The forwardlooking statements in this Annual Report on Form 10K represent our views as of the date of this Annual Report on Form 10K. Except as may be required by law, we assume no obligation to update these forwardlooking statements or the reasons that results could differ from these forwardlooking statements. You should, therefore, not rely on these forwardlooking statements as representing our views as of any date subsequent to the date of this Annual Report on Form 10K. Overview We are a team of experienced drug discoverers, developers, and innovators working to create lifealtering medicines that target wellcharacterized genetic diseases at their source. We founded BridgeBio in 2015 to identify and advance transformative medicines to treat patients who suffer from Mendelian diseases, which are diseases that arise from defects in a single gene, and cancers with clear genetic drivers. Our pipeline of over 20 development programs includes product candidates ranging from early discovery to latestage development. Several of our programs target indications that we believe present the potential for our product candidate, if approved, to target portions of market opportunities of at least $1.0 billion in annual sales. We have initiated a rolling NDA submission for one of our product candidates, and have three product candidates in clinical trials that, if positive, we believe could support the filing of an application for marketing authorization. We focus on genetic diseases because they exist at the intersection of high unmet patient need and tractable biology. Our approach is to translate research pioneered at academic laboratories and leading medical institutions into products that we hope will ultimately reach patients. We are able to realize this opportunity through a confluence of scientific advances: (i) identification of the genetic underpinnings of disease as more costefficient genome and exome sequencing becomes available; (ii) progress in molecular biology; and (iii) the development and maturation of longitudinal data and retrospective studies that enable the linkage of genes to diseases. We believe that this earlystage innovation represents one of the greatest practical sources for new drug creation. Since our inception in 2015, we have focused substantially all of our efforts and financial resources on acquiring and developing product and technology rights, building our intellectual property portfolio and conducting research and development activities for our product candidates within our whollyowned subsidiaries and controlled entities, including partiallyowned subsidiaries and subsidiaries we consolidate based on our deemed majority control of such entities as determined using either the variable interest entity, or VIE model, or the voting interest entity, or VOE model. To support these activities, we and our whollyowned subsidiary, BridgeBio Services, Inc., (i) identify and secure new programs, (ii) set up new whollyowned subsidiaries and controlled entities, (iii) recruit key management team members, (iv) raise and allocate capital across the portfolio and (v) provide certain shared services, including accounting and human resources, as well as workspaces. 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 our equity securities and, to a lesser extent, debt borrowings. On July 1, 2019, immediately prior to the completion of the initial public offering of our common stock (the IPO), we engaged in a series of transactions whereby BridgeBio Pharma LLC, or BBP LLC, became a whollyowned subsidiary of BridgeBio Pharma, Inc., or BB [/INST] Negative. </s>

SciPlay Corp

2020-02-18

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion is intended to enhance the reader’s understanding of our operations and current business environment and should be read in conjunction with the description of our business (see Part I, Item 1 of this Annual Report on Form 10-K) and our Consolidated Financial Statements and Notes (see Part IV, Item 15 of this Annual Report on Form 10-K). This “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and should be read in conjunction with the disclosures and information contained and referenced under “Forward-Looking Statements” and “Risk Factors” included in this Annual Report on Form 10-K. BUSINESS OVERVIEW On May 7, 2019, we completed the IPO as described in Note 1. We are a leading developer and publisher of digital games on mobile and web platforms. We currently offer seven core games, including social casino games Jackpot Party Casino, Gold Fish Casino, Hot Shot Casino and Quick Hit Slots, and casual games MONOPOLY Slots, Bingo Showdown and 88 Fortunes Slots. Our social casino games typically include slots-style game play and occasionally include table games-style game play, while our casual games blend slots-style or bingo game play with adventure game features. All of our games are offered and played on multiple platforms, including Apple, Google, Facebook, and Amazon, with some of our games available on Microsoft and other web and mobile platforms. In addition to our internally created games, our content library includes recognizable, real-world slot and table games content from Scientific Games. This content allows players who like playing land-based slot machines to enjoy some of those same titles in our free-to-play games. We have access to Scientific Games’ library of more than 1,500 iconic casino titles, including titles and content from third-party licensed brands such as JAMES BOND, MONOPOLY, CIRQUE DU SOLEIL, FLINTSTONES, CHEERS and THE GODFATHER. We generate substantially all of our revenue from the sale of virtual coins, chips and bingo cards, which players of our games can use to play casino-style slot games and table games and bingo games. Players who install our games receive free virtual coins, cards or chips upon the initial launch of the game and additional free virtual coins, cards or chips at specific time intervals. Players may exhaust the virtual coins, cards or chips that they receive for free and may choose to purchase additional virtual coins, cards or chips in order to extend their time of game play. Trends and Recent Updates Our year over year total revenue growth of 12% was higher than the overall industry trend. We believe that there is an opportunity for improved operating results in 2020 and beyond, as we continue to execute on our strategic game updates, international pilot testing and enhanced analytics. During the fourth quarter of 2019, we deployed significant updates across a number of our portfolio games, including Gold Fish and Monopoly, and are beginning to see improved results. KEY PERFORMANCE INDICATORS AND NON-GAAP MEASURES We manage our business by tracking several key performance indicators, each of which is tracked by our internal analytics systems and more fully described below and referred to in our discussion of operating results. Our key performance indicators are impacted by several factors that could cause them to fluctuate on a quarterly basis, such as platform providers' policies, restrictions, seasonality, user connectivity and addition of new content to certain portfolios of games. Future growth in players and engagement will depend on our ability to retain current players, attract new players, launch new games and features and expand into new markets and distribution platforms. Mobile Penetration Mobile penetration is defined as the percentage of total revenue generated from mobile platforms. We believe this indicator provides useful information in understanding revenue generated from mobile platforms such as smartphones and tablets. Average Monthly Active Users (MAU) MAU is defined as the number of individual users who played a game during a particular month. An individual who plays multiple games or from multiple devices may, in certain circumstances, be counted more than once. However, we use third-party data to limit the occurrence of multiple counting. Average MAU for a period is the average of MAUs for each month for the period presented. We believe this indicator provides useful information in understanding the number of users reached across our portfolio of games on a monthly basis. Average Daily Active Users (DAU) DAU is defined as the number of individual users who played a game on a particular day. An individual who plays multiple games or from multiple devices may, in certain circumstances, be counted more than once. However, we use third-party data to limit the occurrence of multiple counting. Average DAU for a period is the average of the monthly average DAUs for the period presented. We believe this indicator provides useful information in understanding the number of users reached across our portfolio of games on a daily basis. Average Revenue Per Daily Active User (ARPDAU) ARPDAU is calculated by dividing revenue for the period by the average DAU for the period and then dividing by the number of days in the period. We believe this indicator provides useful information reflecting game monetization. Average Monthly Paying Users (MPU) MPU is defined as the number of individual users who made an in-game purchase during a particular month. An individual who made purchases in multiple games or from multiple devices may, in certain circumstances, be counted more than once. However, we use third-party data to limit the occurrence of multiple counting. Average MPU for a period is the average of MPUs for each month for the period presented. We believe this indicator provides useful information in understanding the number of users reached across our portfolio of games making in-game purchases on a monthly basis. Payer Conversion Rate Payer conversion rate is calculated by dividing average MPU for the period by the average MAU for the same period. We believe this indicator provides useful information reflecting game monetization. Non-GAAP Financial Measures Adjusted EBITDA, or AEBITDA, as used herein, is a non-GAAP financial measure that is presented as supplemental disclosure and is reconciled to net income attributable to SciPlay as the most directly comparable GAAP measure as set forth in the below table. We define AEBITDA to include net income attributable to SciPlay before: (1) net income attributable to noncontrolling interest; (2) interest expense; (3) income tax (benefit) expense; (4) depreciation and amortization; (5) contingent acquisition consideration; (6) restructuring and other, which includes charges or expenses attributable to: (a) employee severance; (b) management changes; (c) restructuring and integration; (d) M&A and other, which includes: (i) M&A transaction costs; (ii) purchase accounting adjustments; (iii) unusual items (including certain legal settlements) and (iv) other non-cash items; and (e) cost-savings initiatives; (7) stock-based compensation; (8) loss (gain) on debt financing transactions; and (9) other expense (income) including foreign currency (gains) and losses. We also use AEBITDA margin, a non-GAAP measure, which we calculate as AEBITDA as a percentage of revenue. Our management uses AEBITDA and AEBITDA margin to, among other things: (i) monitor and evaluate the performance of our business operations; (ii) facilitate our management’s internal comparisons of our historical operating performance and (iii) analyze and evaluate financial and strategic planning decisions regarding future operating investments and operating budgets. In addition, our management uses AEBITDA and AEBITDA margin to facilitate management’s external comparisons of our results to the historical operating performance of other companies that may have different capital structures and debt levels. Our management believes that AEBITDA and AEBITDA margin are useful as they provide investors with information regarding our financial condition and operating performance that is an integral part of our management’s reporting and planning processes. In particular, our management believes that AEBITDA is helpful because this non-GAAP financial measure eliminates the effects of restructuring, transaction, integration or other items that management believes have less bearing on our ongoing underlying operating performance. Management believes AEBITDA margin is useful as it provides investors with information regarding the underlying operating performance and margin generated by our business operations. COMPONENTS OF RESULTS OF OPERATIONS Revenue We generate substantially all of our revenue from the sale of virtual coins, chips and bingo cards, which players of our games can use to play slot games, table games and bingo games. Revenue from the sale of virtual coins, chips and bingo cards is generated on mobile and web platforms. Other revenue primarily represents advertising revenue, which is currently an insignificant portion of our total revenue. We expect our overall revenue to continue to grow as we continue to increase our market share and execute our strategy. As player platform preferences change and continue to migrate to mobile, we expect revenue generated on web platforms to continue to decline. Operating Expenses Operating expenses consist primarily of cost of revenue, sales and marketing expenses, general and administrative expenses, R&D, D&A, contingent acquisition consideration, and restructuring and other expenses, each more fully described below. D&A expense is excluded from cost of revenue and other operating expenses, and is separately presented on the consolidated statements of income. Cost of Revenue Cost of revenue consists primarily of fees paid to platform providers such as Facebook, Google, Apple, Amazon and Microsoft, which generally represent 30% of revenue, and licensing fees, which includes intellectual property royalties paid to both affiliated and unaffiliated third parties, and other direct expenses incurred to generate revenue. We expect the aggregate amount of cost of revenue to increase for the foreseeable future as we grow our revenue and expand our business. Sales and Marketing Sales and marketing expenses consist primarily of advertising costs related to marketing and player acquisition and retention, salaries and benefits for our sales and marketing employees and fees paid to consultants. We intend to continue to invest in sales and marketing to grow our player base both for our existing games and future games we may deploy. As a result, we expect the aggregate amount of sales and marketing expenses to increase for the foreseeable future as we grow our revenues and business and deploy new games. As deployed games mature, we generally expect sales and marketing expenses as a percentage of revenue attributable to such games to decrease. General and Administrative General and administrative expenses consist primarily of salaries, benefits, and stock-based compensation for our executives, finance, information technology, human resources and other administrative employees, and includes administrative parent services (see Note 10). In addition, general and administrative expenses include outside consulting, legal and accounting services, facilities and other supporting overhead costs not allocated to other departments. We expect that our aggregate amount of general and administrative expenses will increase for the foreseeable future as we continue to grow our business and incur additional expenses associated with being a publicly traded company. R&D R&D expenses consist primarily of costs associated with game development, such as associated salaries, benefits, facilities and other supporting overhead costs associated with game development. Continued investment in enhancing existing games and developing new games is important to attaining our strategic objectives. As a result, we expect the aggregate amount of R&D expenses to increase for the foreseeable future as we grow our business, focus on retention of our development team and grow our facilities. Contingent Acquisition Consideration Contingent acquisition consideration expense consists of incremental consideration to be paid to former owners of businesses we acquired, the amount of which exceeds the acquisition date estimation. As described in Note 1, when an acquisition includes future consideration to be paid to previous owners of those businesses we have acquired, we estimate the fair value of the future payments and record the acquisition-date fair value as a component of the purchase price. We monitor such arrangements and evaluate them when conditions change. Any adjustments subsequent to the acquisition date estimate are recorded as contingent acquisition consideration expense. Because such expense is based on our current expectations of the future results of the acquired businesses, any adjustments are recorded if our expectations for the future change. Although we currently do not have any expectation that we will incur future contingent acquisition consideration, any such expenses will be dependent on future merger and acquisition activities and terms of those arrangements. Restructuring and Other Our restructuring and other expenses include charges or expenses attributable to: (i) employee severance; (ii) management restructuring and related costs; (iii) restructuring and integration; (iv) cost savings initiatives; and (v) acquisition related and other unusual items other than contingent acquisition consideration. Restructuring and other expenses will increase or decrease based on management actions and/or occurrence of charges described herein. RESULTS OF OPERATIONS Summary of Results of Operations The following table reconciles Net income attributable to SciPlay to AEBITDA and AEBITDA margin: Revenue, Key Performance Indicators and Other Metrics Revenue information by geography is summarized as follows: The following reflects our Key Performance Indicators and Other Metrics: Mobile platform revenue increased primarily due to the ongoing popularity of Jackpot Party Casino, MONOPOLY Slots, Bingo Showdown and 88 Fortunes. Web platform revenue decreased due to a decline in player levels as a result of player preferences causing a continued migration to mobile platforms. The increase in mobile penetration percentage primarily reflects a continued trend of players migrating from web to mobile platforms to play our games. Average MAU decreased and average DAU stayed relatively flat due to the turnover in users while paying users stayed consistent. Consequently, ARPDAU and average monthly revenue per payer increased due to decreased average MAU and flat average DAU base. The increase in payer conversion rates were due to the growing popularity of our games and increased interaction with the games by our players as a result of the introduction of new content and features into our games. Operating Expenses Cost of Revenue Cost of revenue decreased primarily as a result of a decrease of $16.0 million in Scientific Games IP royalties due to our entry into the IP License Agreement and a decrease of $0.8 million in third-party IP royalties. This decrease was partially offset by an increase of $15.1 million in platform fees, which was correlated with revenue growth. Sales and Marketing Sales and marketing expenses increased primarily due to an increase in player acquisition costs, largely associated with Jackpot Party Casino, Quick Hit Slots, Gold Fish Casino, Bingo Showdown, MONOPOLY Slots, and 88 Fortunes. Sales and marketing expenses as a percentage of revenue increased by 2.4 percentage points for the year ended December 31, 2019 as a result of a management decision to increase spend to drive user engagement in our games. General and Administrative General and administrative expenses increased due to higher stock-based compensation reflecting SciPlay RSUs granted under the Long-Term Incentive Plan (“LTIP”). Stock-based compensation expense increased by $4.9 million. General and administrative expenses as a percentage of revenue increased by 0.4 percentage points. Contingent Acquisition Consideration Contingent acquisition consideration decreased as a result of lower remeasurement charges, which relates to the Bingo Showdown app’s post-acquisition performance measurement period closing. Remaining unpaid contingent acquisition consideration is expected to be fully paid by February 28, 2020. Net Income Net income increased primarily due to continued growth in revenue (as described above) coupled with a decrease in IP royalty expense as a result of our entry into the IP License Agreement, lower depreciation and amortization and lower contingent acquisition consideration. Net income margin improved by 10.7 percentage points as a result of the above stated drivers. AEBITDA AEBITDA increased due to continued growth in revenue and a decrease in IP royalty expense as a result of our entry into the IP License Agreement, which was partially offset by higher sales and marketing expenses (as described above). AEBITDA margin improved by 3.7 percentage points as a result of the above stated drivers. Other Factors Affecting Net Income Attributable to SciPlay For 2018 and 2017 consolidated results comparison, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section included in the Prospectus. RECENTLY ISSUED ACCOUNTING GUIDANCE For a description of recently issued accounting pronouncements, see Note 1. CRITICAL ACCOUNTING ESTIMATES Information regarding significant accounting policies is included in the Notes to the audited consolidated financial statements. As stated in Note 1, the preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Management bases its estimates on historical experience and on various 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. We believe that the estimates, assumptions, and judgments involved in the following accounting policies have the greatest potential impact on our consolidated financial statements: • Revenue recognition; • Business combinations; • Contingent acquisition consideration; • Income taxes; and • Variable interest entities (VIE). Revenue Recognition As described in Note 1, on January 1, 2018, we adopted ASC 606 using the modified retrospective method, which was applied to customer contracts that were not completed as of January 1, 2018. Our revenue recognition policy described fully in Note 1 requires us to make significant judgments and estimates. The guidance in ASC 606 requires that we apply judgments or estimates to determine the performance obligations, the standalone selling prices of our performance obligations to customers and the timing of transfer of control of the respective performance obligations. The evaluation of each of these criteria in light of contract specific facts and circumstances is inherently judgmental, but certain judgments could significantly affect the timing or amount of revenue recognized if we were to reach a different conclusion than we have. The critical judgments we are required to make in our assessment of contracts with customers that could significantly affect the timing or amount of revenue recognized are: • Satisfaction of our performance obligation - We estimate the amount of outstanding purchased virtual currency at period end based on customer behavior, because we are unable to distinguish between the consumption of purchased or free virtual currency. Based on an analysis of the customers' historical play behavior, the timing difference between when virtual currencies are purchased by a customer and when those virtual currencies are consumed in game play is relatively short. Future usage patterns may differ from historical usage patterns, and therefore the estimated average playing periods may change in the future, and such changes could be material. • Principal-agent considerations - We recognize revenues on a gross basis because we have control over the content and functionality of games before players access our games on our platform providers platforms. We evaluated our current agreements with our platform providers and end-user agreements and based on the preceding, we determined that we are the principal in such arrangements. Any future changes in these arrangements or to our games and related method of distribution may result in a different conclusion, and such change would have a material impact on our gross revenues. Business Combinations We account for business combinations in accordance with ASC 805. This standard requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction and establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed in a business combination. Determining the fair value of assets acquired and liabilities assumed requires management judgment and often involves the use of significant estimates and assumptions with respect to the timing and amounts of future cash inflows and outflows, discount rates, market prices and asset lives, among other items. Any changes in the underlying assumptions can impact the estimates of fair value by material amounts, which can in turn materially impact our results of operations. If the subsequent actual results and updated projections of the underlying business activity change compared with the assumptions and projections used to develop these fair values, we could record impairment charges. In addition, we have estimated the useful lives of certain acquired assets, and these lives are used to calculate D&A expense. If our estimates of the useful lives change, D&A expense could be accelerated or slowed. Contingent Acquisition Consideration The valuation of contingent acquisition consideration (which is required each reporting period) requires significant judgments, and any changes in the underlying assumptions can impact the estimates of fair value by material amounts. As a result of changes in significant unobservable inputs primarily consisting of projected earnings-based measures and probability of achievement (categorized as Level 3 in the fair value hierarchy as established by ASC 820), we increased the fair value of SpiceRack contingent consideration by $1.7 million in 2019 and by $27.5 million in 2018, which changes were included in Contingent acquisition consideration expense. The discount rate used in estimating contingent acquisition consideration was approximately 10% (see Note 1). During the second quarter of 2019, we agreed with the SpiceRack selling shareholders to pay them $31.0 million in total contingent acquisition consideration. We paid $27.0 million during the year ended December 31, 2019 with the remaining balance to be fully paid by February 28, 2020. Income Taxes We are subject to the income tax laws of the U.S. federal, state and foreign jurisdictions in which we operate. These tax laws are complex, and the manner in which they apply to our facts is sometimes open to interpretation. In establishing the provision for income taxes, we must make judgments about the application of these inherently complex tax laws. For periods prior to the IPO, the provision for income taxes is calculated as if SciPlay completed separate tax returns apart from its Parent ("Separate-return Method"), which requires significant judgments. Certain legal entities that are included in these financial statements under the Separate-return Method were included in tax filings of affiliated entities that are not part of these financial statements. Our income tax positions and analysis are based on currently enacted tax law. Future changes in tax law could significantly impact the provision for income taxes, the amount of taxes payable and the deferred tax asset and liability balances in future periods. Deferred tax assets generally represent the excess of tax basis in our investment and tax benefits for tax deductions available in future tax returns. Certain estimates and assumptions are required to determine whether it is more likely than not that all or some portion of the benefit of a deferred tax asset will not be realized. In making this assessment, management analyzes and estimates the impact of future taxable income, available carry-backs and carry-forwards, reversing temporary differences and available prudent and feasible tax planning strategies. Should a change in facts or circumstances lead to a change in judgment about the ultimate realizability of a deferred tax asset, we record or adjust the related valuation allowance in the annual period that the change in facts and circumstances occurs, along with a corresponding increase or decrease in the provision for income taxes. For discussion of our income taxes, see Note 9. Variable Interest Entities (VIE) As described in Note 1, upon the completion of the IPO, SciPlay's sole material asset is its member's interest in SciPlay Parent LLC. Due to SciPlay's power to control combined with its significant economic interest in SciPlay Parent LLC, we concluded that SciPlay is the primary beneficiary of the VIE, and therefore it will consolidate the financial results of SciPlay Parent LLC and its subsidiaries. Any future changes to the economic interest and/or the SciPlay Parent LLC Agreement, among other factors, may result in a different conclusion, and such change would have a material impact on SciPlay financial statements, as SciPlay Parent LLC and its subsidiaries would not be consolidated but rather accounted for under the equity method of accounting. LIQUIDITY, CAPITAL RESOURCES AND WORKING CAPITAL On May 7, 2019, we completed the offering of 22,720,000 shares of Class A common stock at a public offering price of $16.00 per share, after giving effect to the underwriters’ exercise of their over-allotment option on June 4, 2019. We received $341.7 million in proceeds, net of underwriting discount, but before offering expenses of $9.3 million. Refer to Note 1 for a more detailed description of the IPO. SciPlay is a holding company, with no material assets other than its ownership of SciPlay Parent LLC interests, no operating activities on its own and no independent means of generating revenue or cash flow. Operations are carried out by SciPlay Parent LLC and its subsidiaries, and we depend on distributions from SciPlay Parent LLC to pay our taxes and expenses. SciPlay Parent LLC’s ability to make distributions to us is restricted by the terms of the Revolver, and may be restricted by any future credit agreement we or our subsidiaries enter into, any future debt or preferred equity securities we or our subsidiaries issue, other contractual restrictions or applicable Nevada law. We have funded our operations primarily through cash flows from operating activities. Based on our current plans and market conditions, we believe that cash flows generated from our operations, the proceeds from the IPO and borrowing capacity under the Revolver will be sufficient to satisfy our anticipated cash requirements for the foreseeable future. However, we intend to continue to make significant investments to support our business growth and may require additional funds to respond to business challenges, including the need to develop new games and features or enhance our existing games, improve our operating infrastructure or acquire complementary businesses, personnel and technologies. Accordingly, we may need to engage in equity or debt financings to secure additional funds. We may not be able to obtain additional financing on terms favorable to us, if at all. If we are unable to obtain adequate financing or financing on terms satisfactory to us when we require it, our ability to continue to support our business growth and to respond to business challenges could be significantly impaired, and our business may be harmed. Revolving Credit Facility In connection with the IPO, we entered into the $150.0 million Revolver by and among SciPlay Holding, as the borrower, SciPlay Parent LLC, as a guarantor, the subsidiary guarantors party thereto, the lenders party thereto and Bank of America, N.A., as administrative agent and collateral agent. The interest rate is either Adjusted LIBOR (as defined in the Revolver) plus 2.250% (with one 0.250% leverage-based step-down to the margin and one 0.250% leverage-based step-up to the margin) or ABR plus 1.250% (with one 0.250% leverage-based step-down to the margin and one 0.250% leverage-based step-up to the margin) at our option. We are required to pay to the lenders a commitment fee of 0.500% per annum on the average daily unused portion of the revolving commitments through maturity, which will be the five-year anniversary of the closing date of the Revolver, which fee varies based on the total net leverage ratio and is subject to a floor of 0.375%. As of December 31, 2019 the commitment fee was 0.375% per annum.The Revolver provides for up to $15.0 million in letter of credit issuances, which requires customary issuance and administration fees, and a fronting fee of 0.125%. The Revolver contains covenants that, among other things, restrict our ability to incur additional indebtedness; incur liens; sell, transfer or dispose of property and assets; invest; make dividends or distributions or other restricted payments; and engage in affiliate transactions, with the exception of certain payments under the TRA and payments in respect of certain tax distributions under the Operating Agreement. In addition, the Revolver requires us to maintain a maximum total net leverage ratio not to exceed 2.50:1.00 and to maintain a minimum fixed charge coverage ratio of no less than 4.00:1.00. Such covenants are tested quarterly at the end of each fiscal quarter. We were in compliance with the financial covenants under the Revolver as of December 31, 2019. The Revolver is secured by a (i) first priority pledge of the equity securities of SciPlay Holding, SciPlay Parent LLC’s restricted subsidiaries and each subsidiary guarantor party thereto and (ii) first priority security interests in, and mortgages on, substantially all tangible and intangible personal property and material fee-owned real property of SciPlay Parent LLC, SciPlay Holding and each subsidiary guarantor party thereto, in each case, subject to customary exceptions. Changes in Cash Flows The following table presents a summary of our cash flows for the periods indicated: Net cash provided by operating activities increased primarily due to higher earnings, which was partially offset by payment of contingent acquisition consideration. Net cash used in investing activities increased primarily due to higher leasehold improvement expenditures related to our Austin facility and higher development costs of our capitalized software. Net cash provided by financing activities increased primarily due to net proceeds from the IPO during the second quarter of 2019. The increase was substantially offset by distributions to Scientific Games (including payments under the previous IP licensing arrangement) and payments of offering and financing costs. Credit Agreement and Other Debt For additional information regarding our credit agreement and other debt and interest rate risk, see “Contractual Obligations” in this Item 7 below, Part II,

<s>[INST] This “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains forwardlooking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and should be read in conjunction with the disclosures and information contained and referenced under “ForwardLooking Statements” and “Risk Factors” included in this Annual Report on Form 10K. BUSINESS OVERVIEW On May 7, 2019, we completed the IPO as described in Note 1. We are a leading developer and publisher of digital games on mobile and web platforms. We currently offer seven core games, including social casino games Jackpot Party Casino, Gold Fish Casino, Hot Shot Casino and Quick Hit Slots, and casual games MONOPOLY Slots, Bingo Showdown and 88 Fortunes Slots. Our social casino games typically include slotsstyle game play and occasionally include table gamesstyle game play, while our casual games blend slotsstyle or bingo game play with adventure game features. All of our games are offered and played on multiple platforms, including Apple, Google, Facebook, and Amazon, with some of our games available on Microsoft and other web and mobile platforms. In addition to our internally created games, our content library includes recognizable, realworld slot and table games content from Scientific Games. This content allows players who like playing landbased slot machines to enjoy some of those same titles in our freetoplay games. We have access to Scientific Games’ library of more than 1,500 iconic casino titles, including titles and content from thirdparty licensed brands such as JAMES BOND, MONOPOLY, CIRQUE DU SOLEIL, FLINTSTONES, CHEERS and THE GODFATHER. We generate substantially all of our revenue from the sale of virtual coins, chips and bingo cards, which players of our games can use to play casinostyle slot games and table games and bingo games. Players who install our games receive free virtual coins, cards or chips upon the initial launch of the game and additional free virtual coins, cards or chips at specific time intervals. Players may exhaust the virtual coins, cards or chips that they receive for free and may choose to purchase additional virtual coins, cards or chips in order to extend their time of game play. Trends and Recent Updates Our year over year total revenue growth of 12% was higher than the overall industry trend. We believe that there is an opportunity for improved operating results in 2020 and beyond, as we continue to execute on our strategic game updates, international pilot testing and enhanced analytics. During the fourth quarter of 2019, we deployed significant updates across a number of our portfolio games, including Gold Fish and Monopoly, and are beginning to see improved results. KEY PERFORMANCE INDICATORS AND NONGAAP MEASURES We manage our business by tracking several key performance indicators, each of which is tracked by our internal analytics systems and more fully described below and referred to in our discussion of operating results. Our key performance indicators are impacted by several factors that could cause them to fluctuate on a quarterly basis, such as platform providers' policies, restrictions, seasonality, user connectivity and addition of new content to certain portfolios of games. Future growth in players and engagement will depend on our ability to retain current players, attract new players, launch new games and features and expand into new markets and distribution platforms. Mobile Penetration Mobile penetration is defined as the percentage of total revenue generated from mobile platforms. We believe this indicator provides useful information in understanding revenue generated from mobile platforms such as smartphones and tablets. Average Monthly Active Users (MAU) MAU is defined as the number of individual users who played a game during a particular month. An individual who plays multiple games or from multiple devices may, in certain circumstances, be counted more than once. However, we use thirdparty data to limit the occurrence of multiple counting. Average MAU for a period is the average of MAUs for each month for the period presented. We believe this indicator provides useful information in understanding the number of users reached across our portfolio of games on a monthly basis. Average Daily Active Users (DAU) DAU is defined as the number of individual users who played a game on a particular day. An individual who plays multiple games or from multiple devices may, [/INST] Negative. </s>

Broadmark Realty Capital 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 together with the “Selected Financial Data” and “Business” sections, as well as the consolidated financial statements and related notes in Part II, Item 8 of this Annual Report on Form 10-K. In addition, the following discussion and analysis contains forward-looking statements and involves numerous risks and uncertainties, including those described under the heading “Risk Factors.” Actual results may differ materially from those contained in any forward-looking statements. You should read this discussion and analysis together with the consolidated financial statements and related notes included elsewhere in this Report for the Company and Predecessor Company Group. In this “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” references to the “Predecessor Company Group,” or the “Predecessor,” refers to the Predecessor Companies and the Predecessor Management Companies and their respective subsidiaries, on a consolidated basis. Broadmark Realty, a Maryland corporation, is an internally managed commercial real estate finance company that intends to elect to be taxed as a REIT for federal income tax purposes. Based in Seattle, Washington, Broadmark Realty offers short-term, first deed of trust loans, secured by real estate to fund the construction and development of, or investment in, residential or commercial properties. Broadmark Realty operates in select states that it believes to have favorable demographic trends, and that provide more efficient and quicker access to collateral in the event of borrower default. As of December 31, 2019, Broadmark Realty’s combined portfolio of active loans had approximately $1.1 billion of principal commitments outstanding across 241 loans to over 151 borrowers in ten states and the District of Columbia, of which approximately $829.0 million was funded. Properties securing Broadmark Realty’s loans are generally classified as either residential or commercial properties, or undeveloped land, and are typically not income producing. Each loan is secured by a first mortgage lien on real estate. Broadmark Realty’s lending policy limits the amount of the loan to a maximum loan-to-value (“LTV”) ratio of up to 65% of the “as-is” appraised value of the underlying collateral as determined by an independent appraiser at the time of the loan origination. As of December 31, 2019, the average LTV across Broadmark Realty’s active loan portfolio was less than 59% of the most recent appraised value. In addition, each loan is also personally guaranteed on a recourse basis by the principals of the borrower, and/or others at the discretion of Broadmark Realty to further help ensure that Broadmark Realty will receive full repayment of the loan. The guaranty may be collaterally secured by a pledge of the guarantor’s interest in the borrower or other real estate or assets owned by the guarantor. Broadmark Realty’s loans typically range from $500,000 to $50 million in face value (average of $4.9 million at December 31, 2019), generally bear interest at a fixed annual rate of 10% to 13% and have initial terms typically ranging from five to twelve months in duration (which may be renewed or extended before the expiration of the loan’s term). Broadmark Realty usually receives loan origination fees, or “points,” typically ranging from 4% to 5% of the original principal amount of the loan, along with loan renewal fees, each of which varies in amount based upon the term of the loan and the quality of the borrower and the underlying real estate. In addition to loan origination fees Broadmark Realty receives late fees paid by borrowers, and/or is reimbursed by borrowers for costs associated with services provided by Broadmark Realty, such as closing costs, collection costs on defaulted loans and construction draw inspection fees. Broadmark Realty Capital Inc. In addition to the natural seasonality inherent in our business whereby winter months are less favorable to construction, restrictions related to the Business Combination decreased the amount of our loan originations for the second half of 2019 and early 2020. After August 2019, the pending Business Combination required us to essentially pause our ability to raise capital and in turn originate new loans. In the first quarter of 2020, we rebuilt our pipeline and began to strategically deploy the proceeds from the Business Combination. We believe that the launch of the Private REIT provides access to additional capital and positions us to increase originations and grow our asset base, subject to market conditions. The COVID-19 coronavirus epidemic is significantly affecting the capital markets and trading markets and can be expected to impact the construction lending market, at least in the near term. A significant percentage of our loans and our headquarters are in the Seattle, Washington area, which is experiencing a major outbreak of COVID-19. While we have implemented a variety of business continuity initiatives, restrictions imposed in connection with COVID-19 or the impact on key employees could create significant challenges for our operations. While we have not to date experienced a material impact on our loan portfolio, the spread of COVID-19 could have a material adverse impact on commercial loan demand and our results of operations. Key Indicators of Financial Condition and Operating Performance In assessing the performance of our business, we consider a variety of financial and operating metrics, which include both GAAP and non-GAAP metrics, including the following: Interest income earned on our loans. A primary source of our revenue is interest income earned on our loan portfolio. Our loans typically bear interest at a fixed annual rate of 10% to 13%, paid monthly through cash payments or interest reserves. As we have historically had no debt outstanding, we have had no borrowing costs making our gross interest income earned on our loans has been equivalent to its net interest income. Fees and other revenue recognized from originating and servicing our loans. Fee income is comprised of loan origination fees, loan renewal fees and inspection fees. The majority of fee income is comprised of loan origination fees or “points,” which typically range from 4% to 5%, on an annualized basis, of the original principal amount of the loan. In addition to origination fees, we earn loan renewal fees when maturing loans are renewed or extended. Loans are generally only renewed or extended if the loan is not in default and satisfies our underwriting criteria, including, our maximum LTV ratio of up to 65% of the appraised value as determined by an independent appraiser at the time of loan origination, or based on an updated appraisal if required. We also earn inspection fees when an inspection of work progress is required to fund a loan draw, although inspection fees are typically passed on to pay third party inspectors. Loan originations. Our operating performance is heavily dependent upon our ability to originate new loans to invest new capital and re-invest returning capital from loans being repaid. Given the short-term nature of our loans, loan principal is repaid on a faster basis than to other types of lenders, making our originations function an important factor in our success. Credit quality of our loan portfolio. Maintaining the credit quality of the loans in our portfolio is of critical importance as loans that do not perform in accordance with their terms may have a negative impact on earnings and liquidity. During the Company's nearly ten year history, a total of 46 loans out of more than 1,046 originated loans defaulted representing an aggregate $91.7 million or 4% of the aggregate outstanding principal amount. These loan defaults have resulted in $1.1 million in principal losses or 0.05% of the face amount of the total originated loans. As of December 31, 2019, a total of 15 loans are in default representing $32.9 million or 3.8% of the aggregate outstanding principal amount. Core Earnings Core earnings is a non-GAAP financial measure used by management as a supplemental measure to evaluate our performance. We define core earnings as net income attributable to common stockholders adjusted for: (i) impairment recorded on our investments; (ii) realized and unrealized gains or losses on our investments; (iii) non-capitalized transaction-related expenses; (iv) non-cash stock-based compensation; (v) amortization of our intangible assets; and (vi) deferred taxes, which are subject to variability and generally not indicative of future economic performance or representative of current operations. Broadmark Realty Capital Inc. Management believes that the adjustments to compute “core earnings” specified above allow investors and analysts to readily identify and track the operating performance of the assets that form the core of our activity, assist in comparing the core operating results between periods, and enable investors to evaluate our current core performance using the same measure that management uses to operate the business. Core earnings excludes certain recurring items, such as gains and losses (including provision for loan losses) and non-capitalized transaction-related expenses, because they are not considered by management to be part of our core operations for the reasons described herein. As such, core earnings is not intended to reflect all of our activity and should be considered as only one of the factors used by management in assessing our performance, along with GAAP net income which is inclusive of all of our activities. Core earnings does not represent and should not be considered as a substitute for, or superior to, net income or as a substitute for, or superior to, cash flows from operating activities, each as determined in accordance with GAAP, and our calculation of this measure may not be comparable to similarly entitled measures reported by other companies. Set forth below is a reconciliation of core earnings to the most directly comparable GAAP financial measure: Broadmark Realty Capital Inc. (1) Substantially all of the Company's outstanding common stock was issued as part of the closing of the Business Combination, and therefore, no common stock was outstanding during the Predecessor periods. The pro forma weighted average shares outstanding utilizes the weighted average shares for the Successor period as if they were outstanding as of the beginning of the periods presented. Segment Reporting We operate our business as one reportable segment. Principal Factors Affecting the Comparability of our Results of Operations As a commercial real estate finance company, our results are affected by factors such as changes in economic climate, demand for housing, population trends, construction costs and the availability of real estate financing from other lenders. These factors may have an impact on our ability to originate new loans or the performance of its existing loan portfolio. The Business Combination From November 15, 2019, Broadmark Realty’s consolidated financial statements reflect BRELF II, one of the Predecessor Companies, as the accounting acquirer and successor entity, acquiring the other three Predecessor Companies, the four Predecessor Management Companies, and Trinity in the successor period. The Business Combination transaction reflects a change in accounting basis for the Predecessor Company Group (other than BRELF II). As Trinity was a special purpose acquisition company, its acquisition is reflected as the issuance of shares for cash. For periods prior to November 15, 2019, in lieu of presenting separate financial statements of each of the Predecessor Companies and Predecessor Management Companies, consolidated financial statements have been presented, as these entities were under common management. Broadmark Realty is the successor issuer to Trinity. Results from Operations The table below sets forth the results of operations of Broadmark Realty and the Predecessor for the periods presented. The period-to-period comparison of results is not necessarily indicative of results for future periods. As a result of the Business Combination, beginning from November 15, 2019, Broadmark Realty’s consolidated financial statements are presented on a new basis of accounting pursuant to Accounting Standards Codification ("ASC") 805, Business Combinations (refer to Note 3 to the consolidated financial statements included in this annual report), to reflect BRELF II acquiring the other entities within the Predecessor Company Group and Trinity. The following tables summarizes key components of our results of operations for the periods indicated, both in dollars and as a percentage of revenue. Broadmark Realty Capital Inc. Period from November 15, 2019 to December 31, 2019 (Successor) and Period from January 1, 2019 to November 14, 2019 (Predecessor) Compared to the Year Ended December 31, 2018 (Predecessor) Revenues Total revenue for the successor period from November 15 to December 31, 2019 (the “2019 Successor Period”), the predecessor period from January 1 to November 14, 2019 (the “2019 Predecessor Period”) and the predecessor year ended December 31, 2018 (the “2018 Predecessor Period”) was $16.0 million, $115.0 million and $95.8 million, respectively. An increase of $35.1 million in the Successor and Predecessor Period from the 2018 Predecessor Period was due to increased access to capital through fundraising and the related expansion of the lending portfolio. Expenses Total expenses for the 2019 Successor Period, the 2019 Predecessor Period and the 2018 Predecessor Period was $10.7 million, $45.1 million and $14.0 million, respectively. An increase of $41.8 million in the 2019 Successor and 2019 Predecessor Periods from the 2018 Predecessor Period was due to nonrecurring expenses related to the business combination, costs related to launching a new regional lending entity, and additional personnel costs from the growth of the Company. Interest Income Interest income increased by $37.0 million for the 2019 Successor and 2019 Predecessor Periods from the 2018 Predecessor Period was primarily attributable to incremental interest income from a year over year net increase in the size of our loan portfolio of more than $232 million from December 31, 2018 to December 31, 2019. Broadmark Realty Capital Inc. Fee Income Fee income decreased by $1.9 million for the 2019 Successor and 2019 Predecessor Periods from the 2018 Predecessor Period primarily attributable to a decrease in origination and extension fee income during the 2019 Predecessor Periods relative to the 2018 Predecessor Period as a result of certain restrictions on our capital raising and deployment as we awaited completion of the Business Combination. We began to defer and amortize these fees beginning November 15, 2019 whereas in the past, the Predecessor’s policy was to record the fees when received, as differences resulting from this practice and GAAP were deemed immaterial. Provision for loan losses Provision for loan losses increased by $1.6 million for the 2019 Successor and 2019 Predecessor Periods from the 2018 Predecessor Period as a result of an increase in loans in default of $21.6 million primarily associated with an increase in the size of our loan portfolio. Other Expense The change of fair value of a warrant liability is an unrealized loss that is as a result of the issuance of an optional subscription of up to $25 million of additional common stock (“Farallon Optional Subscription”) as part of the merger agreement. The Farallon Optional Subscription warrants contain a cash settlement feature, which requires accounting for the fair value of the warrant liability at each reporting period. The increase in expense is associated with the increase in stock price from November 15, 2019 to December 31, 2019 and does not impact the Predecessor Period. Compensation and Employee Benefits Compensation and employee benefits expense increased by $4.1 million for the 2019 Successor and 2019 Predecessor Periods from the 2018 Predecessor Period primarily attributable to $1.4 million of stock-based compensation expense recorded for the period from November 15, 2019 through December 31, 2019 and an increase in employee headcount and performance-based bonuses. The stock-based compensation expenses resulted from restricted stock units (“RSUs”) with 2019 grant dates for financial reporting purposes. The fair values of the RSUs are being amortized over the vesting periods. General and Administrative General and administrative expense increased by $5.0 million for the 2019 Successor and 2019 Predecessor Periods from the 2018 Predecessor Period as a result of increased operating costs associated with growth in the loan portfolio, including broker commissions, and costs associated with implementing and maintaining public company compliance. Transaction Costs Transaction costs for the 2019 Successor and 2019 Predecessor Periods was $0.4 million and $25.8 million, respectively, include fees paid to investment banks, legal counsel and accounting firms as well as one-time payments associated with the Business Combination. Broadmark Realty Capital Inc. Comparison of Results of Operations for the years ended December 31, 2018 and 2017 Revenues Total revenue for the year ended December 31, 2018 was $95.8 million compared to $52.2 million for the year ended December 31, 2017. An increase of $43.6 million, or 83.5% was due to increased access to capital through fundraising and the related expansion of the lending portfolio. Expenses Total expenses for the year ended December 31, 2018 was $14.0 million compared to $6.8 million for the year ended December 31, 2017. An increase of $7.2 million, or 105.0% was due to costs related to launching a new regional lending entity and additional personnel costs from the growth of the Company. Interest Income Interest income increased by $26.7 million primarily attributable to incremental interest income from a year over year net increase in the size of our loan portfolio of more than $272 million during the twelve months ended December 31, 2018. Fee Income Fee income increased by $17 million primarily attributable to incremental origination fee income driven by a year over year increase in loan originations of $247 million. Broadmark Realty Capital Inc. Provision for Loan Losses Provision for loan losses increased by $1.5 million primarily as a result of an increase in loans in default of $11.2 million associated with an increase in the size of our loan portfolio year over year. Compensation and Employee Benefits Compensation and employee benefits expense increased by $2.1 million primarily as a result of the increase in the number of employees related to the growth of the Company’s business operations. General and Administrative General and administrative expenses increased by $3.6 million primarily as a result of an increase in legal fees and operating expenses associated with the growth of the business operations. Liquidity and Capital Resources Overview Our primary liquidity needs include ongoing commitments to fund our lending activities and future funding obligations for existing loan portfolio, paying dividends and funding other general business needs. Our primary sources of liquidity and capital resources to date have been derived from the capital contributions from members of the Predecessor Companies, cash flow from operations and payoffs of existing loans. Neither the Successor nor the Predecessor, has utilized any borrowings since inception. As of December 31, 2019, our cash and cash equivalents totaled $238.2 million. We seek to meet our long-term liquidity requirements, such as real estate lending needs, including future construction draw commitments through our existing cash resources and return of capital from investments, including loan repayments. Additionally, going forward, we intend to fund our growth through the issuance of common stock, potential use of cash management tools such as a credit facility, and the sale of participation interests in loans we originate to the Private REIT, and fee income from the Private REIT. As of December 31, 2019, we had $1.1 billion of loan commitments, of which $829 million were funded and outstanding. As a REIT, we are required to distribute at least 90% of our annual REIT taxable income to our stockholders, including taxable income where Broadmark Realty does not receive corresponding cash. We intend to distribute all or substantially all of our REIT taxable income in order to comply with the REIT distribution requirements of the Code and to avoid federal income tax and the non-deductible excise tax. Broadmark Realty Capital Inc. Sources and Uses of Cash The following table sets forth changes in cash and cash equivalents for the 2019 Successor and Predecessor Periods, and the years ended December 31, 2018 and 2017: Period from November 15, 2019 through December 31, 2019 (Successor) and Period from January 1, 2019 through November 14, 2019 (Predecessor) Compared to the Year Ended December 31, 2018 (Predecessor) and Year Ended December 31, 2017 (Predecessor) Net cash provided by operating activities was $5.6 million for the 2019 Successor Period and $91.5 million for the 2019 Predecessor Period for a combined total of $97.1 million, compared to $81.5 million for the 2018 Predecessor year. The increase was primarily due to the larger loan portfolio and higher real estate lending activity. This increase is partially offset by $25.8 million of transaction costs related to the Business Combination that were expenses during the Successor Period. Net cash provided by operating activities was $48.0 million in the 2017 Predecessor year. When compared to the 2018 Predecessor year, the increase was primarily due to the larger loan portfolio and higher real estate lending activity. Net cash used in investing activities was $25.9 million for the 2019 Successor Period and $216.4 million for the 2019 Predecessor period for a total of $242.3 million compared to $275.7 million for the 2018 Predecessor year, a decrease in cash used of $33.4 million. This change primarily relates to cash used for loans and acquisitions. Cash used to pay for acquisitions net of cash acquired was $13.7 million in 2019 with no amounts paid for acquisitions in 2018. Cash used for investments in mortgage loans during 2019 was $43.7 million less than cash used for investments in mortgage loans during 2018 primarily due a slowing of new loan originations resulting from the suspension of fundraising mandated by the guidelines of the Business Combination. Cash used for investments in mortgage loans during 2018 was $152.8 million more than cash used for investments in mortgage loans during 2017 primarily due continued increases in fundraising and expansion of the loan portfolio. Net cash provided by financing activities was $258.4 million and $101.2 million for the 2019 Successor Period and 2019 Predecessor Period, respectively, for a total of $359.6 million as compared to $240.2 million in the 2018 Predecessor year, an increase of $119.4 million. The increase was primarily due to the proceeds from there capitalization with Trinity Merger Sub I, Inc. of $327.1 million partially offset by the consent fee paid to holders of public warrants of $66.7 million and a year over year increase in redemptions of $128.2 million. Net cash provided by financing activities was $91.5 million in the 2017 Predecessor year. When compared to 2018 Predecessor year, an increase of $148.7 million was due to an expanded fund investor base to accommodate the growth of the existing Predecessor Companies and the introduction of a new Predecessor Company (BRELF IV). Off-Balance Sheet Arrangements We have no obligations, assets or liabilities, which would be considered off-balance sheet arrangements as of December 31, 2019. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. Broadmark Realty has not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets as of December 31, 2019. Broadmark Realty Capital Inc. Contractual Obligations and Commitments The following table illustrates our contractual obligations and commercial commitments by due date as of December 31, 2019 ($ in thousands): Critical Accounting Policies and Estimates 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 financial statements and the reported amounts of revenues and expenses during the reporting period.. Actual amounts could differ from those estimates. Loan Impairment and Valuation of Investments in Real Estate Because of, among other factors, the fluctuating market conditions that currently exist in the national real estate markets, and the volatility and uncertainty in the financial and credit markets, it is possible that the estimates and assumptions, most notably those related to the fair value of impaired mortgage loans and investments in real property, could change materially due to the continued volatility of the real estate and financial markets or as a result of a significant dislocation in those markets. The fair value of impaired mortgage loans and investments in real estate, is generally determined using third party appraisals, comparable sales and competitive market analyses. The valuation inputs are highly judgmental. We evaluate each loan for impairment at least quarterly. Impairment occurs when it is deemed probable that we will not be able to collect all amounts due according to the contractual terms of the loan, at which time, the loan is placed into default. If a loan is considered to be impaired, we record an allowance through the provision for loan losses to reduce the carrying value of the loan to the fair value of the collateral, as all of our loans are classified as collateral dependent as repayment is expected solely from the collateral. We regularly evaluate the extent and impact of any credit deterioration associated with the performance and/or value of the underlying collateral, as well as the financial capability of the borrower, through a personal guarantee to make this determination. Broadmark Realty Capital Inc. Income Taxes We intend to elect to be taxed as a REIT under the Code and the corresponding provisions of state law. To qualify as a REIT, we must distribute at least 90% of our annual REIT taxable income to stockholders (not including taxable income retained in our taxable subsidiaries) within the time frame set forth in the Code and we must also meet certain other requirements that relate to, among other things, assets it may hold, income it may generate and its stockholder composition. We have formed a taxable REIT subsidiary (TRS) to engage in certain activities, which, if we were to carry on such activities directly, would give rise to non-qualifying gross income for REIT compliance purposes and could jeopardize our ability to continue to be taxed as a REIT. The TRS’s activities are included in our consolidated financial statements. Taxable income generated by our TRS’s activities will be subject to income taxation, as will any REIT taxable income that we do not distribute to stockholders. The U.S. federal rate of tax imposed on income earned by a corporation is currently 21%. State income taxation may apply as well, including in states which we operate that may not recognize our REIT election for state income tax purposes. In addition, if we should fail to distribute by the end of each year at least the sum of (i) 85% of our REIT ordinary income for such year, (ii) 95% of our REIT capital gain net income for such year, and (iii) any undistributed taxable income from prior periods, we will be subject to a 4% excise tax on the excess of such required distribution over the amounts actually distributed. We also could be subject to federal taxation of 100% of the net income derived from the sale or other disposition of property, including in some cases foreclosure property, if we hold the property primarily for sale to customers in the ordinary course of a trade or business. In order to avoid 100% taxation of income or gain realized on such property, we may contribute the property to our TRS, in which case any income or gain will be subject to taxation at regular corporate rates. We believe that we do not currently hold assets for sale to customers in the ordinary course of business and that none of the assets currently held for sale or that have been sold would be considered a prohibited transaction within the REIT taxation rules. If we fail to qualify for taxation as a REIT in any taxable year, and we do not qualify for certain statutory relief provisions, we would be required to pay U.S. federal income tax on our taxable income at regular corporate rates, and distributions to our stockholders would not be deductible by us in determining our taxable income. In such a case, we might need to borrow money or sell assets in order to pay our taxes. Our payment of income tax would decrease our cash available for distribution to our stockholders. Furthermore, if we fail to maintain our qualification as a REIT, we no longer would be required to distribute substantially all of our taxable income to our stockholders. In addition, unless we were eligible for certain statutory relief provisions, we could not re-elect to qualify as a REIT until the fifth calendar year following the year in which we failed to qualify. We would also fail to qualify as a REIT in the event we were treated under applicable Treasury regulations as a successor to another REIT whose qualification as a REIT was previously terminated or revoked. If a Predecessor Company failed to qualify as a REIT prior to the Business Combination, it is possible that we would be treated as a successor REIT under the foregoing rules and thus be unable to qualify as a REIT. Recently Issued Accounting Pronouncements For a description of our adoption of new accounting pronouncements and the impact thereof on our business, see "Note 2 - Summary of Significant Accounting Policies" of our consolidated financial statements set forth in Item 8 of this Annual Report on Form 10-K. JOBS Act The JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. Broadmark Realty qualifies 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. Broadmark Realty is electing to delay the adoption of new or revised accounting standards, and as a result, Broadmark Realty 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, Broadmark Realty’s financial statements may not be comparable to companies that comply with public company effective dates. Broadmark Realty Capital Inc. Internal Control over Financial Reporting and Disclosure Control Management has identified certain material weaknesses in our internal control over financial reporting as of December 31, 2019. See Item 9A below.

<s>[INST] Broadmark Realty, a Maryland corporation, is an internally managed commercial real estate finance company that intends to elect to be taxed as a REIT for federal income tax purposes. Based in Seattle, Washington, Broadmark Realty offers shortterm, first deed of trust loans, secured by real estate to fund the construction and development of, or investment in, residential or commercial properties. Broadmark Realty operates in select states that it believes to have favorable demographic trends, and that provide more efficient and quicker access to collateral in the event of borrower default. As of December 31, 2019, Broadmark Realty’s combined portfolio of active loans had approximately $1.1 billion of principal commitments outstanding across 241 loans to over 151 borrowers in ten states and the District of Columbia, of which approximately $829.0 million was funded. Properties securing Broadmark Realty’s loans are generally classified as either residential or commercial properties, or undeveloped land, and are typically not income producing. Each loan is secured by a first mortgage lien on real estate. Broadmark Realty’s lending policy limits the amount of the loan to a maximum loantovalue (“LTV”) ratio of up to 65% of the “asis” appraised value of the underlying collateral as determined by an independent appraiser at the time of the loan origination. As of December 31, 2019, the average LTV across Broadmark Realty’s active loan portfolio was less than 59% of the most recent appraised value. In addition, each loan is also personally guaranteed on a recourse basis by the principals of the borrower, and/or others at the discretion of Broadmark Realty to further help ensure that Broadmark Realty will receive full repayment of the loan. The guaranty may be collaterally secured by a pledge of the guarantor’s interest in the borrower or other real estate or assets owned by the guarantor. Broadmark Realty’s loans typically range from $500,000 to $50 million in face value (average of $4.9 million at December 31, 2019), generally bear interest at a fixed annual rate of 10% to 13% and have initial terms typically ranging from five to twelve months in duration (which may be renewed or extended before the expiration of the loan’s term). Broadmark Realty usually receives loan origination fees, or “points,” typically ranging from 4% to 5% of the original principal amount of the loan, along with loan renewal fees, each of which varies in amount based upon the term of the loan and the quality of the borrower and the underlying real estate. In addition to loan origination fees Broadmark Realty receives late fees paid by borrowers, and/or is reimbursed by borrowers for costs associated with services provided by Broadmark Realty, such as closing costs, collection costs on defaulted loans and construction draw inspection fees. Broadmark Realty Capital Inc. In addition to the natural seasonality inherent in our business whereby winter months are less favorable to construction, restrictions related to the Business Combination decreased the amount of our loan originations for the second half of 2019 and early 2020. After August 2019, the pending Business Combination required us to essentially pause our ability to raise capital and in turn originate new loans. In the first quarter of 2020, we rebuilt our pipeline and began to strategically deploy the proceeds from the Business Combination. We believe that the launch of the Private REIT provides access to additional capital and positions us to increase originations and grow our asset base, subject to market conditions. The COVID19 coronavirus epidemic is significantly affecting the capital markets and trading markets and can be expected to impact the construction lending market, at least in the near term. A significant percentage of our loans and our headquarters are in the Seattle, Washington area, which is experiencing a major outbreak of COVID19. While we have implemented a variety of business continuity initiatives, restrictions imposed in connection with COVID19 or the impact on key employees could create significant challenges for our operations. While we have not to date experienced a material impact on our loan portfolio, the spread of COVID19 could [/INST] Negative. </s>

Oportun Financial Corp

2020-02-28

2019-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations An index to our management's discussion and analysis follows: Topic Overview Key Financial and Operating Metrics Historical Credit Performance Results of Operations Fair Value Estimate Methodology for Loans Receivable at Fair Value Non-GAAP Financial Measures Liquidity and Capital Resources Off-Balance Sheet Arrangements Critical Accounting Policies and Significant Judgments and Estimates Recently Issued Accounting Pronouncements 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 and other financial information included elsewhere in this report and the audited consolidated financial statements and the related notes and the discussion under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for the fiscal year ended December 31, 2018 included in the final prospectus for our initial public offering, dated September 25, 2019 and filed with the Securities and Exchange Commission pursuant to Rule 424(b)(4) under the Securities Act of 1933, as amended, or the Securities Act, on September 27, 2019, or our Prospectus. Some of the information contained in this discussion and analysis, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. You should review the “Risk Factors” section of this 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. Overview We are a high-growth, mission-driven provider of inclusive, affordable financial services powered by a deep, data-driven understanding of our customers and advanced proprietary technology. Our proprietary lending platform and application of machine learning to our unique alternative data set enable us to provide loans at a fraction of the price of other providers to customers who either do not have a credit history or credit score, known as credit invisibles, or who may have a limited credit history and are “mis-scored,” meaning that traditional credit scores do not properly reflect their credit worthiness. In our 14-year history, we have originated more than 3.7 million loans, representing over $8.4 billion of credit extended, to more than 1.7 million customers. A study commissioned by us and conducted by the Financial Health Network (formerly known as the Center for Financial Services Innovation) estimated that, as of December 31, 2019, our customers have saved more than $1.7 billion in aggregate interest and fees compared to alternative products available to them. Our core offering is a simple-to-understand, affordable, unsecured, fully amortizing personal installment loan with fixed payments and fixed interest rates throughout the life of the loan. Our personal loans do not have prepayment penalties or balloon payments and range in size from $300 to $10,000 with terms ranging from six to 48 months. As part of our commitment to be a responsible lender, we verify income for 100% of our personal loan customers and only make loans to customers that our ability-to-pay model indicates should be able to afford a loan after meeting their other debts and regular living expenses. We execute our sales and marketing strategy through a variety of acquisition channels including our retail locations, direct mail, broadcast and digital marketing, as well as other channels. We also benefit significantly from word-of-mouth referrals, nearly one-third of new customers in the last 12 months tell us they heard about Oportun from a friend or family member. Our omni-channel network provides our customers with flexibility to apply for a loan at one of over 335 retail locations, over the phone, or via mobile or online through our responsive web-designed origination solution. As part of our strategy, we have begun to expand beyond our core offering of unsecured installment loans into other financial services that a significant portion of our customers already use and have asked us to provide, such as auto loans and credit cards. In April 2019, we began offering direct auto loans online on a limited basis to customers in California. In November 2019, we began offering an auto refinance product enabling customers to refinance an existing secured auto loan or to consolidate an existing secured auto loan with an unsecured Oportun loan. Currently, our auto loans range from $5,000 to $35,000 with terms from 24 to 72 months. In December 2019, we launched the Oportun® Visa® Credit Card, issued by WebBank, Member FDIC as a pilot to a limited number of potential customers. To fund our growth at a low and efficient cost, we have built a diversified and well-established capital markets funding program, which allows us to partially hedge our exposure to rising interest rates by locking in our interest expense for up to three years. Over the past six years, we have executed 14 bond offerings in the asset-backed securities market, the last 11 of which include tranches that have been rated investment grade. We issued two- and three-year fixed rate bonds which have provided us committed capital to fund future loan originations at a fixed Cost of Debt. In addition to our whole loan sale program, we also have a committed three-year, $400.0 million secured line of credit, which also helps to fund our loan portfolio growth. In order to achieve our profit goals, we closely manage our operating expenses, which consist of technology and facilities, sales and marketing, personnel, outsourcing and professional fees and general, administrative and other expenses, with the goal of increasing our investment in our technology platform and development of new capabilities. We have elected the fair value option to account for all loans receivable held for investment that were originated on or after January 1, 2018, or the Fair Value Loans, and for all asset-backed notes issued on or after January 1, 2018, or the Fair Value Notes, as compared to the loans held for investment that were originated prior to January 1, 2018, or the Loans Receivable at Amortized Cost. We believe the fair value option enables us to report GAAP net income that more closely approximates our net cash flow generation and provides increased transparency into our profitability and asset quality. Loans Receivable at Amortized Cost and asset-backed notes issued prior to January 1, 2018 are accounted for in our 2018 and subsequent financial statements at amortized cost, net of reserves. Loans that we designate for sale are accounted for as held for sale and recorded at the lower of cost or fair value until the loans receivable are sold. We estimate the fair value of the Fair Value Loans using a discounted cash flow model, which considers various factors such as the price that we could sell our loans to a third party in a non-public market, credit risk, net charge-offs, customer payment rates and market conditions such as interest rates. We estimate the fair value of our Fair Value Notes based upon the prices at which our or similar asset-backed notes trade. We reevaluate the fair value of our Fair Value Loans and our Fair Value Notes at the close of each measurement period. Key Financial and Operating Metrics We monitor and evaluate the following key metrics in order to measure our current performance, develop and refine our growth strategies, and make strategic decisions. For a presentation of the actual impact of the election of the fair value option for the periods presented in the financial statements included elsewhere in this report, please see the next section, "Non-GAAP Financial Measures". The Fair Value Pro Forma information is presented in that section because it is non-GAAP presentation. The following table and related discussion set forth key financial and operating metrics for the Company's operations as of and for the years ended December 31, 2019 and 2018. For similar financial and operating metrics and discussion of the Company’s 2018 results compared to its 2017 results, refer to Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under Part I of the Company’s registration statement on Form S-1 (File No. 333-232685), which was declared effective by the SEC on September 25, 2019. (1) Credit card amounts have been excluded from these metrics for the year ended December 31, 2019 because they are de minimis. See “Glossary” at the beginning of this report for formulas and definitions of our key performance metrics. Aggregate Originations Aggregate Originations increased to $2.1 billion for the year ended December 31, 2019 from $1.8 billion for the year ended December 31, 2018, representing a 16.6% increase. The increase is primarily driven by the continued investment in marketing, increase in the average loan size, strategic growth in new retail locations, the increase in originations through our mobile platform, and a continued high percentage of returning customers who generally qualify for larger loan amounts. We originated 726,964 and 644,551 loans for the year ended December 31, 2019 and 2018, respectively, representing a 12.8% increase. Active Customers As of December 31, 2019, Active Customers increased by 14.0% from December 31, 2018 due to our strategic marketing initiatives, which continue to attract new customers and retain existing customers, the expansion of our retail footprint and the enhancement of our mobile capabilities. Customer Acquisition Cost For the year ended December 31, 2019 and 2018, our Customer Acquisition Cost was $134 and $120 respectively, an increase of 11.7%. The increase is primarily due to an increase in our retail and telesales staff and investment in testing new marketing channels like digital advertising and lead aggregators, as well as the expansion of our direct mail program. As we continue to optimize customer lifetime value, we project that our Customer Acquisition Cost may continue to increase. Managed Principal Balance at End of Period Managed Principal Balance at End of Period as of December 31, 2019 increased by 23.2% from December 31, 2018 driven by the increase in Aggregate Originations. Average Daily Principal Balance Average Daily Principal Balance increased by 26.7% from $1.3 billion for the year ended December 31, 2018 to $1.6 billion for the year ended December 31, 2019. This increase reflects an increase in the number of loans originated, which has grown 12.8% from the year ended December 31, 2018 to the same period in 2019, as well as an increase in average loan size. 30+ Day Delinquency Rate Our 30+ Day Delinquency Rate was 4.0% as of December 31, 2019 and 2018, respectively due to our ability to successfully manage credit performance. Delinquency rates converged to the prior year level as credit performance strengthened. Annualized Net Charge-Off Rate Annualized Net Charge-Off Rate for the years ended December 31, 2019 and 2018 was 8.3% and 7.4%, respectively. Net charge-offs for the year increased due to relative receivables growth and delays in the receipt of tax refunds due to the government shutdown earlier in 2019. Operating Efficiency and Adjusted Operating Efficiency For the year ended December 31, 2019 and 2018, Operating Efficiency was 60.4%, and 57.7%, respectively and Adjusted Operating Efficiency was 57.2% and 57.8%, respectively. The increase in Operating Efficiency is a result of operating expenses growing slightly faster than total revenue. The increase in operating expenses is driven by $14.3 million in investments in new products, as well as additional investments in technology, engineering, data science and public company readiness. Adjusted Operating Efficiency improved due to strong expense discipline compared to revenue and prudent capital allocation in order to permit the investments previously described. For a reconciliation of Operating Efficiency to Adjusted Operating Efficiency, see “Non-GAAP Financial Measures-Fair Value Pro Forma.” Return on Equity and Adjusted Return on Equity For the year ended December 31, 2019 and 2018, Return on Equity was 14.7% and 43.8%, respectively, and Adjusted Return on Equity was 14.9% and 13.2%, respectively. The decrease in Return on Equity is primarily due to the one-time impact related to the adoption of fair value accounting in 2018. The increase in Adjusted Return on Equity is due to improved Operating Efficiency and increased Net Revenue on a Fair Value Pro Forma basis, year over year. For a reconciliation of Return on Equity to Adjusted Return on Equity, see “Non-GAAP Financial Measures-Fair Value Pro Forma.” Historical Credit Performance In addition to monitoring our loss and delinquency performance on an owned portfolio basis, we also monitor the performance of our loans by the period in which the loan was disbursed, generally years or quarters, which we refer to as a vintage. We calculate net lifetime loan loss rate by vintage as a percentage of original principal balance. Net lifetime loan loss rates equal the net lifetime loan losses for a given year through December 31, 2019 divided by the total origination loan volume for that year. Loans are charged off no later than after becoming 120 days contractually delinquent. The below table shows our net lifetime loan loss rate for each annual vintage since we began lending in 2006. We have managed to stabilize cumulative net lifetime loan losses since the financial crisis that started in 2008. Our proprietary, centralized credit scoring model and continually evolving data analytics have enabled us to maintain consistent net lifetime loan loss rates ranging between 5.5% and 8.1% since 2009. We even achieved a net lifetime loan loss rate of 5.5% during the peak of the recession in 2009. The evolution of our credit models has allowed us to increase our average loan size and commensurately extend our average loan terms. Cumulative net lifetime loan losses for the 2015, 2016, 2017, and 2018 vintages increased partially due to the delay in tax refunds in 2017 and 2019, the impact of natural disasters such as Hurricane Harvey, and the longer duration of the loans. The chart below includes all personal loan originations by vintage, excluding loans originated under the Access Loan Program. * Vintage is not yet fully mature from a loss perspective. Results of Operations The following tables and related discussion set forth our Consolidated Statements of Operations for the years ended December 31, 2019 and 2018. For similar operating and financial data and discussion of the Company’s 2018 results compared to its 2017 results, refer to Item 7, “Management's Discussion and Analysis of Financial Condition and Results of Operations” under Part I of the Company’s registration statement on Form S-1 (File No. 333-232685), which was declared effective by the SEC on September 25, 2019. Total revenue Total Revenue. Total revenue increased by $102.6 million, or 20.6%, from $497.6 million for 2018 to $600.1 million for 2019. Interest income. Total interest income increased by $95.3 million, or 21.2%, from $448.8 million for 2018 to $544.1 million for 2019. The increase is primarily attributable to growth in our Average Daily Principal Balance, which grew from $1.3 billion for 2018 to $1.6 billion for 2019, an increase of 26.7%. This is partially offset by $8.5 million accretion of deferred origination fees related to the election of fair value accounting in 2018 and a decline in portfolio yield. Non-interest income. Total non-interest income increased by $7.2 million, or 14.8%, from $48.8 million for 2018 to $56.0 million for 2019. The increase is primarily due to a $3.6 million increase in servicing revenue from loans sold to Ellington and a $3.1 million increase in gain on sale of loans. See Note 2, Summary of Significant Accounting Policies, and Note 12, Revenue, of the Notes to the Consolidated Financial Statements included elsewhere in this report for further discussion on the Company's interest income, non-interest income and revenue. Interest expense Interest expense. Interest expense increased by $13.6 million, or 29.0%, from $46.9 million for 2018 to $60.5 million for 2019. We financed approximately 85.5% of our loans receivable through debt for 2019 as compared to 83.5% for 2018, and our Average Daily Debt Balance increased from $1.1 billion to $1.4 billion for 2019, an increase of 30.3%. While interest expense has increased in aggregate as we have grown our loans receivable, we have maintained a stable Cost of Debt as we have become a more established issuer and have been able to refinance and increase the size of our securitizations. See Note 2, Summary of Significant Accounting Policies, and Note 8, Borrowings, in the Notes to the Consolidated Financial Statements included in this report for further information on the Company's Interest expense and the Company's secured financing facility and asset-backed notes. Provision (release) for loan losses Provision (release) for loan losses represents a provision to maintain an allowance for loan losses adequate to provide for losses over the next 12 months for our Loans Receivable at Amortized Cost. Our allowance for loan losses represents our estimate of the credit losses inherent in our loans and is based on a variety of factors, including current economic conditions, our historical loan loss experience, recent trends in delinquencies and loan seasoning. There is no provision for loan losses for the Fair Value Loans because lifetime loan losses are incorporated in the measurement of fair value for loans receivable. We expect the provision for loan losses for Loans Receivable at Amortized Cost will decrease as these loans run off, assuming losses remain constant. Provision (release) for loan losses. Provision (release) for loan losses decreased by $20.6 million, or 127.8%, from $16.1 million for 2018 to $(4.5) million for 2019, mainly due to the partial liquidation of the amortized cost portfolio. The amortized cost portfolio balance at the end of 2019 is $42.5 million compared to $323.8 million at the end of 2018. Total net increase (decrease) in fair value Net increase (decrease) in fair value reflects changes in fair value of Fair Value Loans and Fair Value Notes on an aggregate basis and is based on a number of factors, including benchmark interest rates, credit spreads, remaining cumulative charge-offs and customer payment rates. Increases in the fair value of loans increase Net Revenue. Conversely, decreases in the fair value of loans decrease Net Revenue. Increases in the fair value of asset-backed notes result in a decrease of Net Revenue. Decreases in the fair value of asset-backed notes increase Net Revenue. * Not meaningful. Net increase (decrease) in fair value. Net decrease in fair value for 2019 was $97.2 million. This amount represents a total fair value mark-to-market increase of $19.7 million offset by $116.9 million of charge-offs, net of recoveries on Fair Value Loans. The total fair value mark-to-market adjustment consists of a $31.7 million mark-to-market adjustment on Fair Value Loans due to (a) a decrease in the discount rate from 9.20% as of December 31, 2018 to 7.77% as of December 31, 2019 caused by declining interest rates and credit spreads, (b) a decrease in remaining cumulative charge-offs from 10.52% as of December 31, 2018 to 9.61% as of December 31, 2019, and offset by (c) a decline in average life from 0.85 years as of December 31, 2018 to 0.81 years as of December 31, 2019 due to further seasoning of the Fair Value Loan portfolio. The $(12.0) million mark-to-market adjustment on Fair Value Notes is due to a decrease in interest rates. Charge-offs, net of recoveries * Not meaningful Charge-offs, net of recoveries. We optimized growth while maintaining an annualized net charge-off rate of 8.3% for the year ended December 31, 2019. We believe this experience indicates the strength of our proprietary credit scoring technology as well as the efficacy and scalability of our business model. Operating expenses Operating expenses consist of technology and facilities, sales and marketing, personnel, outsourcing and professional fees and general, administrative and other expenses. For Fair Value Loans, we no longer capitalize direct loan origination expenses, instead expensing them in operating expenses as incurred. For Fair Value Notes, we no longer capitalize financing expenses, instead including them within operating expenses as incurred. Technology and facilities Technology and facilities expenses are the largest component of our operating expenses, representing the costs required to build our omni-channel network, and consist of three components. The first component is comprised of costs associated with our technology, engineering, information security, cybersecurity, platform development, maintenance, and end user services, including fees for software licenses, consulting, legal and other services as a result of our efforts to grow our business, as well as personnel expenses. The second includes rent for retail and corporate locations, utilities, insurance, telephony costs, property taxes, equipment rental expenses, licenses and fees and depreciation and amortization. Lastly, this category also includes all software licenses, subscriptions, and technology service costs to support our corporate operations, excluding sales and marketing. Technology and facilities. Technology and facilities expense increased by $19.1 million, or 23.1%, from $82.8 million for 2018 to $102.0 million for 2019. As we have continued to build our omni-channel network, we have increased the number of retail locations from 312 at December 31, 2018 to 337 at December 31, 2019, an increase of 8.0%, and our headcount has grown 7.6% during the same period. We also had a $4.7 million increase in service costs related to higher usage of software and cloud services, $3.0 million increase in professional services and other related costs due to growth in staffing at our India technology service center and $2.4 million increase related to new products and services. Sales and marketing Sales and marketing expenses consist of two components and represents the costs to acquire our customers. The first component is comprised of the expense to acquire a customer through various paid marketing channels including direct mail, radio, television, digital marketing and brand marketing. The second component is the costs associated with our telesales, lead generation and retail operations, including personnel expenses, but excluding costs associated with retail locations. For Fair Value Loans, sales and marketing-related direct origination expenses are expensed when incurred. Sales and marketing. Sales and marketing expenses to acquire our customers increased by $19.5 million, or 25.2%, from $77.6 million for 2018 to $97.2 million for 2019. As we expanded our omni-channel network, we added headcount to our retail locations and telesales, leading to increased personnel-related and outsourced service costs of $10.0 million. To grow our loan originations, we increased our investment in marketing initiatives by $11.0 million across various marketing channels, including direct mail, digital advertising channels, lead aggregators, brand marketing and $1.8 million investment in new products and services. This was partially offset by a decline in dues and subscription expenses of $1.9 million. As a result of our increased marketing investment, our CAC has increased by 11.7% from 2018 to 2019. Personnel Personnel expenses represent compensation and benefits that we provide to our employees, and include salaries, wages, bonuses, commissions, related employer taxes, medical and other benefits provided and stock-based compensation expense for all of our staff with the exception of our telesales, lead generation, retail operations and technology which are included in sales and marketing expenses and technology and facilities, respectively. Personnel. Personnel expense increased by $27.4 million, or 43.2%, from $63.3 million for 2018 to $90.6 million for 2019, primarily driven by a 13.7% increase in corporate employee headcount associated with preparing to become a public company, $7.2 million due to increased stock compensation triggered by the successful completion of the IPO and $5.1 million increased investment related to new products and services. Outsourcing and professional fees Outsourcing and professional fees consist of costs for various third-party service providers and contact center operations, primarily for the sales, customer service, collections and store operation functions. Our contact centers located in Mexico and our third-party contact centers located in Colombia and Jamaica provide support for the business including application processing, verification, customer service and collections. We utilize third parties to operate the contact centers in Colombia and Jamaica and include the costs in outsourcing and other professional fees. Professional fees also include the cost of legal and audit services, credit reports, recruiting, cash transportation, collection services and fees and consultant expenses. For Fair Value Loans, direct loan origination expenses related to application processing are expensed when incurred. In addition, outsourcing and professional fees include any financing expenses, including legal and underwriting fees, related to our Fair Value Notes. Outsourcing and professional fees. Outsourcing and professional fees increased by $4.5 million, or 8.6%, from $52.7 million for 2018 to $57.2 million for 2019. The increase resulted primarily from an increased use of professional services of $4.5 million to support public company readiness, a $2.9 million increase in spending on risk analytics, outsourcing costs of $2.5 million in part to increase our usage of offshore service centers, an increase in legal costs of $2.0 million and $1.4 million of expenses related to new products and services. These increases were partially offset by a $6.1 million decrease in debt financing fees as we executed four offerings of asset-backed notes in 2018 compared to one offering of asset-backed notes in 2019. General, administrative and other General, administrative and other expenses include non-compensation expenses for employees, who are not a part of the technology and sales and marketing organization, which include travel, lodging, meal expenses, office supplies, printing and shipping. Also included are franchise taxes, bank fees, foreign currency gains and losses, transaction gains and losses, debit card expenses and litigation reserve. General, administrative and other. General, administrative and other expense increased by $4.6 million, or 42.1%, from $10.8 million for 2018 to $15.4 million for 2019, primarily due to increases in travel expenses, postage and shipping expenses, and other general and administrative expenses due to new products and services and continuing growth of the business. Income taxes Income taxes consist of U.S. federal, state and foreign income taxes, if any. For the years ended December 31, 2019 and 2018 we recognized tax expense attributable to U.S. federal, state and Mexico income taxes. Income tax expense. Income tax expense decreased by $23.9 million or 51.1%, from $46.7 million for 2018 to $22.8 million for 2019, primarily as a result of higher pretax income for 2018 due to the one-time impact of our election of the fair value option for Fair Value Loans and Fair Value Notes. See Note 2, Summary of Significant Accounting Policies, and Note 13, Income Taxes, of the Notes to the Consolidated Financial Statements included elsewhere in this report for further discussion on the Company's income taxes. Fair Value Estimate Methodology for Loans Receivable at Fair Value Election of Fair Value Option We have elected the fair value option to account for loans held for investment and asset-backed notes effective as of January 1, 2018. We believe the fair value option for loans held for investment and asset-backed notes is a better fit for us given our high growth, short duration, high quality assets and funding structure. As compared to the loans held for investment that were originated prior to January 1, 2018, or Loans Receivable at Amortized Cost, we believe the fair value option enables us to report GAAP net income that more closely approximates our net cash flow generation and provides increased transparency into our profitability and asset quality. Loans Receivable at Amortized Cost and asset-backed notes issued prior to January 1, 2018 are accounted for in our 2018 and 2019 financial statements at amortized cost, net. Upon adoption of ASU 2019-05, effective January 1, 2020, the Company will elect the fair value option on all remaining loans receivable currently recorded at amortized cost. Upon adoption of ASU 2019-05, the Company will (i) release the remaining allowance for loan losses on Loan Receivables at Amortized Cost; (ii) recognize the unamortized net originations fee income; and (iii) measure the remaining loans originated prior to January 1, 2018 at fair value. Loans that we designate for sale will continue to be accounted for as held for sale and recorded at the lower of cost or fair value until the loans are sold. Summary Fair value is an electable option under GAAP to account for any financial instruments, including loans receivable and debt. It differs from amortized cost accounting in that loans receivable and debt are recorded on the balance sheet at fair value rather than on a cost basis. Under the fair value option credit losses are recognized through income as they are incurred rather than through the establishment of an allowance and provision for losses. The fair value of instruments under this election is updated at the end of each reporting period, with changes since the prior reporting period reflected in the Consolidated Statements of Operations and Comprehensive Income as net increase (decrease) in fair value which impacts Net Revenue. Changes in interest rates, credit spreads, realized and projected credit losses and cash flow timing will lead to changes in fair value and therefore impact earnings. These changes in the fair value of the Fair Value Loans may be partially offset by changes in the fair value of the Fair Value Notes, depending upon the relative duration of the instruments. Comparison of Fair Value and Amortized Cost Accounting The primary differences between fair value and amortized cost accounting are: • Loans and notes are recorded at their fair value, not their principal balance or cost basis; • The fair value of the loans takes into consideration net charge-offs for the remaining life of the loans, thus no separate allowance for loan loss is required; • Upfront fees and expenses of loans and notes are no longer deferred but recognized at origination in income or expense, respectively; • Changes in the fair value of loans and notes impact Net Revenue; and • Net charge-offs are recognized as they occur as part of the change in fair value for loans. Fair Value Estimate Methodology for Loans Receivable at Fair Value We calculate the fair value of Fair Value Loans using a model that projects and discounts expected cash flows. The fair value is a function of: • Portfolio yield; • Average life; • Prepayments; • Remaining cumulative charge-offs; and • Discount rate. Portfolio yield is the expected interest and fees collected from the loans as an annualized percentage of outstanding principal balance. Portfolio yield is based upon (a) the contractual interest rate, reduced by expected delinquencies and interest charge-offs and (b) late fees, net of late fee charge-offs based upon expected delinquencies. Origination fees are not included in portfolio yield since they are generally capitalized as part of the loan’s principal balance at origination. Average life is the time-weighted average of expected principal payments divided by outstanding principal balance. The timing of principal payments is based upon the contractual amortization of loans, adjusted for the impact of prepayments, Good Customer Program refinances, and charge-offs. Prepayments are the expected remaining cumulative principal payments that will be repaid earlier than contractually required over the life of the loan, divided by the outstanding principal balance. Remaining cumulative charge-offs is the expected net principal charge-offs over the remaining life of the loans, divided by the outstanding principal balance. Discount rate is the sum of the interest rate and the credit spread. The interest rate is based upon the interpolated LIBOR/swap curve rate that corresponds to the average life. The credit spread is based upon the credit spread implied by the whole loan purchase price at the time the flow sale agreement was entered into, updated for changes in credit spreads on our Fair Value Notes, which serve as a proxy for how a whole loan buyer would adjust their yield requirements relative to the originally agreed price. It is also possible to estimate the fair value of our loans using a simplified calculation. The table below illustrates a simplified calculation to aid investors in understanding how fair value may be estimated using the last eight quarters: • Subtracting the servicing fee from the weighted average portfolio yield over the remaining life of the loans to calculate net portfolio yield; • Multiplying the net portfolio yield by the weighted average life in years of the loans receivable, which is based upon the contractual amortization of the loans and expected remaining prepayments and charge-offs to calculate net cash flow; • Subtracting the remaining cumulative charge-offs from the net portfolio yield to calculate the net cash flow; • Subtracting the product of the discount rate and the average life from the net cash flow to calculate the gross fair value premium as a percentage of loan principal balance; and • Subtracting the accrued interest and fees as a percentage of loan principal balance from the gross fair value premium as a percentage of loan principal balance to calculate the fair value premium as a percentage of loan principal balance. The table below reflects the application of this methodology for the eight quarters since the election of the fair value option on January 1, 2018: The table below reflects the application of this methodology for eight quarters under Fair Value Pro Forma as if we had elected the fair value option since inception: The illustrative tables included above are designed to assist investors in understanding the impact of our election of the fair value option. For a presentation of the actual impact of the election of the fair value option for the periods presented in the financial statements included elsewhere in this report, please see the next section, “Non-GAAP Financial Measures.” The Fair Value Pro Forma information is presented in that section because they are non-GAAP presentations, as they show the impact of Fair Value Pro Forma adjustment for periods that before January 1, 2018. Sensitivity to Key Drivers Credit Performance Sensitivity Increases in expected future charge-offs will decrease expected cash flow and decrease fair value of the loans. Conversely, decreases in expected future charge-offs will increase expected cash flow and increase fair value of the loans. The following table presents estimates at December 31, 2019 under Fair Value Pro Forma as if we had elected the fair value option since inception: The following table presents estimates at December 31, 2018 under Fair Value Pro Forma as if we had elected the fair value option since inception: Interest Rate Sensitivity Changes in benchmark interest rates are likely to impact the discount rate the market uses to value our loans and notes. Decreases in discount rate increase the fair value of the loans and notes and increases in the discount rate decrease the fair value of the loans and notes. The amount of change for the notes is greater because they have a longer average life (1.3 years on average) than the loans (0.80 years). Because an increase in the fair value of a liability is a net decrease in fair value, if the discount rate decreases for both the loans and notes then Net Revenue will be reduced; and if the discount rate increases for both, then Net Revenue will be increased. Given the differences in average life between the loans and the debt, if the yield or spread curves experience a change in slope rather than vertical shift, then the fair value of the loans and notes will change independently. This occurred in, for example, the year ended December 31, 2018 when the yield curve inverted, and the discount rate increased for the Fair Value Loans and decreased for the Fair Value Notes. In the year ended December 31, 2019, the discount rate of the Fair Value Loans fell more than the discount rate for the Fair Value Notes. While the interest rate curve may twist, we believe credit spreads are more likely to shift vertically, albeit the magnitude of the shift for loans may be greater than debt since the debt cash flows are the senior portion of the loan cash flows. The following table presents estimates at December 31, 2019 under Fair Value Pro Forma as if we had elected the fair value option since inception: The following table presents estimates at December 31, 2018 under Fair Value Pro Forma as if we had elected the fair value option since inception: Prepayment Sensitivity Increases in prepayments will decrease the average life and thus decrease the fair value of the loans. Conversely, decreases in prepayments will increase the average life of the loans and thus increase the fair value of the loans. The following table presents estimates at December 31, 2019 under Fair Value Pro Forma as if we had elected the fair value option since inception: The following table presents estimates at December 31, 2018 under Fair Value Pro Forma as if we had elected the fair value option since inception: Drivers of Fair Value for Fair Value Notes The fair value of Fair Value Notes is set based upon marks provided by a third-party marking service, which either uses prices at which our Fair Value Notes or similar securities traded. Debt investors trade a bond based upon the interpolated swap curve rate that corresponds to the bond’s average life plus a credit spread (the bond yield or discount rate). For an analysis of the effects of changes in Interest Rates, Remaining Cumulative Charge-offs, and Remaining Cumulative Prepayments on GAAP financial information, see

<s>[INST] Topic Overview Key Financial and Operating Metrics Historical Credit Performance Results of Operations Fair Value Estimate Methodology for Loans Receivable at Fair Value NonGAAP Financial Measures Liquidity and Capital Resources OffBalance Sheet Arrangements Critical Accounting Policies and Significant Judgments and Estimates Recently Issued Accounting Pronouncements 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 and other financial information included elsewhere in this report and the audited consolidated financial statements and the related notes and the discussion under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for the fiscal year ended December 31, 2018 included in the final prospectus for our initial public offering, dated September 25, 2019 and filed with the Securities and Exchange Commission pursuant to Rule 424(b)(4) under the Securities Act of 1933, as amended, or the Securities Act, on September 27, 2019, or our Prospectus. Some of the information contained in this discussion and analysis, including information with respect to our plans and strategy for our business, includes forwardlooking statements that involve risks and uncertainties. You should review the “Risk Factors” section of this 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. Overview We are a highgrowth, missiondriven provider of inclusive, affordable financial services powered by a deep, datadriven understanding of our customers and advanced proprietary technology. Our proprietary lending platform and application of machine learning to our unique alternative data set enable us to provide loans at a fraction of the price of other providers to customers who either do not have a credit history or credit score, known as credit invisibles, or who may have a limited credit history and are “misscored,” meaning that traditional credit scores do not properly reflect their credit worthiness. In our 14year history, we have originated more than 3.7 million loans, representing over $8.4 billion of credit extended, to more than 1.7 million customers. A study commissioned by us and conducted by the Financial Health Network (formerly known as the Center for Financial Services Innovation) estimated that, as of December 31, 2019, our customers have saved more than $1.7 billion in aggregate interest and fees compared to alternative products available to them. Our core offering is a simpletounderstand, affordable, unsecured, fully amortizing personal installment loan with fixed payments and fixed interest rates throughout the life of the loan. Our personal loans do not have prepayment penalties or balloon payments and range in size from $300 to $10,000 with terms ranging from six to 48 months. As part of our commitment to be a responsible lender, we verify income for 100% of our personal loan customers and only make loans to customers that our abilitytopay model indicates should be able to afford a loan after meeting their other debts and regular living expenses. We execute our sales and marketing strategy through a variety of acquisition channels including our retail locations, direct mail, broadcast and digital marketing, as well as other channels. We also benefit significantly from wordofmouth referrals, nearly onethird of new customers in the last 12 months tell us they heard about Oportun from a friend or family member. Our omnichannel network provides our customers with flexibility to apply for a loan at one of over 335 retail locations, over the phone, or via mobile or online through our responsive webdesigned origination solution. As part of our strategy, we have begun to expand beyond our core offering of unsecured installment loans into other financial services that a significant portion of our customers already use and have asked us to provide, such as auto loans and credit cards. In April 2019, we began offering direct auto loans online on a limited basis to customers in California. In November 2019, we began offering an auto refinance product enabling customers to refinance an existing secured auto loan or to consolidate an existing secured auto [/INST] Positive. </s>

Trine Acquisition Corp.

2020-03-26

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 formed under the laws of the State of Delaware on September 26, 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 Private Placement Warrants 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 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 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, 2019 were organizational activities and those necessary to prepare for the Initial Public Offering, described below, and, after our Initial Public Offering, 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 are incurring 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 $2,729,032, which consisted of interest income on marketable securities held in the Trust Account of $5,142,140 and an unrealized gain on marketable securities held in our Trust Account of $169,784, offset by operating costs of $1,856,857 and a provision for income taxes of $726,035. For the period from September 28, 2018 (inception) through December 31, 2018, we had net loss of $43,693, which consisted of operating costs. Liquidity and Capital Resources On March 19, 2019, we consummated the Initial Public Offering of 26,100,000 Units at a price of $10.00 per Unit, generating gross proceeds of $261,000,000. Simultaneously with the closing of the Initial Public Offering, we consummated the sale of 7,720,000 Private Placement Warrants to the Sponsor at a price of $1.00 per warrant, generating gross proceeds of $7,720,000. On March 29, 2019, in connection with the underwriters’ election to fully exercise of their over-allotment option, we consummated the sale of an additional 3,915,000 Units and the sale of an additional 783,000 Private Placement Warrants, generating total gross proceeds of $39,933,000. Following the Initial Public Offering, the exercise of the over-allotment option and the sale of the Private Placement Warrants, a total of $300,150,000 was placed in the Trust Account. We incurred $17,082,640 in transaction costs, including $6,003,000 of underwriting fees, $10,505,250 of deferred underwriting fees and $574,390 of other offering costs. For the year ended December 31, 2019, cash used in operating activities was $2,697,806, which was comprised on our net income of $2,729,032, interest earned on marketable securities held in the Trust Account of $5,142,140, an unrealized gain on marketable securities held in our Trust Account of $169,784, a deferred income tax provision of $35,655 and changes in operating assets and liabilities, which used $150,569 of cash from operating activities. For the period from September 26, 2018 (inception) through December 31, 2018, cash used in operating activities was $47,271, which was comprised on our net loss of $43,693 and changes in operating assets and liabilities, which used $3,578 of cash from operating activities. As of December 31, 2019, we had marketable securities held in the Trust Account of $304,528,924 (including approximately $4,379,000 of interest income and unrealized gains) consisting of cash and U.S. Treasury Bills with a maturity of 180 days or less. Interest income on the balance in the Trust Account may be used by us to pay taxes. Through December 31, 2019, we withdrew $933,000 of interest earned on the Trust Account to pay income taxes. 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. At December 31, 2019, we had cash of $138,533 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. On February 24, 2020, we issued a Note in the principal amount of up to $1,500,000 to our Sponsor. The Note bears no interest and is repayable in full upon consummation of our initial business combination. The Sponsor has the option to convert any unpaid balance of the Note into Working Capital Warrants equal to the principal amount of the Note so converted divided by $1.00. The terms of any such Working Capital Warrants will be identical to the terms of the Private Placement Warrants. If we complete a Business Combination, we would repay such loaned amounts to the extent they are not converted into Working Capital Warrants. 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. 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 did not have any off-balance sheet arrangements as of December 31, 2019. 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 $35,000 for office space, utilities and secretarial and administrative support. We began incurring these fees on March 14, 2019 and will continue to incur these fees monthly until the earlier of the completion of the Business Combination and the Company’s liquidation. The underwriters are entitled to a deferred fee of $0.35 per Unit, or $10,505,250 in the aggregate. The deferred fee will become payable to the underwriters from the amounts held in the Trust Account solely in the event we complete an Initial Business Combination. If we do not complete an Initial Business Combination and subsequently liquidate, the trustee and the underwriters have agreed that (i) they will forfeit any rights or claims to their deferred underwriting discounts and commissions, including any accrued interest thereon, then in the Trust Account upon liquidation, and (ii) that the deferred underwriters’ discounts and commissions will be distributed on a pro rata basis, including interest earned on the funds held in the Trust Account and not previously released to us to pay taxes to the public stockholders. 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 standards Management does not believe that any other recently issued, but not yet effective, accounting pronouncements, 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 formed under the laws of the State of Delaware on September 26, 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 Private Placement Warrants 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 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 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 [/INST] Negative. </s>

Chardan Healthcare Acquisition Corp.

2019-08-21

2019-06-30

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. Recent Developments On July 16, 2019, we entered into the Merger Agreement with BiomX and Merger Sub, pursuant to which Merger Sub will merge with and into BiomX, with BiomX surviving as our wholly-owned subsidiary. As a result of the Merger, subject to reduction for indemnification claims as described below, an aggregate of 16,625,000 shares of CHAC common stock will be issued (or reserved for issuance pursuant to currently exercisable options or warrants) in respect of shares of BiomX capital stock that are issued and outstanding as of immediately prior to the effective time of the Merger and options and warrants to purchase shares of BiomX capital stock, in each case, that are issued, outstanding and vested as of immediately prior to the effective time of the Merger. Additional shares of CHAC common stock will be reserved for issuance in respect of options to purchase shares of BiomX capital stock that are issued, outstanding and unvested as of immediately prior to the effective time of the Merger. Overview We were formed on November 1, 2017 as a blank check company 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. Our efforts to identify a prospective target business will not be limited to any particular industry or geographic location, although we intend to focus on targets located in North American in the healthcare industry. We presently have no revenue, have had losses since inception from incurring formation costs and have had no operations other than the active solicitation of a target business with which to complete a business combination. We have relied upon the sale of our securities and loans from our officers and directors to fund our operations. On December 18, 2018, we consummated our initial public offering (“IPO”) of 7,000,000 units (the “Units”). Each Unit consists of one share of common stock (the “Common Stock”) and one redeemable warrant to purchase one-half of one share of common stock (the “Public Warrants”). The Units were sold at an offering price of $10.00 per Unit, generating gross proceeds of $70,000,000. The Company granted the underwriters a 45-day option to purchase up to 1,050,000 additional Units to cover over-allotments, if any. The over-allotment option expired unexercised on February 4, 2019. On December 18, 2018, simultaneously with the consummation of the IPO, we consummated the private placement (“Private Placement”) with Mountain Wood, LLC, an affiliate of our Sponsor, of 2,900,000 warrants (the “Private Warrants”) at a price of $0.40 per Private Warrant, generating total proceeds of $1,160,000. The Private Warrants are identical to the Warrants sold in the IPO, except that the Private Warrants (i) may be exercised on a cashless basis at the holder’s option, (ii) will not be redeemable by the Company, in each case as long as they are held by our Sponsor or its permitted transferees, and (iii) are exercisable for one share of Common Stock at an exercise price of $11.50 per share. Additionally, the Private Warrants are exercisable on a cashless basis and are non-redeemable so long as they are held by the initial purchasers or their permitted transferees. Additionally, our Mountain Wood, LLC agreed not to transfer, assign or sell any of the Private Warrants or underlying securities (except in limited circumstances, as described in the registration statement relating to the IPO) until the completion of the Company’s initial business combination. Mountain Wood, LLC was granted certain demand and piggyback registration rights in connection with the Private Warrants. A total of $70,000,000 of the net proceeds from the sale of Units in the IPO and the private placement on December 18, 2018 were placed in a trust account established for the benefit of the Company’s public stockholders at Morgan Stanley maintained by Continental Stock Transfer & Trust Company, acting as trustee. None of the funds held in trust will be released from the trust account, other than interest income to pay any tax obligations, until the earlier of (i) the consummation of the Company’s initial business combination and (ii) the Company’s failure to consummate a business combination by December 18, 2020. Our management has broad discretion with respect to the specific application of the net proceeds of IPO and the Private Placements, although substantially all of the net proceeds are intended to be applied generally towards consummating a business combination. Results of Operations Our entire activity from inception up to December 18, 2018 was related to the Company’s formation, the IPO and general and administrative activities. Since the IPO, our activity has been limited to the evaluation of business combination candidates, and we will not be generating any operating revenues until the closing and completion of our initial business combination. We generate non-operating income in the form of interest income on marketable securities held in the trust account. We are incurring 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 June 30, 2019, we had net income of $347,407, which consisted of interest income on marketable securities held in the trust account of $886,972 and interest income from mutual funds of $5,974, offset by operating costs of $404,521, an unrealized loss on marketable securities held in our trust account of $5,821 and a provision for income taxes of $135,197. For the period from November 1, 2017 (inception) through ended June 30, 2018, we had a net loss of $1,025, which consisted of operating costs of $1,025. Liquidity and Capital Resources As of June 30, 2019, we had marketable securities held in the trust account of $70,881,151 (including approximately $881,000 of interest income, net of unrealized losses) consisting of U.S. Treasury Bills with a maturity of 180 days or less. Interest income on the balance in the trust account may be used by us to pay taxes. Through June 30, 2019, we did not withdraw any interest earned on the Trust Account. For the year ended June 30, 2019, cash and cash equivalents used in operating activities was $204,579. Net income of $347,407 was affected by interest earned on marketable securities held in the trust account of $886,972, an unrealized loss on marketable securities held in our trust account of $5,821 and a deferred tax benefit of $1,222. Changes in our operating assets and liabilities provided $330,387 of cash and cash equivalents for operating activities. For the period from November 1, 2017 (inception) through June 30, 2018, cash and cash equivalents used in operating activities was $25. Net loss of $1,025 was offset by changes in our operating assets and liabilities, which provided $1,000 of cash and cash equivalents. We intend to use substantially all of the net proceeds of the IPO, including the funds held in the trust account, to acquire a target business or businesses and to pay our expenses relating thereto. To the extent that the proceeds of the IPO are used in whole or in part as consideration to effect our initial business combination, the remaining proceeds held in the trust account as well as any other net proceeds not expended will be used as working capital to finance the operations of the target business. Such working capital funds could be used in a variety of ways including continuing or expanding the target business’ operations, for strategic acquisitions and for marketing, research and development of existing or new products. Such funds could also be used to repay any operating expenses or finders’ fees which we had incurred prior to the completion of our initial business combination if the funds available to us outside of the trust account were insufficient to cover such expenses. As of June 30, 2019, we had cash and cash equivalents outside our trust account of $696,830, available for working capital needs. We intend to use the funds held outside the trust account primarily to identify and evaluate prospective acquisition candidates, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses, review corporate documents and material agreements of prospective target businesses, select the target business to acquire and structure, negotiate and complete a business combination. Our Sponsor paid a total of $500,000 in underwriting discounts and commissions and received a non-interest bearing promissory note in exchange for the payment of such amount, which was payable at the closing of a Business Combination. The promissory note was repaid in July 2019. In August 2019, the Sponsor committed to provide us an aggregate of $500,000 in loans to finance transaction costs in connection with a Business Combination. To the extent advanced, the loans will be evidenced by a promissory note, will be non-interest bearing, unsecured and will only be repaid upon the completion of a Business Combination. 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 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 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. 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 As of June 30, 2019, we did not have any off-balance sheet 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 entered into any non-financial assets. Contractual Obligations At June 30, 2019, we did not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities. 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 consolidated 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 standards 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] Recent Developments On July 16, 2019, we entered into the Merger Agreement with BiomX and Merger Sub, pursuant to which Merger Sub will merge with and into BiomX, with BiomX surviving as our whollyowned subsidiary. As a result of the Merger, subject to reduction for indemnification claims as described below, an aggregate of 16,625,000 shares of CHAC common stock will be issued (or reserved for issuance pursuant to currently exercisable options or warrants) in respect of shares of BiomX capital stock that are issued and outstanding as of immediately prior to the effective time of the Merger and options and warrants to purchase shares of BiomX capital stock, in each case, that are issued, outstanding and vested as of immediately prior to the effective time of the Merger. Additional shares of CHAC common stock will be reserved for issuance in respect of options to purchase shares of BiomX capital stock that are issued, outstanding and unvested as of immediately prior to the effective time of the Merger. Overview We were formed on November 1, 2017 as a blank check company 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. Our efforts to identify a prospective target business will not be limited to any particular industry or geographic location, although we intend to focus on targets located in North American in the healthcare industry. We presently have no revenue, have had losses since inception from incurring formation costs and have had no operations other than the active solicitation of a target business with which to complete a business combination. We have relied upon the sale of our securities and loans from our officers and directors to fund our operations. On December 18, 2018, we consummated our initial public offering (“IPO”) of 7,000,000 units (the “Units”). Each Unit consists of one share of common stock (the “Common Stock”) and one redeemable warrant to purchase onehalf of one share of common stock (the “Public Warrants”). The Units were sold at an offering price of $10.00 per Unit, generating gross proceeds of $70,000,000. The Company granted the underwriters a 45day option to purchase up to 1,050,000 additional Units to cover overallotments, if any. The overallotment option expired unexercised on February 4, 2019. On December 18, 2018, simultaneously with the consummation of the IPO, we consummated the private placement (“Private Placement”) with Mountain Wood, LLC, an affiliate of our Sponsor, of 2,900,000 warrants (the “Private Warrants”) at a price of $0.40 per Private Warrant, generating total proceeds of $1,160,000. The Private Warrants are identical to the Warrants sold in the IPO, except that the Private Warrants (i) may be exercised on a cashless basis at the holder’s option, (ii) will not be redeemable by the Company, in each case as long as they are held by our Sponsor or its permitted transferees, and (iii) are exercisable for one share of Common Stock at an exercise price of $11.50 per share. Additionally, the Private Warrants are exercisable on a cashless basis and are nonredeemable so long as they are held by the initial purchasers or their permitted transferees. Additionally, our Mountain Wood, LLC agreed not to transfer, assign or sell any of the Private Warrants or underlying securities (except in limited circumstances, as described in the registration statement relating to the IPO) until the completion of the Company’s initial business combination. Mountain Wood, LLC was granted certain demand and piggyback registration rights in connection with the Private Warrants. A total of $70,000,000 of the net proceeds from the sale of Units in the IPO and the private placement on December 18, 2018 were placed in a trust account established for the benefit [/INST] Negative. </s>

BiomX Inc.

2020-03-26

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 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. Our actual results may differ materially from those discussed in any forward-looking statement because of various factors, including those described in the sections titled “Cautionary Statements Regarding Forward-Looking Statements” and “Risk Factors” in this Annual Report. BiomX is a clinical stage microbiome product discovery company developing products using both natural and engineered phage technologies designed to target and destroy bacteria that affect the appearance of skin, as well as harmful bacteria in chronic diseases, such as IBD, liver disease and cancer. Bacteriophage or phage are viruses that target bacteria and are considered inert to mammalian cells. By developing proprietary combinations of naturally occurring phage and by creating novel phage using synthetic biology, BiomX develops phage-based therapies intended to address large-market and orphan diseases. Since inception in 2015, BiomX has devoted substantially all its resources to organizing and staffing its company, raising capital, acquiring rights to or discovering product candidates, developing its technology platforms, securing related intellectual property rights, and conducting discovery, research and development activities for its product candidates. It does not have any products approved for sale, its products are still in the preclinical development stage, and it has not generated any revenue from product sales. As BiomX moves its product candidates from preclinical to clinical stage, it expects its expenses to increase. To date, BiomX has funded its operations with proceeds from sales of common and preferred shares. Through December 31, 2019, BiomX had received gross proceeds of approximately $60.1 million from sales of its common and preferred shares. To date, BiomX received approximately $224 thousand from its collaboration agreements and recorded a reduction from research and development expenses of $167 thousand during the year ended December 31, 2019. Additional cash amounting to approximately $60 million was obtained by BiomX from the Business Combination. Since inception, BiomX has incurred significant operating losses. BiomX’s ability to generate product revenue sufficient to achieve profitability will depend on the successful development of, the receipt of regulatory approval for, and eventual commercialization of one or more of BiomX’s product candidates. Our net losses were approximately $20.6 million and $12.7 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $44.6 million and expect that for the foreseeable future we will continue to incur significant expenses as BiomX advances its product candidates from discovery through preclinical development and clinical trials and seek regulatory approval of its product candidates. In addition, if BiomX obtains regulatory approval for any of its product candidates, we would expect to incur significant commercialization expenses related to product manufacturing, marketing, sales and distribution. We may also incur expenses in connection with in-licensing or acquiring additional product candidates. In November 2017, BiomX entered into a share purchase agreement to acquire all of the outstanding share capital of RondinX Ltd., a company organized under the laws of Israel. We may incur expenses in the future in connection with similar 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. We anticipate that our general and administrative expenses will increase as a result of the completion of the Business Combination because of the increased costs associated with being a public company, including significant legal, accounting, investor relations and other expenses that we did not incur as a private company. 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. At December 31, 2019, we had cash and cash equivalents and short-term deposits of $82.2 million. We believe that our existing cash and cash equivalents and short-term deposits will enable us to fund our operating expenses and capital expenditure requirements for at least the next 24 months, as discussed further below under “ - Liquidity and Capital Resources” Accounting Treatment The Business Combination was treated as a “reverse merger” in accordance with GAAP. For accounting purposes, BiomX was considered to have acquired the Company. Therefore, for accounting purposes, the Business Combination was treated as the equivalent of a capital transaction in which BiomX issued stock for the net assets of the Company. The net assets of the Company were stated at historical cost, with no goodwill or other intangible assets recorded. The post-acquisition financial statements of the Company had shown the consolidated balances and transactions of the Company and BiomX as well as comparative financial information of BiomX (the acquirer for accounting purposes). Change in Fiscal Year End In November 2019, after the Business Combination, we elected to change our fiscal year end from June 30 to December 31. Our 2018 fiscal year consists of the year ended December 31, 2018, and our 2019 fiscal year consists of the year ended December 31, 2019. In view of this change, this Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” (“MD&A”) includes a discussion and analysis of our financial statements for fiscal years ended December 31, 2019 and 2018. Components of Our Consolidated Results of Operations Revenue To date, we have not generated any revenue from product sales and do not expect to generate any revenue from product sales in the near future. If development efforts for our product candidates are successful and result in any necessary regulatory approvals or otherwise lead to any commercialized products or additional license agreements with third parties, we may generate revenue in the future from product sales. Operating Expenses Research and Development Expenses, net 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, offset by IIA grants. These expenses include: ● license maintenance fees and milestone fees incurred in connection with various license agreements; ● expenses incurred under agreements with CROs, 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; ● employee-related expenses, including salaries, related benefits, travel and share-based compensation expenses for employees engaged in research and development functions, as well as external costs, such as fees paid to outside consultants engaged in such activities; ● costs related to compliance with regulatory requirements; and ● depreciation and other expenses. 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. 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: Research and development activities are central to our business. 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 share-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. General and Administrative Expenses General and administrative expenses consist primarily of salaries, related benefits, travel and share-based compensation expenses 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, directors’ and officers’ 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 expenses as a result of our preparation for commercial operations, especially as it relates to the sales and marketing of our product candidate. Financial expenses, net Financial expenses, net consist primarily of income or expenses related to revaluation of foreign currencies and interest income on our bank deposits. 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: Research and development expenses were $13.5 million for the year ended December 31, 2019, compared to $9.1 million for the year ended December 31, 2018. The increase of $4.4 million, or 48%, in the year ended December 31, 2019 compared to the prior year, is primarily due to the manufacturing of BX001 and BX002, the Company’s product candidates for acne prone skin, and IBD, respectively, and due to initiation of the BX001 clinical study. General and administrative expenses were $8.7 million for the year ended December 31, 2019, compared to $3.4 million for the year ended December 31, 2018. The increase of $5.3 million, or 156%, is primarily due to expenses related to the Business Combination and construction of the in-house manufacturing facility. Liquidity and Capital Resources Since 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 our common and preferred shares, and through the Business Combination. Through December 31, 2019, we had received gross cash proceeds of approximately $60 million from sales of our common and preferred shares. In addition, in 2018 and 2019 we received approximately $175 thousand and $ 945 thousand from our collaboration agreements and grants from the IIA, 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: Net cash used in operating activities for the year ended December 31, 2019 included our net loss of $20.6 million, net cash used by changes in our operating assets and liabilities of $2 million and non-cash charges of $0.9 million, which included share-based compensation expenses of $0.9 million and depreciation of $0.3 million, offset by non-cash revaluation of contingent liabilities expenses of $0.3 million. Net changes in our operating assets and liabilities for the year ended December 31, 2019 consisted primarily of an increase in trade account payables of $3 million, increase in other account payables of $0.8 million and increase in operation leasing liability of $0.1 million, offset by an increase of $1.8 million in other receivables and a decrease of $0.1 million in related parties. Net cash used in operating activities for the year ended December 31, 2018 included our net loss of $12.7 million, net cash used by changes in our operating assets and liabilities of $0.4 million and non-cash charges of $1 million, which included share-based compensation expenses of $1.0 million and depreciation of $0.2 million, offset by non-cash revaluation of contingent liabilities expenses of $0.1 million. Net changes in our operating assets and liabilities for the year ended December 31, 2018 consisted primarily of an increase in other account payables of $0.4 million and a decrease of $0.2 million in other receivables, offset by a decrease of $0.2 million in trade account payables. Investing Activities During the year ended December 31, 2019, net cash provided by investing activities was $19.7 million, mainly as a result of decrease in investment in short-term deposits of $21.0 million and purchase of property and equipment of $1.3 million, which consisted primarily of investment in laboratory equipment and leasehold improvements. During the year ended December 31, 2018, net cash used by investing activities was $30.0 million, mainly as a result of investment in short-term deposits of $29.9 million and purchases of property and equipment of $0.1 million, which consisted primarily of laboratory and office equipment. Financing Activities During the year ended December 31, 2019, net cash provided by financing activities was $61.6 million, consisting of $59.7 million due to the reverse recapitalization, $1.8 million from issuance of shares and $ 0.1 million from exercise of stock options. During the year ended December 31, 2018, net cash provided by financing activities was $43.0 million, consisting of net proceeds from the sale of our Series A Preferred Shares in February 2018 and the sale of our Series B Preferred Shares in November and December 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. In addition, we expect to incur additional costs associated with operating as the subsidiary of a public company. Our expenses will also increase as BiomX: ● continues the development of its product candidates, including its lead product candidate, BX001; ● completes IND-enabling activities and prepares to initiate clinical trials for BiomX’s other product candidates; ● initiates additional clinical trials and preclinical studies for BiomX’s product candidates in its pipeline; ● seeks to identify and develop or in-license or acquire additional product candidates and technologies; ● seeks regulatory approvals for BiomX’s product candidates that successfully complete clinical trials, if any; ● establishes a sales, marketing and distribution infrastructure to commercialize any product candidates for which it may obtain regulatory approval; ● hires and retains additional personnel, such as clinical, quality control, commercial and scientific personnel; and ● expands BiomX’s infrastructure and facilities to accommodate its growing employee base, including adding equipment and physical infrastructure to support its research and development. We believe that our existing cash and cash equivalents, together with our existing resources, which include approximately $60 million we obtained from the Business Combination, will enable us to fund our operating expenses and capital expenditure requirements for at least the next 24 months. 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 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 the sales of our securities, milestone payments and other outside funding sources. 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 by ourselves. Critical Accounting Policies and Significant Judgments and Estimates Our consolidated financial statements are prepared in accordance with GAAP. 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, 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. Share-Based Compensation We apply ASC 718-10, “Share-Based Payment,” which requires the measurement and recognition of compensation expenses for all share-based payment awards made to employees and directors, including employee stock options under our stock plans based on estimated fair values. ASC 718-10 requires that we estimate the fair value of equity-based payment awards on the date of grant using an option-pricing model. The fair value of the award is recognized as an expense over the requisite service periods in our statements of comprehensive loss. We recognize share-based award forfeitures as they occur, rather than estimate by applying a forfeiture rate. In June 2018, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2018-07, “Compensation-Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting,” which simplifies the accounting for nonemployee share-based payment transactions by aligning the measurement and classification guidance, with certain exceptions, to that for share-based payment awards to employees. The amendments expand the scope of the accounting standard for share-based payment awards to include share-based payment awards granted to non-employees in exchange for goods or services used or consumed in an entity’s own operations and supersedes the guidance related to equity-based payments to non-employees. We adopted these amendments on January 1, 2019. We recognize compensation expenses for the fair value of non-employee awards over the requisite service period of each award. We estimate the fair value of stock options granted as equity awards using a Black-Scholes options pricing model. The option-pricing model requires a number of assumptions, of which the most significant are share price, expected volatility and the expected option term (the time from the grant date until the options are exercised or expire). We determine the fair value per share of the underlying stock by taking into consideration its most recent sales of stock as well as additional factors that we deem relevant. BiomX has historically been a private company and lacks company-specific historical and implied volatility information of its stock. Expected volatility is estimated based on volatility of similar companies in the biotechnology sector. BiomX has historically not paid dividends and has no foreseeable plans to issue dividends. The risk-free interest rate is based on the yield from governmental zero-coupon bonds with an equivalent term. The expected option term is calculated for options granted to employees and directors using the “simplified” method. Grants to non-employees are based on the contractual term. Changes in the determination of each of the inputs can affect the fair value of the options granted and the results of our operations. We accounted for the acquisition of RondinX Ltd. using the acquisition method of accounting, which required us to estimate the fair values of the assets acquired and liabilities assumed. This included acquired in-process research and development and contingent consideration. Significant changes in assumptions and estimates subsequent to completing the allocation of the purchase price to the assets and liabilities acquired, as well as differences in actual and estimated results, could impact our financial results. Adjustments to the fair value of contingent consideration are recorded in earnings. In-process research and development In-process research and development acquired in a business combination were recognized at fair value as of the acquisition date and subsequently accounted for as indefinite-lived intangible assets until completion or abandonment of the associated R&D efforts. We review these intangible assets at least annually for impairment, or whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Emerging Growth Company Status The Company is an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act of 2012, or the JOBS Act, and it 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 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 may take advantage of these exemptions up until the last day of the fiscal year following the fifth anniversary of our first registration statement filed under the United States Securities Act of 1933, as amended, 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 shares 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 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 audited consolidated financial statements.

<s>[INST] BiomX is a clinical stage microbiome product discovery company developing products using both natural and engineered phage technologies designed to target and destroy bacteria that affect the appearance of skin, as well as harmful bacteria in chronic diseases, such as IBD, liver disease and cancer. Bacteriophage or phage are viruses that target bacteria and are considered inert to mammalian cells. By developing proprietary combinations of naturally occurring phage and by creating novel phage using synthetic biology, BiomX develops phagebased therapies intended to address largemarket and orphan diseases. Since inception in 2015, BiomX has devoted substantially all its resources to organizing and staffing its company, raising capital, acquiring rights to or discovering product candidates, developing its technology platforms, securing related intellectual property rights, and conducting discovery, research and development activities for its product candidates. It does not have any products approved for sale, its products are still in the preclinical development stage, and it has not generated any revenue from product sales. As BiomX moves its product candidates from preclinical to clinical stage, it expects its expenses to increase. To date, BiomX has funded its operations with proceeds from sales of common and preferred shares. Through December 31, 2019, BiomX had received gross proceeds of approximately $60.1 million from sales of its common and preferred shares. To date, BiomX received approximately $224 thousand from its collaboration agreements and recorded a reduction from research and development expenses of $167 thousand during the year ended December 31, 2019. Additional cash amounting to approximately $60 million was obtained by BiomX from the Business Combination. Since inception, BiomX has incurred significant operating losses. BiomX’s ability to generate product revenue sufficient to achieve profitability will depend on the successful development of, the receipt of regulatory approval for, and eventual commercialization of one or more of BiomX’s product candidates. Our net losses were approximately $20.6 million and $12.7 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $44.6 million and expect that for the foreseeable future we will continue to incur significant expenses as BiomX advances its product candidates from discovery through preclinical development and clinical trials and seek regulatory approval of its product candidates. In addition, if BiomX obtains regulatory approval for any of its product candidates, we would expect to incur significant commercialization expenses related to product manufacturing, marketing, sales and distribution. We may also incur expenses in connection with inlicensing or acquiring additional product candidates. In November 2017, BiomX entered into a share purchase agreement to acquire all of the outstanding share capital of RondinX Ltd., a company organized under the laws of Israel. We may incur expenses in the future in connection with similar 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. We anticipate that our general and administrative expenses will increase as a result of the completion of the Business Combination because of the increased costs associated with being a public company, including significant legal, accounting, investor relations and other expenses that we did not incur as a private company. 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. At December 31, 2019, we had cash and cash equivalents and shortterm deposits of $82.2 million. We believe that our existing cash and cash equivalents and shortterm deposits will enable us to fund our operating expenses and capital expenditure requirements for at least the next 24 months, as discussed further below under “ Liquidity and Capital Resources” Accounting Treatment The Business Combination was treated as a “reverse merger” in accordance with GAAP. For accounting [/INST] Positive. </s>

Ping Identity Holding Corp.

2020-03-04

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis summarizes the significant factors affecting the consolidated operating results, financial condition, liquidity and cash flows of our company as of and for the periods presented below. The following discussion and analysis should be read in conjunction with our consolidated financial statements and the related notes thereto included elsewhere in this Annual Report on Form 10-K. The discussion contains forward-looking statements that are based on the beliefs of management, as well as assumptions made by, and information currently available to, our management. Actual results could differ materially from those discussed in or implied by forward-looking statements as a result of various factors, including those discussed below and elsewhere in this Annual Report on Form 10-K, particularly in the sections entitled “Risk Factors” and “Forward-Looking Statements.” Overview Ping Identity is pioneering Intelligent Identity. We enable secure access to any service, application or API from any device. Our Intelligent Identity Platform can leverage AI and ML to analyze device, network, application and user behavior data to make real-time authentication and security control decisions, enhancing the user experience. Our platform is designed to detect anomalies and automatically insert additional security measures, such as multi-factor authentication, only when necessary. We built our platform to meet the requirements of the most demanding enterprises. Our platform can be deployed across cloud, hybrid and on-premise infrastructures and offers a comprehensive suite of turnkey integrations, and is able to scale to millions of identities and thousands of cloud and on-premise applications. Our Intelligent Identity Platform can secure all primary use cases, including customer, workforce, partner and IoT. For example, enterprises can use our platform to enhance their customers’ user experience by creating a single ID and login across web and mobile properties. For the year ended December 31, 2019, 42% of our subscription revenue was derived from the customer use case. Enterprises can also use our platform to provide their workforce and commercial partners with secure, seamless access from any device to the applications, data and APIs they need to be productive. Enterprises are increasingly using our platform to manage and authenticate identities in a variety of IoT devices, such as connected vehicles and consumer devices. Our Intelligent Identity Platform is comprised of six solutions that can be purchased individually or as a set of integrated offerings for the customer, workforce, partner or IoT use case: SSO, MFA, Access Security, Directory, Data Governance and API Intelligence. Our offerings are predominately priced based on the number of identities, solutions and use cases. We sell our platform through subscription-based contracts, and substantially all of our customers pay annually in advance. We sell our solutions primarily through direct sales, which are enhanced by collaboration with our channel partners, resellers, system integrators and technology partners and includes sourcing new leads, aiding in pre-sale processes such as proof of concepts, demos or requests for proposals and reselling our solutions to customers. We also leverage a number of our channel partners and system integrators to provide the implementation services for some of our larger and more complex deployments, significantly increasing the time-to-value for our customers and maximizing the efficiency of our go-to-market efforts. Key Factors Affecting Our Performance We believe that our future performance will depend on many factors, including the following: Generate Additional Sales to Existing Customers As part of our land and expand strategy, a customer journey often begins with the purchase of one of our solutions for one use case. Once customers realize the value of that solution, their spend with us expands by (i) adopting another identity use case, (ii) deploying additional solutions and solution packages and/or (iii) adding more identities over time. Our future revenue growth is dependent upon our ability to continue to expand our customers’ use of our platform. Our ability to increase sales to existing customers will depend on a number of factors, including satisfaction or dissatisfaction with our solutions, competition, pricing, economic conditions and spending by customers on our solutions. We have adopted a customer success strategy and implemented processes across our customer base to drive revenue retention and expansion. Increase the Size of our Customer Base We believe there is significant opportunity to increase market adoption of our platform by new customers. Our SSO, Access Security and Directory solutions often replace legacy and homegrown systems. We also have significant greenfield opportunities with our MFA, Data Governance, API Intelligence solutions and IoT. To increase our customer base, we plan to expand our sales force and channel partner network, both domestically and internationally, enhance our marketing efforts and target new buyers. For example, we have extended our cloud-based offering to target developers, who represent a new potential buyer for us. Over time, we believe sales to developers could increase the size of our customer base. Maintain our Technology Differentiation and Product Leadership Our Intelligent Identity Platform is designed for large enterprises with complex, hybrid IT requirements. We have spent over a decade building a standards-based platform with turnkey integrations designed to ensure that large enterprises can easily and rapidly deploy our platform within their complex infrastructures. We intend to continue making investments in research and development to extend our platform and technology capabilities while also expanding our solutions to address new use cases. Invest for Growth We believe that our market opportunity is large, and we plan to invest in order to continue to support further growth. This includes investing in our sales force and expanding our network of channel partners, resellers, system integrators and technology partners with which we partner to sell our Intelligent Identity Platform, both domestically and internationally. We have a large and growing international presence and intend to grow our customer base in various international regions by making investments in our sales team globally. For the year ended December 31, 2019, our international revenue was 22% of our total revenue. We expect international sales to be a meaningful revenue contributor in future periods. During 2018, we made a decision with our Board to accelerate investments in our business to take advantage of our large market opportunity. Specifically, we invested in enhancing our salesforce globally to increase our selling capacity and capitalize on our large market opportunity. In addition, we have invested in new cloud-based offerings to broaden our Intelligent Identity Platform and the scope of our solutions to cover new identity security threats, such as APIs. We also invested in deploying our platform as a single tenant cloud-based offering, managed by us, to help extend the reach of our solutions within our customers’ infrastructures, while providing them with the level of control and configuration they require. We have seen progress with these investments and expect to continue to invest heavily in these areas in the near future. However, we are not expecting these investments to provide our business with meaningful increases to ARR growth in the immediate term as we expect natural purchasing cycles will affect the speed of market adoption. Seasonality Given the purchasing patterns of our enterprise customers, we typically experience seasonality in terms of when we receive orders from our customers. Our customers often time their purchases and renewals of our solutions to coincide with their fiscal year end, which is typically June 30 or December 31. Because of these purchasing patterns, a greater percentage of our annual subscription revenue from term-based licenses, the revenue from which is recognized up front at the later of delivery or commencement of the license term, has come from our second and fourth quarters than from other quarters. For the year ended December 31, 2019, 26% and 28% of our annual revenue was in our second and fourth quarter, respectively. We believe this seasonality will continue to affect our quarterly results and may become more pronounced. Key Business Metrics In addition to our GAAP financial information, we review a number of operating and financial metrics, including the following key metrics, to evaluate our business, measure our performance, identify trends affecting our business, formulate business plans and make strategic decisions. Annual Recurring Revenue ARR represents the annualized value of all subscription contracts as of the end of the period. ARR mitigates fluctuations due to seasonality, contract term and the sales mix of subscriptions for term-based licenses and SaaS. ARR only includes the annualized value of subscription contracts. ARR does not have any standardized meaning and is therefore unlikely to be comparable to similarly titled measures presented by other companies. ARR should be viewed independently of revenue and deferred revenue and is not intended to be combined with or to replace either of those items. ARR is not a forecast and the active contracts at the end of a reporting period used in calculating ARR may or may not be extended or renewed by our customers. The table below sets forth our ARR as of the end of December 31, 2019 and 2018. Dollar-Based Net Retention Rate To further illustrate the land and expand economics of our customer relationships, we examine the rate at which our customers increase their subscriptions for our solutions. Our dollar-based net retention rate measures our ability to increase revenue across our existing customer base through expanded use of our platform, offset by customers whose subscription contracts with us are not renewed or renew at a lower amount. We calculate our dollar-based net retention rate as of the end of a reporting period as follows: ● Denominator. We measure ARR as of the last day of the prior reporting period. ● Numerator. We measure ARR as of the last day of the current reporting period from customers with associated ARR as of the last day of the prior reporting period. The quotient obtained from this calculation is our dollar-based net retention rate. Our dollar-based net retention rates were 115% and 116% at December 31, 2019 and 2018, respectively. We believe our ability to cross-sell our new solutions to our installed base, particularly MFA and API Intelligence, will continue to support our high dollar-based net retention rate. Large Customers We believe that our ability to increase the number of customers on our platform, particularly the number of customers with greater than ARR of $1,000,000 and ARR of $250,000, demonstrates our focus on the large enterprise market and our penetration within those enterprises. Increasing awareness of our platform, further developing our sales and marketing expertise and channel partner ecosystem, and continuing to build solutions that address the unique identity needs of large enterprises have increased our number of large customers across industries. We believe there are significant upsell and cross-sell opportunities within our customer base by expanding the number of use cases, adding additional identities and selling new solutions. At December 31, 2019, we had 38 customers with greater than $1,000,000 in ARR, an increase of 52% from 25 customers at December 31, 2018. Additionally, our customers with ARR over $250,000 increased from 202 at December 31, 2018 to 232 at December 31, 2019, representing a growth rate of 15%. Non-GAAP Financial Measures In addition to our results determined in accordance with GAAP, we believe the following non-GAAP measures are useful in evaluating our operating performance. We believe that non-GAAP financial information, when taken collectively, may be helpful to investors because it provides consistency and comparability with past financial performance and assists in comparisons with other companies, some of which use similar non-GAAP financial information to supplement their GAAP results. The non-GAAP financial information is presented for supplemental informational purposes only, and should not be considered a substitute for financial information presented in accordance with GAAP, and may be different from similarly-titled non-GAAP measures used by other companies. A reconciliation is provided below for each non-GAAP financial measure to the most directly comparable financial measure stated in accordance with GAAP. Investors are encouraged to review the related GAAP financial measures and the reconciliation of these non-GAAP financial measures to their most directly comparable GAAP financial measures. Free Cash Flow Free Cash Flow is a supplemental measure of liquidity that is not made under GAAP and that does not represent, and should not be considered as, an alternative to cash flow from operations, as determined by GAAP. We define Free Cash Flow as net cash provided by (used in) operating activities less cash used for purchases of property and equipment and capitalized software development costs. We use Free Cash Flow as one measure of the liquidity of our business. We believe that Free Cash Flow is a useful indicator of liquidity that provides information to management and investors about the amount of cash generated from our core operations that, after the purchases of property and equipment and capitalized software development costs, can be used for strategic initiatives, including investing in our business and selectively pursuing acquisitions and strategic investments. We further believe that historical and future trends in Free Cash Flow, even if negative, provide useful information about the amount of cash generated (or consumed) by our operating activities that is available (or is not available) to be used for strategic initiatives. For example, if Free Cash Flow is negative, we may need to access cash reserves or other sources of capital to invest in strategic initiatives. We also believe that the use of Free Cash Flow enables us to more effectively evaluate our liquidity period-over-period and relative to our competitors. A reconciliation of Free Cash Flow to net cash provided by operating activities, the most directly comparable GAAP measure, is as follows: Free Cash Flow has limitations as an analytical tool, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. For example, Free Cash Flow does not represent the total increase or decrease in our cash balance for a given period. Because of these limitations, Free Cash Flow should not be considered as a replacement for cash flow from operations, as determined by GAAP, or as a measure of our profitability. We compensate for these limitations by relying primarily on our GAAP results and using non-GAAP measures only for supplemental purposes. Non-GAAP Gross Profit Non-GAAP Gross Profit is a supplemental measure of operating performance that is not made under GAAP and that does not represent, and should not be considered as, an alternative to gross profit, as determined by GAAP. We define Non-GAAP Gross Profit as gross profit, adjusted for stock-based compensation expense and certain amortization expense of acquired intangible assets and software developed for internal use. We use Non-GAAP Gross Profit to understand and evaluate our core operating performance and trends, to prepare and approve our annual budget and to develop short-term and long-term operating plans. We believe that Non-GAAP Gross Profit is a useful measure to us and to our investors because it provides consistency and comparability with our past financial performance and between fiscal periods, as the metric generally eliminates the effects of the variability of amortization of acquired intangibles and internal-use software from period to period, which may fluctuate for reasons unrelated to overall operating performance. We believe that the use of this measure enables us to more effectively evaluate our performance period-over-period and relative to our competitors. A reconciliation of Non-GAAP Gross Profit to gross profit, the most directly comparable GAAP measure, is as follows: Non-GAAP Gross Profit has limitations as an analytical tool, and you should not consider it in isolation, or as a substitute for analysis of our results as reported under GAAP. Because of these limitations, Non-GAAP Gross Profit should not be considered as a replacement for gross profit, as determined by GAAP, or as a measure of our profitability. We compensate for these limitations by relying primarily on our GAAP results and using non-GAAP measures only for supplemental purposes. Adjusted EBITDA Adjusted EBITDA is a supplemental measure of operating performance that is not made under GAAP and that does not represent, and should not be considered as, an alternative to net income (loss), as determined by GAAP. We define Adjusted EBITDA as net income (loss), adjusted for interest expense, loss on extinguishment of debt, (benefit) provision for income taxes, depreciation and amortization, stock-based compensation expense, acquisition-related expense and other (income) expense, net. We use Adjusted EBITDA to understand and evaluate our core operating performance and trends, to prepare and approve our annual budget and to develop short-term and long-term operating plans. We believe that Adjusted EBITDA facilitates comparison of our operating performance on a consistent basis between periods, and when viewed in combination with our results prepared in accordance with GAAP, helps provide a broader picture of factors and trends affecting our results of operations. A reconciliation of Adjusted EBITDA to net income (loss), the most directly comparable GAAP measure, is as follows: ______________________ (1) Includes amortization of debt issuance costs. (2) Acquisition-related expense for the years ended December 31, 2019 and 2018, respectively, included $3.3 million and $5.2 million of contingent compensation and retention expense related to the acquisition of Elastic Beam, Inc. (“Elastic Beam”). For more information related to our acquisition of Elastic Beam and the payment of contingent compensation, please refer to Note 5 of our consolidated financial statements included in Part II, Item 8 of this Annual Report on Form 10-K. (3) See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for the components of other (income) expense. Adjusted EBITDA has limitations as an analytical tool, and you should not consider it in isolation, or as a substitute for analysis of our results as reported under GAAP. Because of these limitations, Adjusted EBITDA should not be considered as a replacement for net income (loss), as determined by GAAP, or as a measure of our profitability. We compensate for these limitations by relying primarily on our GAAP results and using non-GAAP measures only for supplemental purposes. Components of Results of Operations Revenue We recognize revenue under ASC 606 when our customer obtains control of goods or services in an amount that reflects the consideration that we expect to receive in exchange for those goods or services. See “Critical Accounting Policies - Revenue Recognition.” We derive revenue primarily from sales of subscriptions for our solutions to new and existing customers and, to a lesser extent, sales of professional services. Subscription. Subscription revenue includes subscription term-based license revenue for solutions deployed on-premise within the customer’s IT infrastructure or in a third-party cloud of their choice, subscription support and maintenance revenue from such deployments, and SaaS subscriptions, which give customers the right to access our cloud-hosted software solutions. We typically invoice subscription fees annually in advance, though certain contracts require invoicing for the entire subscription in advance. Subscription term-based license revenue is recognized upon transfer of control of the software, which occurs at delivery or when the license term commences, if later. All of our support and maintenance revenue and revenue from SaaS subscriptions is recognized ratably over the term of the applicable agreement. For the years ended December 31, 2019, 2018 and 2017, 66%, 66% and 71%, respectively, of our revenue was from subscription term-based licenses. We expect that a majority of our revenue will be from subscription term-based licenses for the foreseeable future. Changes in period-over-period subscription revenue growth are primarily impacted by the following factors: ● the type of new and renewed subscriptions (i.e., term-based or SaaS); and ● the duration of new and renewed term-based subscriptions. While the number of new and increased subscriptions during a period impacts our subscription revenue growth, the type and duration of those subscriptions has a significantly greater impact on the amount and timing of revenue recognized in a period. Subscription revenue from term-based licenses is recognized at the beginning of the subscription term, while subscription revenue from SaaS and support and maintenance is recognized ratably over the subscription term. As a result, our revenue may fluctuate due to the timing of term-based licensing transactions. In addition, keeping other factors constant, when the percentage of subscription term-based licenses to total subscriptions sold or renewed in a period increases relative to the prior period, revenue growth will increase. Conversely, when the percentage of subscription SaaS and support and maintenance to total subscriptions sold or renewed in a period increases, revenue growth will generally decrease. Additionally, a multi-year subscription term-based license will generally result in greater revenue recognition up front relative to a one-year subscription term-based license. Therefore, keeping other factors constant, revenue growth will also trend higher in a period where the percentage of multi-year subscription term-based licenses to total subscription term-based licenses increases. Professional Services and Other. Professional services and other revenue consists primarily of fees from professional services provided to our customers and partners to configure and optimize the use of our solutions, as well as training services related to the configuration and operation of our solutions. Our professional services are generally priced on a time and materials basis, which is generally invoiced monthly and for which revenue is recognized as the services are performed. Revenue from our training services and sponsorship fees is recognized on the date the services are complete. Over time, we expect our professional services revenue to remain relatively stable as a percentage of total revenue. Cost of Revenue Subscription. Subscription cost of revenue consists primarily of employee compensation costs for employees associated with supporting our subscription arrangements and certain third-party expenses. Employee compensation and related costs include cash compensation and benefits to employees, stock-based compensation, costs of third-party contractors and associated overhead costs. Third-party expenses consist of cloud infrastructure costs and other expenses directly associated with our customer support. We expect our subscription cost of revenue to increase in absolute dollars to the extent our subscription revenue increases. Professional Services and Other. Professional services and other cost of revenue consists primarily of employee compensation costs directly associated with delivery of professional services and training, including stock-based compensation, costs of third-party contractors and facility rental charges and other associated overhead costs. We expect our professional services and other cost of revenue to increase in absolute dollars relative to the growth of our business. Amortization Expense. Amortization expense consists of amortization of developed technology and internal-use software. Operating Expenses Our operating expenses consist of sales and marketing, research and development and general and administrative expenses as well as depreciation and amortization. Personnel costs are the most significant component of operating expenses and consist of salaries, benefits, bonuses, payroll taxes and stock-based compensation expense. Sales and Marketing. Sales and marketing expenses consist primarily of employee compensation costs, sales commissions, costs of general marketing and promotional activities, travel-related expenses and allocated overhead. Certain sales commissions earned by our sales force on subscription contracts are deferred and amortized over the period of benefit, which is generally four years. We expect to continue to invest in our sales force domestically and internationally, as well as in our channel relationships. We expect our sales and marketing expenses to increase on an absolute dollar basis and continue to be our largest operating expense category for the foreseeable future. Research and Development. Research and development expenses consist primarily of employee compensation costs, allocated overhead and software and maintenance expenses. We will continue to invest in innovation and offer our customers new solutions to enhance our existing platform. See the section “Business - Research and Development” for more information. We expect such investment to increase on an absolute dollar basis as our business grows. General and Administrative. General and administrative expenses consist primarily of employee compensation costs for corporate personnel, such as those in our executive, human resource, legal, facilities, accounting and finance, information security and information technology departments. In addition, general and administrative expenses include third-party professional fees, as well as all other supporting corporate expenses not allocated to other departments. General and administrative expense also includes acquisition-related expenses, which primarily consist of third-party expenses related to business acquisitions, such as professional services and legal fees. We expect our general and administrative expenses to increase on an absolute dollar basis as our business grows. Also, we expect to incur additional general and administrative expenses as a result of continuing to operate as a public company, including costs to comply with the rules and regulations applicable to companies listed on a national securities exchange, costs related to compliance and reporting obligations pursuant to the rules and regulations of the SEC, and increased expenses for insurance, investor relations and professional services. Depreciation and Amortization. Depreciation and amortization expense consists primarily of depreciation of our fixed assets and amortization of finite-lived acquired intangible assets such as customer relationships, trade names and non-compete agreements. Other Income (Expense) Interest Expense. Interest expense consists primarily of interest payments on our outstanding borrowings as well as the amortization of associated deferred financing costs. See “- Liquidity and Capital Resources - Senior Secured Credit Facilities.” Other Income (Expense), Net. Other income (expense), net primarily consists of gains and losses from transactions denominated in a currency other than the functional currency, interest income and other income (expense). As we have expanded our international operations, our exposure to fluctuations in foreign currencies has increased, and we expect this to continue. Benefit (Provision) for Income Taxes Benefit (provision) for income taxes consists primarily of income taxes related to U.S. federal and state income taxes and income taxes in foreign jurisdictions in which we conduct business. Results of Operations The following table sets forth our consolidated statements of operations data for the periods indicated: ______________________ (1) Includes stock-based compensation as follows: The following table sets forth our consolidated statements of operations data expressed as a percentage of total revenue for the periods indicated: Comparison of the Years Ended December 31, 2019, 2018 and 2017 Revenue Total revenue increased by $41.3 million, or 21%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. 98% of the increase in total revenue was due to an increase in subscription revenue of $40.4 million. The remaining $1.0 million of revenue growth was attributable to an increase in professional services and other revenue. Total revenue increased by $29.0 million, or 17%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. 85% of the increase in total revenue was due to an increase in subscription revenue of $24.8 million. The remaining $4.3 million of revenue growth was attributable to an increase in professional services and other revenue. The table below sets forth the components of subscription revenue for the years ended December 31, 2019, 2018 and 2017. Subscription revenue increased 22%, or $40.4 million, in the year ended December 31, 2019 compared to the year ended December 31, 2018. Subscription revenue increased 15%, or $24.8 million, in the year ended December 31, 2018 compared to the year ended December 31, 2017. The change in subscription revenue was primarily due to the following: ● Change in subscription type. Subscription term-based license revenue as a percentage of subscription revenue was 72% in the years ended December 31, 2019 and 2018. Subscription SaaS and support and maintenance as a percentage of total subscription revenue was 28% in the years ended December 31, 2019 and 2018. As the mix of subscription types stayed consistent between 2019 and 2018, the increase in total subscription revenue was attributable to a greater amount of subscriptions entered into or renewed during the year ended December 31, 2019 compared to the year ended December 31, 2018. Subscription term-based license revenue as a percentage of subscription revenue decreased from 76% in the year ended December 31, 2017 to 72% in the year ended December 31, 2018. Subscription SaaS and support and maintenance as a percentage of total subscription revenue increased from 24% in the year ended December 31, 2017 to 28% in the year ended December 31, 2018. This resulted in greater deferral of revenue from subscriptions entered into or renewed during the year ended December 31, 2018 compared to the year ended December 31, 2017. ● Change in term-based subscription duration. Multi-year subscription term-based license revenue as a percentage of total subscription term-based license revenue increased from 67% in the year ended December 31, 2018 to 70% in the year ended December 31, 2019. This resulted in more upfront revenue recognition from subscriptions entered into or renewed during the year ended December 31, 2019 compared to the year ended December 31, 2018. Multi-year subscription term-based license revenue as a percentage of total subscription term-based license revenue decreased from 71% in the year ended December 31, 2017 to 67% in the year ended December 31, 2018. This resulted in less upfront revenue recognition from subscriptions entered into or renewed during the year ended December 31, 2018 compared to the year ended December 31, 2017. Cost of Revenue Subscription cost of revenue increased by $6.5 million, or 37%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. $3.3 million of the increase was compensation related and primarily attributable to an increase in headcount to support the growth of our subscription SaaS offerings and ongoing maintenance for our expanding customer base. $2.0 million of the increase was attributable to our increased cloud-based hosting costs largely associated with the increased adoption of our solutions. Substantially all of the remaining increase in subscription cost of revenue was due to an increase in allocated overhead. Subscription cost of revenue increased by $3.5 million, or 25%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. $1.8 million of the increase was compensation related and primarily attributable to an increase in headcount to support the growth of our subscription SaaS offerings and ongoing maintenance for our expanding customer base. $1.0 million of the increase was attributable to our increased cloud-based hosting costs largely associated with the increased adoption of our solutions. Substantially all of the remaining increase in subscription cost of revenue was due to an increase in travel costs and allocated overhead. Professional services and other cost of revenue increased by $2.6 million, or 21%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. $3.4 million of the increase was compensation related and primarily attributable to an increase in headcount to support growth of our business, partially offset by a decrease in consulting costs of $1.2 million. The remaining portion of the increase was primarily attributable to travel costs and allocated overhead. Professional services and other cost of revenue increased by $3.5 million, or 39%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. $2.8 million of the increase was compensation related and primarily attributable to an increase in headcount to support growth of our business. $0.5 million of the increase related to consulting costs. The remaining portion of the increase was primarily attributable to travel costs as well as allocated overhead. Amortization expense increased by $1.9 million, or 13%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. Amortization expense increased by $1.8 million, or 14%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. The year-over-year increase were attributable primarily to an increase in the amortization of our capitalized software. Operating Expenses Sales and Marketing. Sales and marketing expenses increased by $18.7 million, or 31%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. $11.7 million of the increase was related to compensation and was notably the result of increased commissions related to the increase in revenue, the increase in our sales force domestically and internationally and continued investment in our channel relationships. As our headcount increased, we also experienced a related increase in travel costs of $0.8 million. $1.8 million of the increase related to promotional expenses including advertising, tradeshows and event sponsorships. An additional $1.9 million of the increase was attributable to increased partner commissions and consulting costs. Substantially all of the remaining increase in sales and marketing expenses was the result of an increase in allocated overhead. Sales and marketing expenses increased by $10.7 million, or 22%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. $6.0 million of the increase was the result of increased commissions related to the increase in revenue, the increase in our sales force domestically and internationally and continued investment in our channel relationships. As our headcount increased, we also experienced a related increase in travel costs of $1.2 million and increased promotional expenses of $1.5 million primarily related to tradeshows and event sponsorships for the year ended December 31, 2018 compared to the year ended December 31, 2017. Substantially all of the remaining increase in sales and marketing expenses was the result of increased partner commissions and consulting costs, as well as allocated overhead. Research and Development. Research and development expenses increased by $9.8 million, or 27%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. $10.2 million was compensation related and primarily the result of an increase in headcount to enhance and expand our solutions. This was offset by a decrease of $1.9 million of contingent compensation and retention expense related to our acquisition of Elastic Beam (as further discussed in Note 5 of our consolidated financial statements appearing in Part II, Item 8 of this Annual Report on Form 10-K). Substantially all of the remaining increase in research and development expenses was the result of increased consulting costs and cloud-based hosting costs to continue to support our development efforts for our SaaS offerings, as well as allocated overhead. Research and development expenses increased by $10.0 million, or 38%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. $4.0 million of the increase was compensation related and primarily the result of an increase in headcount to enhance and expand our solutions. Additionally, $5.2 million of the increase related to contingent compensation and retention expense that was payable on the first anniversary of our acquisition of Elastic Beam, which we acquired in April 2018. Substantially all of the remaining increase in research and development expenses was the result of increased software and maintenance expenses, primarily cloud-based hosting costs to support our development efforts for our SaaS offerings, consulting costs and allocated overhead. General and Administrative. General and administrative expenses increased by $9.9 million, or 35%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. $9.1 million of the increase was the result of an increase in corporate headcount to continue to support the growth and scale of the business. This was offset by a decrease of $0.6 million from acquisition-related expenses that we incurred during the year ended December 31, 2018 for our acquisition of Elastic Beam. Substantially all of the remaining increase in general and administrative expenses related to increased legal fees and director and officer insurance expenses, both resulting from operating as a public company, as well as allocated overhead. General and administrative expenses increased by $8.2 million, or 40%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. $3.9 million of the increase was the result of an increase in corporate headcount to support the growth and scale of the business. An additional $1.3 million of the increase resulted from an increase in consulting costs, driven primarily by the implementation of new accounting standards and our preparation for becoming a public company. General and administrative expenses for the year ended December 31, 2018 also included $0.6 million of acquisition-related expenses related to our acquisition of Elastic Beam. Substantially all of the remaining increase in general and administrative expenses related to increased accounting and legal fees driven by our preparation for becoming a public company. Depreciation and Amortization. Depreciation and amortization expense remained substantially the same for the year ended December 31, 2019 compared to the year ended December 31, 2018 and for the year ended December 31, 2018 compared to the year ended December 31, 2017. Other Income (Expense) Interest Expense. Interest expense decreased by $2.9 million, or 18%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. The decrease was attributable primarily to the repayment of $170.3 million and $26.1 million of outstanding principal on our 2018 Term Loan Facility in September 2019 and October 2019, respectively. The decrease also partially relates to the refinancing of our debt in December 2019, as our 2019 Revolving Credit Facility bears interest at a lower rate than our 2018 Term Loan Facility. The decrease was partially offset by a period-over-period increase in the weighted average interest rate, from 5.8% for the year ended December 31, 2018 to 6.1% for the year ended December 31, 2019. Interest expense decreased by $3.4 million, or 18%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. The decrease was attributable primarily to the refinancing of our debt in January 2018, through which we increased our borrowings of long-term debt from a principal amount of $170.0 million to $250.0 million but were able to obtain more favorable interest rates, from a weighted average interest rate of 10.4% for the year ended December 31, 2017 to 5.8% for the year ended December 31, 2018, resulting in reduced interest expense for the year ended December 31, 2018. Loss on Extinguishment of Debt. During the year ended December 31, 2019, we recorded a loss on extinguishment of debt of $4.5 million. $3.6 million of the loss related to the write off of a portion of our deferred debt issuance costs in conjunction with the repayment of $196.4 million of outstanding principal on our 2018 Term Loan Facility using the proceeds from our IPO. The remaining $0.9 million of the loss related to the refinancing of our debt in December 2019. During the year ended December 31, 2018, we recorded a loss on extinguishment of debt of $9.8 million in conjunction with the refinancing of our debt in January 2018. There was no similar loss during the year ended December 31, 2017. Other Income (Expense), Net. Other income (expense), net increased by $0.7 million, or 208%, from other expense of $0.3 million in the year ended December 31, 2018 to other income of $0.4 million in the year ended December 31, 2019. The increase was attributable primarily to a change in the amount of foreign currency gains and losses, from a loss of $2.0 million in the year ended December 31, 2018 compared to a loss of $0.9 million in the year ended December 31, 2019. These foreign currency losses were offset by interest and other income of $1.3 million and $1.7 million during the years ended December 31, 2019 and 2018, respectively. Other income (expense), net decreased by $1.1 million, or 143%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. The decrease was attributable primarily to a change in the amount of foreign currency gains and losses, from a gain of $0.7 million in the year ended December 31, 2017 compared to a loss of $2.0 million in the year ended December 31, 2018. Benefit (Provision) for Income Taxes For the year ended December 31, 2019, we recorded a benefit for income taxes of $8.2 million. For the year ended December 31, 2018, we recorded a provision for income taxes of $3.4 million. Our effective tax rates for the years ended December 31, 2019 and 2018 were 84.5% and (33.5)%, respectively. The increase in our effective tax rate for 2019 compared to 2018 was primarily driven by the finalization of a research and development (“R&D”) study in the third quarter of 2019 that generated a tax benefit of $4.6 million, of which the Company partially offset with an unrecognized tax benefit reserve of $0.9 million. Additionally, for the year ended December 31, 2018, we recorded tax expense of $4.2 million related to an increase in the state tax rates compared to a tax benefit of $2.7 million for the year ended December 31, 2019. For the year ended December 31, 2018, we recorded a provision for income taxes of $3.4 million. For the year ended December 31, 2017, we recorded a benefit for income taxes of $13.2 million. Our effective tax rates for the years ended December 31, 2018 and 2017 were (33.5)% and (228.2)%, respectively. The increase in our effective tax rate for 2018 compared to 2017 was primarily driven by the enactment of the Tax Act in 2017. As a result of the Tax Act, we remeasured our deferred tax assets and liabilities at the lower U.S. federal tax rate, which resulted in a one-time tax benefit during the year ended December 31, 2017 of $17.0 million. This one-time tax benefit was partially offset by the one-time transition tax expense on certain unremitted earnings of our foreign subsidiaries during the year ended December 31, 2017 of $1.2 million. Additionally, there were changes to our state tax rates which resulted in tax expense of $4.2 million and $1.9 million during the years ended December 31, 2018 and December 31, 2017, respectively. During the year ended December 31, 2018, we also recorded tax expense of $1.0 million for contingent deal consideration related to our acquisition of Elastic Beam. Quarterly Results of Operations and Other Data The following tables set forth selected unaudited consolidated quarterly statements of operations data for each of the eight fiscal quarters ended December 31, 2019, as well as the percentage of revenue that each line item represents for each quarter. 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 statement of the results of operations for these periods. This data should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. These quarterly results are not necessarily indicative of our results of operations to be expected for any future period. (1) Includes stock-based compensation as follows: Quarterly Revenue Trends Our quarterly revenue increased in each of the periods presented when compared to the results of the same quarter in the prior year due primarily to increases in the number of new customers as well as retention within existing customers and sales of new products year-over-year. We typically experience seasonality in terms of when we receive orders from our customers. We generally receive a greater number of orders from new customers, as well as renewal or upsell orders from existing customers, in our second and fourth quarter because of purchasing patterns of our enterprise customers. Our customers often time their purchases and renewals of our solutions to coincide with their fiscal year end, which is typically June 30 or December 31. Our subscription term-based license revenue is recognized up front at the later of delivery or commencement of the license term, thus creating fluctuations in subscription revenue quarter-over-quarter depending on the number and size of term-based licenses sold each quarter. Conversely, our subscription SaaS and support and maintenance revenue is recognized on a straight-line basis over the contract term. For our subscription SaaS and support and maintenance revenue, a portion of the revenue that we report in each period may be attributable to the recognition of deferred revenue recorded in prior periods. As such, increases or decreases in new sales or renewals in any one period may not be immediately reflected in our revenue for that period and may instead affect future periods. Quarterly Operating Expense Trends Our operating expenses have generally increased sequentially due to our growth and are primarily related to increases in personnel-related costs and related overhead in order to support our expanding operations and our continued investments in our solutions and service capabilities. Liquidity and Capital Resources General As of December 31, 2019, our principal sources of liquidity were cash and cash equivalents totaling $67.6 million, which were held for working capital purposes, as well as the available balance of our 2019 Revolving Credit Facility, described further below. As of December 31, 2019, our cash equivalents were comprised of money market funds. During the years ended December 31, 2019, 2018 and 2017, our positive cash flows from operations have enabled us to make continued investments in supporting the growth of our business. We expect that our operating cash flows, in addition to our cash and cash equivalents, will enable us to continue to make such investments in the future. We expect our operating cash flows to further improve as we increase our operational efficiency and experience economies of scale. We have financed our operations primarily through cash received from operations and proceeds from our debt and equity financings. We believe our existing cash and cash equivalents, the proceeds from our IPO, our 2019 Credit Facilities and cash provided by sales of our solutions and services will be sufficient to meet our working capital and capital expenditure needs for at least the next 12 months. Our future capital requirements will depend on several factors, including but not limited to our obligation to repay any amounts outstanding under our 2019 Credit Facilities, our subscription growth rate, subscription renewal activity, billing frequency, the timing and extent of spending to support development efforts, the expansion of sales and marketing activities, the introduction of new and enhanced solutions and the continuing market adoption of our platform. In the future, we may enter into arrangements to acquire or invest in complementary businesses, services and technologies, including 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 or generate cash flows necessary to expand our operations and invest in new technologies, this could reduce our ability to compete successfully and harm our results of operations. A majority of our customers pay in advance for annual subscriptions, a portion of which is recorded as deferred revenue. Deferred revenue consists of the unearned portion of billed fees for our subscriptions, which is later recognized as revenue in accordance with our revenue recognition policy. As of December 31, 2019, we had deferred revenue of $47.5 million, of which $45.4 million was recorded as a current liability and is expected to be recorded as revenue in the next 12 months, provided all other revenue recognition criteria have been met. Senior Secured Credit Facilities On December 12, 2019, in connection with the refinancing of our 2018 Credit Facilities, we entered into the 2019 Credit Agreement providing for the 2019 Revolving Credit Facility with an initial $150.0 million in commitments for revolving loans, which amount may be increased or decreased under specific circumstances, with a $15.0 million letter of credit sublimit and a $50.0 million alternative currency sublimit. In addition, the 2019 Credit Agreement provides for the ability of Ping Identity Corporation to request incremental term loan facilities, in a minimum amount of $10 million for each facility, if, among other things, the Senior Secured Net Leverage Ratio (as defined in the 2019 Credit Agreement), calculated giving pro forma effect to the requested term loan facility, is no greater than 3.50 to 1.00. The interest rates applicable to revolving borrowings under the 2019 Credit Agreement are, at the borrower’s option, either (i) a base rate, which is equal to the greater of (a) the Prime Rate, (b) the Federal Funds Effective Rate plus ½ of 1% and (c) the Adjusted LIBO Rate for a one month Interest Period (each term as defined in the 2019 Credit Agreement) plus 1%, or (ii) the Adjusted LIBO Rate equal to the LIBO Rate for the Interest Period multiplied by the Statutory Reserve Rate (each term as defined in the 2019 Credit Agreement), plus in the case of each of clauses (i) and (ii), the Applicable Rate. The Applicable Rate (i) for base rate loans ranges from 0.25% to 1.0% per annum and (i) for LIBO Rate loans ranges from 1.25% to 2.0% per annum, in each case, based on the Senior Secured Net Leverage Ratio (as defined in the 2019 Credit Agreement). The Adjusted LIBO Rate cannot be less than zero. Base rate borrowings may only be made in dollars. The 2019 Credit Agreement also includes a fallback provision, which, subject to certain terms and conditions, provides for a replacement of the LIBO Rate with (x) one or more SOFR-based rates or (y) any other alternative benchmark rates giving consideration to any evolving or then existing conventions for similar U.S. dollar denominated syndicated credit facilities. The borrower will pay a commitment fee during the term of the 2019 Credit Agreement ranging from 0.20% to 0.35% of the available revolving commitments per annum based on the Senior Secured Net Leverage Ratio (as defined in the 2019 Credit Agreement). Any borrowing under the 2019 Credit Agreement may be repaid, in whole or in part, at any time and from time to time without premium or penalty other than customary breakage costs, and any amounts repaid may be reborrowed. No mandatory prepayments will be required other than when borrowings or letter of credit usage exceed the aggregate commitment of all lenders. Cash Flows The following table presents a summary of our consolidated cash flows from operating, investing and financing activities for the periods indicated. Operating Activities Our largest source of operating cash is cash collections from our customers for subscriptions and professional services. Our primary uses of cash from operating activities are for employee-related expenditures, marketing expenses and third-party hosting costs. For the year ended December 31, 2019, net cash provided by operating activities was $5.8 million, reflecting our net loss of $1.5 million, adjusted for non-cash charges of $41.7 million and net cash outflows of $34.4 million provided by changes in our operating assets and liabilities. Non-cash charges primarily consisted of stock-based compensation, amortization of deferred commissions, depreciation and amortization of property and equipment and intangible assets, loss on extinguishment of debt and deferred income taxes. The primary drivers of the changes in operating assets and liabilities related to an $18.0 million increase in accounts receivable due to the timing of receipt of payment from our customers, an $18.5 million increase in contract assets due to a large number of multi-year deals being signed in the fourth quarter of 2019, a $9.1 million increase in deferred commissions and a $6.6 million increase in prepaid expenses and other current assets due to the timing of cash disbursements. These were partially offset by a $12.1 million increase in deferred revenue related to the upfront invoicing of certain customers in accordance with their subscription agreements as well as a $6.3 million increase in accrued expenses and other due to the timing of payments. During the year ended December 31, 2018, net cash provided by operating activities was $22.9 million due to our net loss of $13.4 million that was adjusted for non-cash charges of $52.2 million and net cash outflows of $15.9 million provided by changes in our operating assets and liabilities. Non-cash charges primarily consisted of stock-based compensation, amortization of deferred commissions, depreciation and amortization of property and equipment and intangible assets, loss on extinguishment of debt and deferred income taxes. The primary drivers of the changes in operating assets and liabilities related to a $6.8 million increase in contract assets, a $10.0 million increase in deferred commissions and a $5.8 million increase in prepaid expenses and other current assets due to the timing of payments, and a $1.5 million increase in accounts receivable due to the timing of receipt of payment from our customers, offset by a $1.4 million increase in deferred revenue resulting from the timing of when we recognize revenue, as well as a $6.1 million increase in accrued compensation and a $1.1 million increase in accrued expenses and other due to the timing of payments. For the year ended December 31, 2017, net cash provided by operating activities was $3.4 million, reflecting our net income of $19.0 million, adjusted for non-cash charges of $23.3 million and net cash outflows of $38.8 million provided by changes in our operating assets and liabilities. Non-cash charges primarily consisted of stock-based compensation, amortization of deferred commissions, depreciation and amortization of property and equipment and intangible assets and deferred income taxes. The primary drivers of the changes in operating assets and liabilities related to a $22.2 million increase in contract assets, a $7.7 million increase in deferred commissions and a $6.2 million increase in deferred revenue, primarily driven by the increase in subscription sales in the fourth quarter of 2017 and the associated recognition of revenue, as well as a $10.0 million increase in accounts receivable due to the timing of receipt of payment from our customers and a $3.8 million decrease in accrued compensation due to the timing of cash disbursements. Investing Activities Net cash used in investing activities was $19.8 million and $26.7 million during the years ended December 31, 2019 and 2018, respectively, a decrease of $6.9 million. The net decrease is primarily attributable to the acquisition of Elastic Beam for $17.4 million in cash that occurred in the year ended December 31, 2018, partially offset by an increase in the capitalization of internal-use software costs of $4.2 million associated with the development of additional features and functionality of our hosted platform as well as an increase in purchases of property and equipment of $5.3 million related to continued expansion of our business. Net cash used in investing activities was $26.7 million and $6.0 million during the years ended December 31, 2018 and 2017, respectively, an increase of $20.7 million. The net increase is primarily attributable to the acquisition of Elastic Beam for $17.4 million in cash as well as an increase in the capitalization of internal-use software costs of $2.9 million associated with the development of additional features and functionality of our hosted platform. Financing Activities Net cash used in financing activities was $2.0 million during the year ended December 31, 2019 whereas net cash provided by financing activities was $67.1 million during the year ended December 31, 2018. During the year ended December 31, 2019, our primary cash inflows related to the receipt of proceeds from our IPO of $200.5 million, proceeds from the refinancing of our long-term debt of $52.7 million, and receipt of proceeds from stock option exercises of $1.6 million, offset by the payment of long-term debt, issuance costs of long-term debt and deferred offering costs of $248.8 million, $1.2 million and $5.2 million, respectively, as well as the payment of Elastic Beam contingent compensation of $1.1 million. Conversely, during the year ended December 31, 2018, we received proceeds from long-term debt of $250.0 million, partially offset by issuance costs of $6.0 million and the repayment of our previous term loan and revolving credit facility and payment of the associated debt extinguishment costs of $170.0 million and $5.1 million, respectively. Net cash provided by financing activities was $67.1 million and $0.1 million during the years ended December 31, 2018 and 2017, respectively, an increase of $67.0 million. The net increase primarily relates to the receipt of proceeds from our 2018 Term Loan Facility of $250.0 million, partially offset by issuance costs of $6.0 million and the repayment of our previous term loan and revolving credit facility and payment of the associated debt extinguishment costs of $170.0 million and $5.1 million, respectively. This is offset by an additional $1.3 million related to quarterly principal payments on our 2018 Term Loan Facility that began in September 2018. Contractual Obligations and Commitments Our principal commitments consist of obligations under operating leases for office space and repayments of long-term debt. The following table summarizes our contractual obligations as of December 31, 2019: (1) Interest payments that relate to long-term debt are calculated and estimated for the periods presented based on the expected principal balance for each period and the interest rate at December 31, 2019 of 3.0%, given that our debt is at floating interest rates. Excluded from these payments is the amortization of debt issuance costs related to our indebtedness. (2) Comprised of future minimum payments under noncancelable purchase commitments primarily related to third-party cloud hosting and data services, IT operations and marketing events. The contractual commitment amounts in the tables above are associated with agreements that are enforceable and legally binding. Obligations under contracts that we can cancel without a significant penalty are not included in the table above. Purchase orders issued in the ordinary course of business are not included in the table above, as our purchase orders represent authorizations to purchase rather than binding agreements. Indemnification Agreements In the ordinary course of business, we enter into agreements of varying scope and terms pursuant to which we agree to indemnify customers, vendors, lessors, business partners and other parties with respect to certain matters, including, but not limited to, losses arising out of the breach of such agreements, services to be provided by us or from intellectual property infringement claims made by third parties. In addition, in connection with the completion of our IPO, we entered into indemnification agreements with our directors and certain officers and employees that require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors, officers or employees. No demands have been made upon us to provide indemnification under such agreements and there are no claims that we are aware of that could have a material effect on our consolidated balance sheets, consolidated statements of operations and comprehensive income (loss), or consolidated statements of cash flows. Off-Balance Sheet Arrangements As of December 31, 2019, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structure finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. JOBS Act Accounting Election We qualify as an emerging growth company pursuant to the provisions of the JOBS Act. The JOBS Act permits an emerging growth company like us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies. We have elected to use the extended transition period until we are no longer an emerging growth company or until we choose to affirmatively and irrevocably opt out of the extended transition period. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements applicable to public companies. Critical Accounting Policies The 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. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenue and expenses and related disclosures of contingent assets and liabilities at the date of our financial statements. Actual results may differ from these estimates under different assumptions or conditions, impacting our reported results of operations and financial condition. Certain accounting policies involve significant judgments and assumptions by management, which have a material impact on the carrying value of assets and liabilities and the recognition of income and expenses. Management considers these accounting policies to be critical accounting policies. The estimates and assumptions used by management are based on historical experience and other factors, which are believed to be reasonable under the circumstances. The significant accounting policies which we believe are the most critical to aid in fully understanding and evaluating our reported financial results are described below. Refer to “Note 2 - Summary of Significant Accounting Policies” to the consolidated financial statements included in Part II, Item 8 of this Annual Report on Form 10-K for more detailed information regarding our critical accounting policies. Revenue Recognition We recognize revenue under ASC 606. In accordance with ASC 606, revenue is recognized when a customer obtains control of promised goods or services. The amount of revenue recognized reflects the consideration that we expected to be entitled to receive in exchange for those goods or services. To adhere to the requirements of the new standard, we determine revenue recognition through the following steps: (1) Identification of the contract, or contracts, with a customer: We primarily contract with our customers through order forms, which in some cases are governed by master sales agreements. We determine that we have a contract with a customer when (i) the contract is approved, (ii) we can identify each party’s rights and obligations under the contract, (iii) we can identify the payment terms, (iv) we determine the customer has the ability and intent to pay and (v) we conclude that the contract has commercial substance. We are required to use judgment to determine whether the customer has the ability and intent to pay, which is based on a variety of factors including the customer’s historical payment experience or, when the contract is with a new customer, the credit, reputation and financial information of that customer. At contract inception we evaluate whether two or more contracts should be combined and accounted for as a single contract and whether the combined or single contract includes more than one performance obligation. (2) Identification of the performance obligations in the contract: We identify performance obligations in a contract based on the goods and services that will be transferred to the customer. Those goods or services must (i) be capable of being distinct, so the customer can benefit from a good or service either on its own or together with readily available resources (either from third parties or from us) and (ii) be distinct in the context of the contract, where the transfer of control is separately identifiable from other promises in the contract. We sell our software using a subscription model. Our subscriptions for solutions deployed on-premise within the customer’s IT infrastructure are comprised of a term-based license and an obligation to provide support and maintenance, where the term-based license and the support and maintenance constitute separate performance obligations. Our SaaS subscriptions provide customers the right to access cloud-hosted software and support for the SaaS service, which we consider to be a single performance obligation. Additionally, we renew subscriptions for support and maintenance, which we consider to be a single performance obligation. We have also identified services-related performance obligations that relate to the provisioning of consulting and training services. These services are distinct from subscriptions and do not result in significant customization of the software. (3) Determination of the transaction price: We determine the transaction price based on the consideration to which we expect to be entitled in exchange for transferring goods or services to the customer in accordance with the contract. Our transaction price excludes amounts collected on behalf of third parties, such as sales tax and value-added tax. Because we typically do not offer refunds, rebates, or credits to customers in the normal course of business, the impact of variable consideration has not been material. In instances where the timing of revenue recognition differs from the timing of invoicing, we have determined that our contracts generally do not contain a significant financing component. The primary purpose of our invoicing terms is to provide our customers with simple and predictable ways to purchase our subscriptions and not to provide them with financing. (4) Allocation of the transaction price to the performance obligations in the contract: If the contract contains a single performance obligation, the entire transaction price is allocated to the single performance obligation. Conversely, some of our contracts with customers contain multiple performance obligations. For these contracts, we account for individual performance obligations separately if they are distinct. The transaction price is allocated to the separate performance obligations on a relative standalone selling price (“SSP”) basis. We determine SSP based on an observable standalone selling price when it is available. In situations where SSP is not available, for example where software licenses are not sold separately, we determine SSP using information such as market conditions and other observable inputs that may require significant judgment. There is typically a range of standalone selling prices for individual products and services due to a stratification of those products and services by quantity and other circumstances. If a performance obligation is outside the SSP range, we determine the SSP to be the nearest endpoint of the range. (5) Recognition of revenue when, or as, we satisfy a performance obligation: Revenue is recognized at the time the performance obligation is satisfied by transferring control of the promised good or service to a customer. Our subscription term-based license revenue is recognized upfront at the later of delivery or commencement of the license term. Support and maintenance revenue is recognized ratably over the contract period based on the stand-ready nature of those subscription elements. Our SaaS subscription revenue is recognized ratably over the contract period as we satisfy the performance obligation. Professional services revenue is recognized on a time and materials basis as the services are performed. Revenue from training services and sponsorship fees is recognized on the date the services are complete. Channel Partner Sales. We generate sales directly through our sales team as well as through our channel partners. Where channel partners are involved, we have determined that we are generally the principal in these arrangements. Sales to channel partners are generally made at a discount, and revenues are recorded at the discounted price once the revenue recognition criteria above have been met. In certain instances, we pay referral fees to our partners, which we have determined to be commensurate with our internal sales commissions, so we record these payments as sales commissions. Channel partners generally receive an order from an end customer prior to placing an order with us, and payment from channel partners is not contingent on the partner’s collection from end customers. Deferred Commissions Sales commissions earned by our internal and external sales force are considered incremental and recoverable costs of obtaining a contract with a customer. Sales commissions for new revenue contracts and additional sales to existing customers are deferred and recorded in deferred commissions, current and noncurrent in the consolidated balance sheets. Deferred commissions are amortized over the period of benefit, which we have determined to be generally four years. We determined the period of benefit by taking into consideration our customer contracts, technology and other factors. Deferred commissions are amortized consistent with the pattern of revenue recognition for each performance obligation for contracts for which the commissions paid were earned. We include amortization of deferred commissions in sales and marketing expense in the consolidated statements of operations. We periodically review the carrying amount of deferred commissions to determine whether events or changes in circumstances have occurred that could impact the period of benefit of these deferred costs. Capitalized Software Costs For software products sold to customers, we expense costs for the development of new software products and substantial enhancements to existing software products as incurred until technological feasibility has been established. Once technological feasibility has been established, we capitalize certain costs during the application development stage as part of intangible assets. We believe our current process for developing software sold to customers will be essentially completed concurrently with the establishment of technological feasibility and thus, no costs have been capitalized to date. Additionally, maintenance and training costs are expensed as incurred. For software used internally, we capitalize qualifying costs during the application development stage and amortize those costs on a straight-line basis over the software’s estimated useful life, which is generally three to four years. Costs related to preliminary project activities and post implementation activities, however, are expensed as incurred. Acquisitions, Goodwill and Identifiable Intangible Assets We account for acquired businesses using the acquisition method of accounting, which requires that the assets acquired and liabilities assumed be recorded at the date of acquisition at their respective fair values. The fair value of identifiable intangible assets is based on significant judgments and estimates made by management. We typically engage third-party valuation appraisal firms to assist in determining the fair values and useful lives of the assets acquired. Such valuations and useful life determinations require us to make significant estimates and assumptions. These estimates and assumptions are based on historical experience and information obtained from the management of the acquired companies, and also include, but are not limited to, future expected cash flows earned from the product-related technology and discount rates applied in determining the present value of those cash flows. Unanticipated events and circumstances may occur that could affect the accuracy or validity of such assumptions, estimates or actual results. Goodwill represents the excess of the purchase price over the fair value of net assets acquired in business combinations using the acquisition method of accounting, which requires that the assets acquired and liabilities assumed be recorded at the date of acquisition at their respective fair values. We evaluate goodwill for impairment at least annually in the fourth quarter of each year, and as events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Our test for goodwill impairment starts with a qualitative assessment to determine whether it is necessary to perform a quantitative goodwill impairment test. If qualitative factors indicate that the fair value of the reporting unit is more likely than not less than its carrying amount, then a quantitative goodwill impairment test is performed. Under the quantitative impairment test, if the carrying amount of the reporting unit exceeds its fair value, then an impairment loss is recognized in an amount equal to that excess, not to exceed the total amount of goodwill. We record acquired in-process research and development as indefinite-lived intangible assets. Purchased intangible assets with indefinite lives are not amortized but assessed for potential impairment annually and when events or circumstances indicate that their carrying amounts might be impaired. We review long-lived assets, including property and equipment and finite-lived intangible assets, for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. Such events and changes may include significant changes in performance relative to expected operating results, significant changes in asset use, significant negative industry or economic trends and changes in our business strategy. An impairment loss is recognized when estimated undiscounted future cash flows expected to result from the use of the asset and its eventual disposition are less than its carrying amount. Stock-Based Compensation We recognize stock-based compensation expense in accordance with the provisions of Accounting Standards Codification 718, Compensation - Stock Compensation (“ASC 718”). ASC 718 requires compensation expense for all stock-based compensation awards made to employees and directors to be measured and recognized based on the grant date fair value of the awards. Stock-based compensation expense for time-based awards is determined based on the grant-date fair value and is recognized on a straight-line basis over the requisite service period of the award, which is typically the vesting term of the award. Stock-based compensation expense for awards subject to market and performance conditions is determined based on the grant-date fair value and is recognized on a graded vesting basis over the term of the award once it is probable that the performance conditions will be met. Stock-based compensation expense is recognized net of forfeitures. On January 1, 2018, we elected to adopt Accounting Standards Update No. 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”). Prior to the adoption of ASU 2016-09, we estimated forfeiture rates annually using our historical experience of forfeited awards and subsequently adjusted for actual forfeitures at each vesting date. After the adoption of ASU 2016-09, we recognize forfeitures as they occur. Adoption of this provision on January 1, 2018 resulted in a cumulative-effect adjustment to retained earnings of $38 thousand. To estimate the grant date fair value of our time-based awards, we utilize the Black-Scholes option pricing model. For awards subject to performance and market conditions, we use a Monte Carlo simulation model, which utilizes multiple inputs to estimate the probability that market conditions will be achieved. Both models involve inherent uncertainties and require the following highly subjective assumptions as inputs: ● Risk-free rate: We base the risk-free interest rate on the implied yield currently available on U.S. Treasury securities with a remaining term commensurate with the estimated expected term. ● Expected term: For time-based awards, the estimated expected term of options granted is generally calculated as the vesting period plus the midpoint of the remaining contractual term, as we do not have sufficient historical information to develop reasonable expectations surrounding future exercise patterns and post-vesting employment termination behavior. For awards subject to market and performance conditions, the expected term represents the period of time that the options granted are expected to be outstanding. ● Dividend yield: We estimate the dividend yield at zero, as we do not currently issue dividends and have no plans to issue dividends in the foreseeable future. ● Volatility: Since we do not have a trading history of our common stock, expected volatility is estimated based on the historical volatility of peer companies over the period commensurate with the estimated expected term. ● Fair value: Prior to our IPO in September 2019, our common stock was not yet publicly traded and thus, the fair value of the shares of common stock was established by the Board using various inputs, including an independent valuation. Following the IPO, our common stock is traded in the public market, and accordingly we use the applicable closing price of our common stock to determine fair value. The following assumptions were used for the time-based options that we granted during the years ended December 31, 2019, 2018 and 2017: The following assumptions were used for the awards subject to performance and market conditions that we granted during the years ended December 31, 2019, 2018 and 2017: For our RSUs, we calculate the fair value of each unit based on the estimated fair value of our common stock on the date of grant and subsequently record compensation expense over the vesting period using a straight-line method. Prior to the adoption of ASU 2016-09, we factored an estimated forfeiture rate in calculating compensation expense on RSUs and adjusted for actual forfeitures upon the vesting of each tranche of RSUs. After the adoption of ASU 2016-09, we account for forfeitures as they occur. Long-Term Incentive Plan Our long-term incentive plan (“LTIP”) could provide cash compensation to certain employees upon vesting if certain market and performance conditions are met and are thus liability-classified awards. Accordingly, we will remeasure the fair value of the LTIP awards at each reporting period until the awards are settled, which includes an evaluation of the probability of whether the awards meet vesting conditions. Income Taxes We account for income taxes using the asset and liability method, which requires the recognition of deferred tax assets and liabilities for temporary differences between the financial statement basis and the income tax basis of assets and liabilities that will result in taxable or deductible amounts in the future. Our temporary differences result primarily from net operating losses, stock-based compensation, deferred revenue, intangible assets and accrued expenses. Deferred income tax asset and liability computations are based on enacted tax laws and rates anticipated to be in effect when these differences reverse. We then assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that it is more likely than not that all or a portion of the deferred tax assets will not be realized, we establish a valuation allowance to reduce deferred income tax assets to the amounts expected to be realized. We evaluate our tax positions taken or expected to be taken in the course of preparing our tax returns to determine whether the tax positions are more likely than not of being sustained by the applicable tax authority. Tax positions not deemed to meet the more likely than not threshold would not be recorded as a tax benefit or expense in the current period. We include interest and penalties related to income tax liabilities in our benefit (provision) for income taxes. Recent Accounting Pronouncements For a description of our recently adopted accounting pronouncements and recently issued accounting standards not yet adopted, see “Note 2 - Summary of Significant Accounting Policies - Recent Accounting Pronouncements” to our condensed consolidated financial statements included in Part II, Item 8 of this Annual Report on Form 10-K.

<s>[INST] Overview Ping Identity is pioneering Intelligent Identity. We enable secure access to any service, application or API from any device. Our Intelligent Identity Platform can leverage AI and ML to analyze device, network, application and user behavior data to make realtime authentication and security control decisions, enhancing the user experience. Our platform is designed to detect anomalies and automatically insert additional security measures, such as multifactor authentication, only when necessary. We built our platform to meet the requirements of the most demanding enterprises. Our platform can be deployed across cloud, hybrid and onpremise infrastructures and offers a comprehensive suite of turnkey integrations, and is able to scale to millions of identities and thousands of cloud and onpremise applications. Our Intelligent Identity Platform can secure all primary use cases, including customer, workforce, partner and IoT. For example, enterprises can use our platform to enhance their customers’ user experience by creating a single ID and login across web and mobile properties. For the year ended December 31, 2019, 42% of our subscription revenue was derived from the customer use case. Enterprises can also use our platform to provide their workforce and commercial partners with secure, seamless access from any device to the applications, data and APIs they need to be productive. Enterprises are increasingly using our platform to manage and authenticate identities in a variety of IoT devices, such as connected vehicles and consumer devices. Our Intelligent Identity Platform is comprised of six solutions that can be purchased individually or as a set of integrated offerings for the customer, workforce, partner or IoT use case: SSO, MFA, Access Security, Directory, Data Governance and API Intelligence. Our offerings are predominately priced based on the number of identities, solutions and use cases. We sell our platform through subscriptionbased contracts, and substantially all of our customers pay annually in advance. We sell our solutions primarily through direct sales, which are enhanced by collaboration with our channel partners, resellers, system integrators and technology partners and includes sourcing new leads, aiding in presale processes such as proof of concepts, demos or requests for proposals and reselling our solutions to customers. We also leverage a number of our channel partners and system integrators to provide the implementation services for some of our larger and more complex deployments, significantly increasing the timetovalue for our customers and maximizing the efficiency of our gotomarket efforts. Key Factors Affecting Our Performance We believe that our future performance will depend on many factors, including the following: Generate Additional Sales to Existing Customers As part of our land and expand strategy, a customer journey often begins with the purchase of one of our solutions for one use case. Once customers realize the value of that solution, their spend with us expands by (i) adopting another identity use case, (ii) deploying additional solutions and solution packages and/or (iii) adding more identities over time. Our future revenue growth is dependent upon our ability to continue to expand our customers’ use of our platform. Our ability to increase sales to existing customers will depend on a number of factors, including satisfaction or dissatisfaction with our solutions, competition, pricing, economic conditions and spending by customers on our solutions. We have adopted a customer success strategy and implemented processes across our customer base to drive revenue retention and expansion. Increase the Size of our Customer Base We believe there is significant opportunity to increase market adoption of our platform by new customers. Our SSO, Access Security and Directory solutions often replace legacy and homegrown systems. We also have significant greenfield opportunities with our MFA, Data Governance, API Intelligence solutions and IoT. To increase our customer base, we plan to expand our sales force and channel partner network, both domestically and internationally, enhance our marketing efforts and target new buyers. For example, we have extended our cloudbased offering to target developers, who represent a new potential buyer for us. Over time, we believe sales to developers could increase the size of our customer base. Maintain our Technology Differentiation and Product Leadership Our Intelligent Identity Platform is designed for large enterprises with complex, hybrid IT requirements. We have spent over a decade building a standardsbased platform with turnkey integrations designed to ensure that large enterprises can easily and rapidly deploy our platform within their complex infrastructures. We intend to continue making investments in research and development to extend our platform and technology capabilities while also expand [/INST] Negative. </s>

BELLRING BRANDS, INC.

2019-11-22

2019-09-30

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion summarizes the significant factors affecting the combined operating results, financial condition, liquidity and capital resources of BellRing Brands, Inc. (“BellRing”) and its subsidiaries. This discussion should be read in conjunction with the balance sheet and accompanying notes for BellRing Brands, Inc., the historical combined financial statements and the accompanying notes for Post Holdings, Inc.’s (“Post”) Active Nutrition business (“Active Nutrition”), as well as the “Cautionary Statement Regarding Forward-Looking Statements” on page 1. Active Nutrition’s historical combined financial statements have been prepared on a stand-alone basis and are derived from the consolidated financial statements and accounting records of Post. The combined financial statements reflect the historical results of operations, financial position and cash flows of Active Nutrition and the allocation of certain Post corporate expenses relating to Active Nutrition based on the historical financial statements and accounting records of Post. In the opinion of management, the assumptions underlying the Active Nutrition historical combined financial statements, including the basis on which the expenses have been allocated from Post, are reasonable. However, the allocations may not reflect the expenses that BellRing may have incurred as a separate company for the periods presented. For additional information, see “Risk Factors” in Item 1A. OVERVIEW BellRing was formed as a Delaware corporation in 2019 to become the holding company for Active Nutrition, which, effective as of Post’s quarter ended June 30, 2015, has been comprised of Premier Nutrition Company, LLC, the successor to Premier Nutrition Corporation (“Premier Nutrition”), Dymatize Enterprises, LLC (“Dymatize”) and the PowerBar brand, and also includes Active Nutrition International GmbH, which manufactures and sells Active Nutrition products in certain international markets. We are a provider of highly nutritious, great-tasting products including ready-to-drink (“RTD”) protein shakes, other RTD beverages, powders, nutrition bars and nutritional supplements in the convenient nutrition category. The following discussion contains references to the years ended September 30, 2019, 2018 and 2017, which represent the financial results of our predecessor, Active Nutrition, for the same periods. On October 21, 2019, BellRing completed its initial public offering (the “IPO”) of 39.4 million shares of its Class A common stock, $0.01 par value per share (the “Class A Common Stock”), which number of shares included the underwriters’ exercise in full of their option to purchase up to an additional 5.1 million shares of Class A Common Stock, at an offering price of $14.00 per share. We received net proceeds from the IPO of approximately $524.4 million, after deducting underwriting discounts and commissions, all of which were contributed to BellRing Brands, LLC, a Delaware limited liability company which became a subsidiary of BellRing (“BellRing Brands, LLC”) on October 21, 2019, in exchange for BellRing Brands, LLC non-voting common units (“BellRing Brands, LLC units”). Our Class A Common Stock is traded on the NYSE under the ticker symbol “BRBR”. For additional information, see Note 14 within “Notes to Combined Financial Statements.” Industry & Company Trends The success of companies in the convenient nutrition category is driven by how well such companies can grow, develop and differentiate their brands. We expect the convergence of several factors to support the continued growth of the convenient nutrition category, including: • consumers’ increasingly dedicated pursuit of active lifestyles and growing interest in nutrition and wellness; • growing awareness of the numerous health benefits of protein, including sustained energy, muscle recovery and satiety; and • a rise in snacking and the desire for products that can be consumed on-the-go as nutritious snacks or meal replacements. Nonetheless, the consumer food and beverage industry faces a number of challenges and uncertainties, including: • the highly competitive nature of the industry, which involves competition from a host of nutritional food and beverage companies, including manufacturers of other branded food and beverage products as well as manufacturers of private label products; and • changing consumer preferences which require food manufacturers to identify changing preferences and to offer products that appeal to consumers. In addition to the trends described above, we also experienced short-term supply constraints for our RTD protein shakes during the year ended September 30, 2019. With the rapid consumption growth of our Premier Protein RTD shakes, we added significant capacity at our contract manufacturing partners in order to keep up with consumer demand. However, due to a combination of better than expected volume growth for our Premier Protein RTD shakes in the second half of fiscal 2018 and delays in planned incremental production capacity by our third party contract manufacturer network, our customer demand exceeded our available capacity and resulted in inventory below acceptable levels at September 30, 2018. To increase inventory and to minimize the overall impact to customers and consumers, Active Nutrition temporarily reduced its available RTD protein shake flavors in the first quarter of fiscal 2019 from seven to its two best-selling flavors, chocolate and vanilla. This decision adversely impacted the year-over-year growth rate for the year ended September 30, 2019 compared to growth trends experienced in fiscal 2018 and 2017. During the second quarter of fiscal 2019, all flavors were re-introduced and available to our customers. Additionally, we have significantly increased our RTD shake inventory levels, and believe we are positioned to meet customer demand and accelerate growth. Seasonality We have experienced in the past, and expect to continue to experience, seasonal fluctuations in our sales and earnings before income taxes (“EBIT”) margins because of customer spending patterns and timing of promotional activity. Historically, our first fiscal quarter is seasonally low for all brands driven by a slowdown of consumption of our products during the holiday season and during colder weather, which impacts outdoor activities. However, sales typically increase throughout the remainder of the fiscal year as a result of promotional activity at key retailers as well as organic growth of the business. Items Affecting Comparability During the years ended September 30, 2019, 2018 and 2017, net sales and/or EBIT was impacted by the following items: • short-term supply constraints for our RTD protein shakes, which resulted in smaller volume increases in the year ended September 30, 2019 as compared to prior periods (see “Industry & Company Trends” above for further discussion); • separation costs of $6.7 million related to our separation from Post for the year ended September 30, 2019; • the reclassification of certain payments to customers of $8.8 million from selling, general and administrative expenses to net sales in the year ended September 30, 2019, in connection with the adoption of Accounting Standards Update (“ASU”) 2014-09, “Revenue from Contracts with Customers (Topic 606);” • litigation settlement accruals of $9.0 million in the year ended September 30, 2018; • a goodwill impairment charge of $26.5 million in the year ended September 30, 2017; and • insurance proceeds of $2.0 million in the year ended September 30, 2017. For further discussion, refer to “Results of Operations” within this section. RESULTS OF OPERATIONS Net Sales Fiscal 2019 compared to 2018 Net sales increased $26.9 million, or 3%, during the year ended September 30, 2019, as compared to the prior year. Sales of Premier Protein products were up $43.8 million, or 7%, with volume up 5%, driven by higher average net selling prices resulting from targeted price increases and higher RTD protein shake product volumes, partially offset by lower sales of nutrition bars. Increases in RTD protein shake product volumes for the year ended September 30, 2019 were below recent growth trends primarily due to short-term supply constraints (for further discussion, see “Industry & Company Trends” above). Sales of Dymatize products were up $4.3 million, or 4%, with volume up 3%, primarily due to distribution gains in the mass channel and organic growth in the eCommerce channel, partially offset by declines in the domestic specialty channel. Sales of PowerBar products were down $15.6 million, or 26%, with volume down 29%, driven by distribution losses and strategic sales reductions of low performing products within our North American portfolio. Sales of all other products were down $5.6 million. Current year net sales were impacted by the reclassification of certain payments to customers of $8.8 million from selling expenses to net sales in connection with the adoption of ASU 2014-09 (see below for further discussion). Fiscal 2018 compared to 2017 Net sales increased $114.3 million, or 16%, during the year ended September 30, 2018, as compared to the prior year. Sales of Premier Protein products were up $135.0 million, or 27%, with volume up 29%, driven by increased consumption and distribution of RTD protein shakes, as well as new product introductions. Sales of Dymatize products were down $2.1 million, or 2%, with volume down 13%, primarily due to weakness in the domestic specialty channel, partially offset by volume gains in the eCommerce channel, new distribution in the club and mass channels and a favorable customer and product mix. Sales of PowerBar products were down $18.9 million, or 24%, with volume down 27%, primarily due to lost distribution in the mass channel, portfolio reductions on low performing product and reduced consumption in North America. These negative impacts were partially offset by new product introductions and favorable foreign exchange rates. Sales of all other products were up $0.3 million. Earnings before Income Taxes Fiscal 2019 compared to 2018 EBIT increased $42.7 million, or 36%, for the year ended September 30, 2019. EBIT in the year ended September 30, 2019 was impacted by separation costs of $6.7 million and the year ended September 30, 2018 was impacted by a litigation settlement accrual of $9.0 million. Excluding these impacts, EBIT increased $40.4 million, or 31%. This increase was primarily driven by higher net sales, as previously discussed, lower net product costs of $19.6 million, as favorable raw materials and freight costs were partially offset by increased manufacturing costs, and reduced marketing spending of $5.4 million. These positive impacts were partially offset by higher employee-related expenses of $6.6 million and increased brokerage and warehousing costs of $2.2 million. Fiscal 2018 compared to 2017 EBIT increased $54.2 million, or 83%, for the year ended September 30, 2018. EBIT in the year ended September 30, 2018 was impacted by a litigation settlement accrual of $9.0 million and in the year ended September 30, 2017, by an impairment of goodwill of $26.5 million (see below for further discussion) and insurance proceeds of $2.0 million. Excluding these impacts, EBIT increased $38.7 million, or 43%. This increase was driven by higher Premier Protein product volumes, as previously discussed, and lower advertising and consumer spending of $9.7 million, partially offset by higher raw material costs of $2.3 million, increased freight costs of $8.4 million (excluding volume-driven increases) and increased employee-related expenses to support growth. Impairment of Goodwill Fiscal 2017 For the year ended September 30, 2017, Active Nutrition recorded a charge of $26.5 million for the impairment of goodwill. The impairment charge related to the Dymatize reporting unit. In fiscal 2017, consistent with the prior year, the specialty channel, from which the Dymatize reporting unit derived the majority of its sales, continued to experience weak sales, which resulted in management lowering its long-term expectations for the Dymatize reporting unit. After conducting the impairment analysis, it was determined that the carrying value of the Dymatize reporting unit exceeded its fair value by $76.6 million, and Active Nutrition recorded an impairment charge for goodwill down to the fair value. At the time of the analysis, the Dymatize reporting unit had $26.5 million of remaining goodwill, and therefore, an impairment charge for the entire goodwill balance of $26.5 million was recorded. Income Taxes The effective income tax rate for fiscal 2019 was 24.2%, compared to 19.8% for fiscal 2018 and 46.3% for fiscal 2017. A reconciliation of income tax expense with amounts computed at the federal statutory tax rate follows: (a) Fiscal 2019 and 2017 federal corporate income tax was computed at the federal statutory tax rates of 21% and 35%, respectively. The fiscal 2018 federal corporate income tax was computed using a blended United States (“U.S.”) federal corporate income tax rate of 24.5%. The fiscal 2018 federal corporate income tax rate was impacted by the Tax Cuts and Jobs Act (the “Tax Act”), as discussed below. In fiscal 2018, the effective income tax rate was impacted by the Tax Act, which was enacted on December 22, 2017. The Tax Act resulted in significant impacts to the accounting for income taxes with the most significant of these impacts relating to the reduction of the U.S. federal corporate income tax rate, a one-time transition tax on unrepatriated foreign earnings and full expensing of certain qualified depreciable assets placed in service after September 27, 2017 and before January 1, 2023. The Tax Act enacted a new U.S. federal corporate income tax rate of 21% that went into effect for the 2019 tax year and was prorated with the pre-December 22, 2017 U.S. federal corporate income tax rate of 35% for the 2018 tax year. This proration resulted in a blended U.S. federal corporate income tax rate of 24.5% for fiscal 2018. During the year ended September 30, 2018, Active Nutrition: (i) remeasured its existing deferred tax assets and liabilities considering both the 2018 fiscal blended rate and the 21% rate for future periods and recorded a tax benefit of $9.9 million and (ii) calculated the one-time transition tax and recorded tax expense of $0.5 million. Full expensing of certain depreciable assets will result in a temporary difference as assets are placed in service. Revenue from Contracts with Customers On October 1, 2018, Active Nutrition adopted ASU 2014-09, “Revenue from Contracts with Customers (Topic 606),” which superseded all existing revenue recognition guidance under GAAP. As a result of the adoption, certain payments to customers were reclassified from “Selling, general and administrative expenses” to “Net Sales” in the Combined Statement of Operations and Comprehensive Income for the year ended September 30, 2019. For additional information regarding ASU 2014-09, refer to Note 4 of “Notes to Combined Financial Statements.” LIQUIDITY AND CAPITAL RESOURCES Financial resources for our U.S. operations have historically been provided by Post, which has managed cash and cash equivalents on a centralized basis. Under Post’s centralized cash management system, cash requirements are provided directly by Post, and cash generated by us is generally remitted directly to Post. Transaction systems (e.g. payroll and employee benefits) used to record and account for cash disbursements are generally provided by Post. Cash receipts associated with our U.S. business have been transferred to Post on a daily basis and Post has funded our cash disbursements. Financial resources for our international operations have been historically managed by us. On October 21, 2019, BellRing closed its IPO of 39.4 million shares of its Class A Common Stock, $0.01 par value per share, which number of shares included the underwriters’ exercise in full of their option to purchase up to an additional 5.1 million shares of Class A Common Stock, at an offering price of $14.00 per share. The Company received net proceeds from the IPO of $524.4 million, after deducting underwriting discounts and commissions. On October 11, 2019, in connection with the IPO and certain other transactions completed in connection with the IPO (the “formation transactions”), Post entered into a $1,225.0 million Bridge Facility Agreement (the “Post Bridge Loan Facility”) and borrowed $1,225.0 million under the Post Bridge Loan Facility (the “Post Bridge Loan”). Certain of Post’s domestic subsidiaries (other than BellRing but including BellRing Brands, LLC and its domestic subsidiaries) guaranteed the Post Bridge Loan. On October 21, 2019, BellRing Brands, LLC entered into a Borrower Assignment and Assumption Agreement with Post and the administrative agent, pursuant to which (i) BellRing Brands, LLC became the borrower under the Post Bridge Loan and assumed all interest of $2.2 million and all other material obligations thereunder, and Post and its subsidiary guarantors (which do not include BellRing Brands, LLC or its domestic subsidiaries) were released from all material obligations under the Post Bridge Loan, (ii) the domestic subsidiaries of BellRing Brands, LLC continued to guarantee the Post Bridge Loan, and (iii) BellRing Brands, LLC’s obligations under the Post Bridge Loan became secured by a first priority security interest in substantially all of the assets of BellRing Brands, LLC and in substantially all of the assets of its subsidiary guarantors. We did not receive any of the proceeds of the Post Bridge Loan. On October 21, 2019, BellRing Brands, LLC entered into a Credit Agreement (the “Credit Agreement”). The Credit Agreement provides for a term B loan facility in an aggregate principal amount of $700.0 million (the “Term B Facility”), and a revolving credit facility in an aggregate principal amount of $200.0 million (the “Revolving Credit Facility”). On October 21, 2019, BellRing Brands, LLC borrowed the full amount under the Term B Facility and $100.0 million under the Revolving Credit Facility and used the proceeds, together with the net proceeds of the IPO that were contributed to it by us, (i) to repay in full the balance of the Post Bridge Loan and all interest thereunder and related costs and expenses, (ii) to pay directly, or reimburse Post for, as applicable, all fees and expenses incurred by us or Post in connection with the IPO and the formation transactions, (iii) to reimburse Post for the amount of cash on our balance sheet immediately prior to the completion of the IPO and (iv) to the extent there were any remaining proceeds, for general corporate and working capital purposes. On October 31, 2019, BellRing Brands, LLC repaid $40.0 million of outstanding borrowings under the Revolving Credit Facility, increasing the available borrowing capacity under the Revolving Credit Facility to $140.0 million. We have $140.0 million of borrowing capacity under the Revolving Credit Facility as of October 31, 2019 (all of which would be secured when drawn), and letters of credit are available under the Revolving Credit Facility in an aggregate amount of up to $20.0 million. The Credit Agreement provides for potential incremental revolving and term facilities at the request of BellRing Brands, LLC and at the discretion of the Lenders or other persons providing such incremental facilities, in each case on terms to be determined, and also permits BellRing Brands, LLC to incur other secured or unsecured debt, in all cases subject to conditions and limitations on the amount as specified in the Credit Agreement. For additional information on the IPO, the formation transactions and the Credit Agreement, see Note 14 within Active Nutrition’s “Notes to Combined Financial Statements.” Additionally, we entered into a tax receivable agreement with Post and BellRing Brands, LLC that provides for the payment by us or one of our subsidiaries to Post (or certain of its transferees or other assignees) of 85% of the amount of cash savings, if any, in U.S. federal income tax, as well as state and local income tax and franchise tax (using an assumed tax rate) and foreign tax that we realize (or, in some circumstances, are deemed to realize) as a result of (a) the increase in the tax basis of assets of BellRing Brands, LLC attributable to (i) the redemption of Post’s (or certain transferees’ or assignees’) BellRing Brands, LLC units for shares of our Class A Common Stock or cash, (ii) deemed sales by Post (or certain of its transferees or assignees) of BellRing Brands, LLC units or assets to us, (iii) certain actual or deemed distributions from BellRing Brands, LLC to Post (or certain transferees or assignees) and (iv) certain formation transactions, (b) disproportionate allocations of tax benefits to us as a result of Section 704(c) of the Internal Revenue Code and (c) certain tax benefits (e.g., imputed interest, basis adjustments, etc.) attributable to payments under the tax receivable agreement. For additional information on the IPO, the formation transactions, the Credit Agreement and the tax receivable agreement, see Note 14 within Active Nutrition’s “Notes to Combined Financial Statements.” We expect to generate positive cash flows from operations and believe our cash on hand, cash flows from operations and possible future credit facilities will be sufficient to satisfy our future working capital requirements, research and development activities and other financing requirements for the foreseeable future. Our asset-light business model requires modest capital expenditures, with annual capital expenditures over the last three fiscal years averaging less than 1% of net sales. No significant capital expenditures are planned for fiscal 2020. Our ability to generate positive cash flows from operations is dependent on general economic conditions, competitive pressures and other business risk factors. If we are unable to generate sufficient cash flows from operations, or otherwise to comply with the terms of our credit facilities, we may be required to seek additional financing alternatives. Under its amended and restated limited liability company agreement, BellRing Brands, LLC may make distributions to its members from time to time at the discretion of the Board of Managers. Such distributions will be made to the members on a pro rata basis in proportion to the number of BellRing Brands, LLC units held by each member, except that the Board of Managers may cause BellRing Brands, LLC to make non-proportionate distributions to BellRing in connection with any cash redemption of BellRing’s Class A Common Stock. The amended and restated limited liability company agreement provides, to the extent cash is available, for distributions pro rata to the holders of BellRing Brands, LLC units such that members receive an amount of cash sufficient to cover the estimated taxes payable by them including, in the case of BellRing, an amount sufficient to allow BellRing to make any payments required under the tax receivable agreement. In addition, the amended and restated limited liability company agreement will provide that BellRing Brands, LLC will reimburse BellRing for any reasonable out-of-pocket expenses incurred on behalf of us, including all fees, costs and expenses of BellRing associated with being a public company and maintaining its corporate existence. Operating Activities Fiscal 2019 compared to 2018 Cash provided by operating activities for the year ended September 30, 2019 decreased by $42.9 million compared to the year ended September 30, 2018, driven by unfavorable working capital changes of $86.7 million, partially offset by higher earnings before income taxes. Changes in working capital were driven by an increase in finished goods inventory for our Premier Protein RTD shakes as compared to unusually low inventory levels at September 30, 2018, as well as the impacts of fluctuations in the timing of sales, largely connected with the timing of promotional activity, and payments of legal settlements. Fiscal 2018 compared to 2017 Cash provided by operating activities for the year ended September 30, 2018 increased by $60.8 million compared to the year ended September 30, 2017. The increase was driven by higher earnings before income taxes as well as $31.3 million of favorable working capital changes during the year ended September 30, 2018, as compared to the prior year period. The change in working capital was driven by a reduction in finished goods inventory, the timing of purchases and payments of trade payables and an increase in accrued legal settlements, partially offset by increased receivables due to higher net sales. Investing Activities Fiscal 2019 compared to 2018 Cash used in investing activities for the year ended September 30, 2019 decreased $1.8 million compared to the prior year, resulting from a decrease in capital expenditures. Fiscal 2018 compared to 2017 Cash used in investing activities for the year ended September 30, 2018 was $5.0 million compared to cash provided by investing activities of $2.1 million in the year ended September 30, 2017. Cash provided by investing activities in the year ended September 30, 2017 included proceeds of $6.0 million received from the sale of the Dymatize manufacturing facility located in Farmers Branch, Texas. Capital expenditures increased $1.1 million in the year ended September 30, 2018, as compared to the prior year period. Financing Activities Fiscal 2019 compared to 2018 Cash used in financing activities for the year ended September 30, 2019 decreased $32.8 million compared to the prior year. Financing activities primarily related to cash transfers to and from Post. The components of net transfers included cash deposits from Active Nutrition to Post and cash borrowings received from Post used to fund operations or capital expenditures and allocations of Post’s corporate expenses (see Note 9 within “Notes to Combined Financial Statements”). Fiscal 2018 compared to 2017 Cash used in financing activities for the year ended September 30, 2018 increased $49.0 million compared to the prior year. Financing activities primarily related to cash transfers to and from Post. The components of net transfers included cash deposits from Active Nutrition to Post and cash borrowings received from Post used to fund operations or capital expenditures and allocations of Post’s corporate expenses (see Note 9 within “Notes to Combined Financial Statements”). Contractual Obligations In the normal course of business, we enter into contracts and commitments which obligate us to make payments in the future. The table below sets forth our significant future obligations by time period as of September 30, 2019. For consideration of the table below, “Less Than 1 Year” refers to obligations due between October 1, 2019 and September 30, 2020, “1-3 Years” refers to obligations due between October 1, 2020 and September 30, 2022, “3-5 Years” refers to obligations due between October 1, 2022 and September 30, 2024 and “More Than 5 Years” refers to any obligations due after September 30, 2024. (a) Purchase obligations are legally binding agreements to purchase goods, services or equipment that specify all significant terms, including: fixed or minimum quantities to be purchased and/or penalties imposed for failing to meet contracted minimum purchase quantities; fixed, minimum or variable price provisions; and the approximate timing of the transaction. (b) Operating lease obligations consist of minimum rental payments under noncancelable operating leases, as shown in Note 10 within “Notes to Combined Financial Statements.” (c) The above table excludes the following fiscal 2020 transactions completed in connection with the IPO and the formation transactions: •$1,225.0 million outstanding principal balance repayment of the Post Bridge Loan by BellRing Brands, LLC; •$700.0 million of borrowings by BellRing Brands, LLC under the Term B Facility; and •$60.0 million of net borrowings by BellRing Brands, LLC under the Revolving Credit Facility. Additionally, we have excluded interest payments of $238.4 million related to the Term B Facility and Revolving Credit Facility entered into in October 2019 and interest of $2.2 million related to the repayment of the Post Bridge Loan. The outstanding amounts under the Revolving Credit Facility and Term B Facility must be repaid on or before October 21, 2024. For additional information on the IPO and formation transactions, refer to Note 14 within Active Nutrition’s “Notes to Combined Financial Statements.” COMMODITY TRENDS We are exposed to price fluctuations primarily from purchases of ingredients and packaging materials, transportation costs and energy. Our principal ingredients are milk-based, whey-based and soy-based proteins and protein blends. Our principal packaging materials consist of aseptic foil and plastic lined cardboard cartons, aseptic plastic bottles, plastic jars and lids, flexible film, cartons and corrugate. These costs have been volatile in recent years and future changes in such costs may cause our results of operations and our operating margins to fluctuate significantly. We manage the impact of cost increases, wherever possible, on commercially reasonable terms, by locking in prices on the quantities through purchase commitments required to meet our production requirements. In addition, we attempt to offset the effect of increased costs by raising prices to our customers. However, for competitive reasons, we may not be able to pass along the full effect of increases in raw materials and other input costs as we incur them. In addition, inflationary pressures can have an adverse effect on our business through higher raw material and fuel costs. We believe that inflation has not had a material adverse impact on our operations for the years ended September 30, 2019, 2018 and 2017, but could have a material impact in the future if inflation rates were to significantly exceed our ability to achieve price increases. CURRENCY Certain sales and costs of our foreign operations are denominated in the Euro. Consequently, profits from these operations are impacted by fluctuations in the value of this currency relative to the U.S. Dollar. OFF-BALANCE SHEET ARRANGEMENTS As of September 30, 2019, 2018 and 2017, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4) of Regulation S-K that are likely to have a material impact on our financial position or results of operations. CRITICAL ACCOUNTING ESTIMATES The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America (“GAAP”) requires the use of judgment, estimates and assumptions. We make these subjective determinations after considering our historical performance, management’s experience, current economic trends and events and information from outside sources. Inherent in this process is the possibility that actual results could differ from these estimates and assumptions for any particular period. Throughout the periods covered by the financial statements, Active Nutrition’s operations were conducted by and accounted for as part of Post. The Active Nutrition financial statements were derived from Post’s historical accounting records and reflect significant allocations of direct costs and expenses. All of the allocations and estimates in the financial statements are based on assumptions that we believe are reasonable. The financial statements do not necessarily represent our financial position, results of operations and cash flows had our business been operated as a separate independent entity. Active Nutrition’s significant accounting policies are described in Note 2 within “Notes to Combined Financial Statements”. The critical accounting estimates are those that have a meaningful impact on the reporting of our financial condition and results of operations. Revenue Recognition - We recognize revenue when performance obligations have been satisfied by transferring control of the goods to customers. Control is generally transferred upon delivery of the goods to the customer. At the time of delivery, the customer is invoiced using previously agreed-upon credit terms. Shipping and/or handling costs that occur before the customer obtains control of the goods are deemed fulfillment activities and are accounted for as fulfillment costs. Our contracts with customers generally contain one performance obligation. Many of our contracts with customers include some form of variable consideration. The most common forms of variable consideration are trade promotions, rebates and discounts. Variable consideration is treated as a reduction of revenue at the time product revenue is recognized. Depending on the nature of the variable consideration,we primarily use the “expected value” method to determine variable consideration. We do not believe that there will be significant changes to our estimates of variable consideration when any uncertainties are resolved with customers. We review and update estimates of variable consideration each period. Uncertainties related to the estimates of variable consideration are resolved in a short time frame and do not require any additional constraint on variable consideration. Our products are sold with no right of return, except in the case of goods which do not meet product specifications or are damaged. No services beyond this assurance-type warranty are provided to customers. Customer remedies include either a cash refund or an exchange of the product. As a result, the right of return and related refund liability is estimated and recorded as a reduction of revenue based on historical sales return experience. Long-Lived Assets - We review long-lived assets, including leasehold improvements, property and equipment and amortized intangible assets, for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. Long-lived assets to be disposed of are reported at the lower of the carrying amount or fair value less the cost to sell. Estimating future cash flows and calculating the fair value of assets requires significant estimates and assumptions by management. Goodwill - Goodwill represents the excess of the cost of acquired businesses over the fair market value of their identifiable net assets. We conduct a goodwill impairment qualitative assessment during the fourth quarter of each fiscal year following the annual forecasting process, or more frequently if facts and circumstances indicate that goodwill may be impaired. The goodwill impairment qualitative assessment requires us to perform an assessment to determine if it is more likely than not that the fair value of the business is less than its carrying amount. The qualitative assessment considers various factors, including the macroeconomic environment, industry and market specific conditions, financial performance, cost impacts and issues or events specific to the business. If adverse qualitative trends are identified that could negatively impact the fair value of the business, we perform a quantitative goodwill impairment test. In fiscal 2019, 2018 and 2017, Active Nutrition performed a quantitative impairment test. The goodwill impairment test requires an entity to compare the fair value of each reporting unit with its carrying amount. An impairment charge should be recognized for the amount by which the carrying amount of goodwill exceeds the reporting unit’s fair value with the loss not exceeding the total amount of goodwill allocated to that reporting unit. The estimated fair values of each reporting unit were determined using a combined income and market approach with a greater weighting on the income approach (75% of the calculation for all reporting units with goodwill). The income approach is based on discounted future cash flows and requires significant assumptions, including estimates regarding future revenue, profitability and capital requirements. The market approach (25% of the calculation for all reporting units with goodwill) is based on a market multiple (revenue and EBITDA, which stands for earnings before interest, income taxes, depreciation and amortization) and requires an estimate of appropriate multiples based on market data. Revenue growth assumptions (along with profitability and cash flow assumptions) were based on historical trends for the reporting units and management's expectations for future growth. The discount rates were based on a risk adjusted weighted-average cost of capital utilizing industry market data of businesses similar to the reporting units and based upon management judgment. Active Nutrition did not record a goodwill impairment charge at September 30, 2019 or September 30, 2018, as it passed the quantitative impairment test. For the year ended September 30, 2017, Active Nutrition recorded a charge of $26.5 million for the impairment of goodwill. The impairment charge related to the Dymatize reporting unit. In fiscal 2017, consistent with the prior year, the specialty channel, from which the Dymatize reporting unit derived the majority of its sales, continued to experience weak sales, which resulted in management lowering its long-term expectations for the Dymatize reporting unit. After conducting the impairment analysis, it was determined that the carrying value of the Dymatize reporting unit exceeded its fair value by $76.6 million and Active Nutrition recorded an impairment charge of goodwill down to fair value. At the time of the analysis, the Dymatize reporting unit had $26.5 million of remaining goodwill, and therefore an impairment charge was recorded for the entire goodwill balance of $26.5 million. Income Tax - We estimate income tax expense based on taxes in each jurisdiction. We estimate current tax exposures together with temporary differences resulting from differing treatment of items for tax and financial reporting purposes. These temporary differences result in deferred tax assets and liabilities. We believe that sufficient income will be generated in the future to realize the benefit of most of our deferred tax assets. Where there is not sufficient evidence that such income is likely to be generated, we establish a valuation allowance against the related deferred tax assets. We are subject to periodic audits by governmental tax authorities of our income tax returns. These audits generally include questions regarding our tax filing positions, including the amount and timing of deductions and the allocation of income among various tax jurisdictions. We evaluate our exposures associated with our tax filing positions, including state and local taxes, and record reserves for estimated exposures. See Note 6 within Active Nutrition’s “Notes to Combined Financial Statements” for more information about estimates affecting income taxes. RECENTLY ISSUED AND ADOPTED ACCOUNTING STANDARDS See Note 3 within Active Nutrition’s “Notes to Combined Financial Statements” for a discussion regarding recently issued and adopted accounting standards.

<s>[INST] The following discussion summarizes the significant factors affecting the combined operating results, financial condition, liquidity and capital resources of BellRing Brands, Inc. (“BellRing”) and its subsidiaries. This discussion should be read in conjunction with the balance sheet and accompanying notes for BellRing Brands, Inc., the historical combined financial statements and the accompanying notes for Post Holdings, Inc.’s (“Post”) Active Nutrition business (“Active Nutrition”), as well as the “Cautionary Statement Regarding ForwardLooking Statements” on page 1. Active Nutrition’s historical combined financial statements have been prepared on a standalone basis and are derived from the consolidated financial statements and accounting records of Post. The combined financial statements reflect the historical results of operations, financial position and cash flows of Active Nutrition and the allocation of certain Post corporate expenses relating to Active Nutrition based on the historical financial statements and accounting records of Post. In the opinion of management, the assumptions underlying the Active Nutrition historical combined financial statements, including the basis on which the expenses have been allocated from Post, are reasonable. However, the allocations may not reflect the expenses that BellRing may have incurred as a separate company for the periods presented. For additional information, see “Risk Factors” in Item 1A. OVERVIEW BellRing was formed as a Delaware corporation in 2019 to become the holding company for Active Nutrition, which, effective as of Post’s quarter ended June 30, 2015, has been comprised of Premier Nutrition Company, LLC, the successor to Premier Nutrition Corporation (“Premier Nutrition”), Dymatize Enterprises, LLC (“Dymatize”) and the PowerBar brand, and also includes Active Nutrition International GmbH, which manufactures and sells Active Nutrition products in certain international markets. We are a provider of highly nutritious, greattasting products including readytodrink (“RTD”) protein shakes, other RTD beverages, powders, nutrition bars and nutritional supplements in the convenient nutrition category. The following discussion contains references to the years ended September 30, 2019, 2018 and 2017, which represent the financial results of our predecessor, Active Nutrition, for the same periods. On October 21, 2019, BellRing completed its initial public offering (the “IPO”) of 39.4 million shares of its Class A common stock, $0.01 par value per share (the “Class A Common Stock”), which number of shares included the underwriters’ exercise in full of their option to purchase up to an additional 5.1 million shares of Class A Common Stock, at an offering price of $14.00 per share. We received net proceeds from the IPO of approximately $524.4 million, after deducting underwriting discounts and commissions, all of which were contributed to BellRing Brands, LLC, a Delaware limited liability company which became a subsidiary of BellRing (“BellRing Brands, LLC”) on October 21, 2019, in exchange for BellRing Brands, LLC nonvoting common units (“BellRing Brands, LLC units”). Our Class A Common Stock is traded on the NYSE under the ticker symbol “BRBR”. For additional information, see Note 14 within “Notes to Combined Financial Statements.” Industry & Company Trends The success of companies in the convenient nutrition category is driven by how well such companies can grow, develop and differentiate their brands. We expect the convergence of several factors to support the continued growth of the convenient nutrition category, including: consumers’ increasingly dedicated pursuit of active lifestyles and growing interest in nutrition and wellness; growing awareness of the numerous health benefits of protein, including sustained energy, muscle recovery and satiety; and a rise in snacking and the desire for products that can be consumed onthego as nutritious snacks or meal replacements. Nonetheless, the consumer food and beverage industry faces a number of challenges and uncertainties, [/INST] Positive. </s>

Atreca, Inc.

2020-03-11

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 consolidated financial statements and related notes thereto included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Form 10-K, including information with respect to our plans and strategy for our business, includes forward-looking statements that involves risks and uncertainties. See “Special Note Regarding Forward-Looking Statements” and “Risk Factors” for a discussion of forward-looking statements and important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements. All information presented herein is based on our fiscal calendar. Unless otherwise stated, references to particular years, quarters, months or periods refer to our fiscal years ended December 31 and the associated quarters, months and periods of those fiscal years. Overview We are a clinical-stage biopharmaceutical company utilizing our differentiated platform to discover and develop novel antibody-based immunotherapeutics to treat a range of solid tumor types. While more traditional oncology drug discovery approaches attempt to generate antibodies against known targets, our approach relies on the human immune system to direct us to unique antibody-target pairs from patients experiencing a clinically meaningful, active immune response against their tumors. These unique antibody-target pairs represent a potentially novel and previously unexplored landscape of immuno-oncology targets. We believe the fact that our approach has the potential to deliver novel, previously unexplored immuno-oncology targets provides us with a significant competitive advantage over traditional approaches which focus on known targets that many companies are aware of and can pursue. We have utilized our drug discovery approach to identify over 1,600 distinct human antibodies that bind preferentially to tumor tissue from patients who are not the source of the antibody. Our lead product candidate, ATRC-101, is a monoclonal antibody with a novel mechanism of action and target derived from an antibody identified using our discovery platform. ATRC-101 reacts in vitro with a majority of human ovarian, non-small cell lung, colorectal and breast cancer samples from multiple patients. It has demonstrated robust anti-tumor activity as a single agent in multiple preclinical models, including one model in which PD-1 checkpoint inhibitors typically display limited activity. We filed the Investigational New Drug, or IND, application for ATRC-101, which was cleared by the U.S. Food and Drug Administration, or FDA, in the fourth quarter of 2019 and have initiated a Phase 1b clinical trial in patients with select solid tumors in which the first patient was dosed in February 2020. Since commencing operations in 2010, we have devoted substantially all our resources to research and development, raising capital, building our management team and building our intellectual property portfolio. We do not have any products approved for marketing or sale and have not generated any revenue from product sales. We have funded our operations to date primarily from the sale of convertible preferred stock. We have also received more than $15 million in payments to date under our service agreement with the Bill & Melinda Gates Foundation. We have incurred significant operating losses since our inception. Our ability to generate product revenue sufficient to achieve or sustain profitability will depend on the successful development, regulatory approval and eventual commercialization of one or more of our current or future product candidates. Our net losses were $67.5 million and $37.9 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $164.1 million. We anticipate that a substantial portion of our capital resources and efforts in the foreseeable future will be focused on discovering, completing the necessary development, obtaining regulatory approval for and preparing for potential commercialization of product candidates. As of December 31, 2019, our cash, cash equivalents and investments were $183.4 million. We expect to continue to incur significant expenses and increasing operating losses for the foreseeable future. Our net losses may fluctuate significantly from period to period, depending on the timing of our planned preclinical - 67 - studies and clinical trials and expenditures on other research and development activities. We expect our expenses will increase substantially over time as we: § complete clinical trials for ATRC-101 and initiate preclinical studies on any additional product candidates that we may pursue in the future; § continue research and development to expand our growing library of more than 1,600 antibodies and develop potential future product candidates from that collection; § continue to invest in advancing our differentiated discovery platform, and the underlying technologies; § seek marketing approvals for product candidates that successfully complete clinical trials; § maintain, protect and expand our portfolio of intellectual property rights, including patents, trade secrets and know-how; § implement additional operational, financial and management systems; and § attract, hire and retain additional administrative, clinical, regulatory and research personnel. Furthermore, as a result of the closing of our initial public offering in June 2019, costs associated with operating as a public company have increased. Such costs include significant legal, accounting, insurance, investor relations and other expenses that we did not incur historically as a private company. Financial Operations Overview Revenue We have no products approved for marketing or commercial sale and have never generated any revenue from product sales. 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, including intellectual property legal expenses, salaries, employee benefits and stock-based compensation for personnel contributing to research and development activities, laboratory supplies, outsourced research and development expenses, professional services and allocated facilities-related costs. We expect our research and development expenses to increase in the foreseeable future as we continue to invest in our differentiated discovery platform to expand our pipeline of product candidates, advance our product candidates into and through preclinical studies and clinical trials and pursue regulatory approval of our product candidates. General and Administrative Our general and administrative expenses consist primarily of personnel costs, allocated facilities costs and other expenses for outside professional services, including legal, human resource, audit and accounting services. We expect to incur additional general and administrative expenses as we continue to support the growth of our business and incur the costs of compliance associated with being a public company. Interest and Other Income (Expense) Other income (expense) includes other income which represents amounts received from partners for research and discovery services, interest income earned on our cash, cash equivalents and investments, interest expense, revaluation expense resulting from the liability recorded for certain preferred stock warrants and gains or losses on the periodic disposals of property and equipment. - 68 - Results of Operations Comparison of the Years Ended December 31, 2019 and 2018 The following table summarizes our results of operations during the respective periods: *Not meaningful Research and Development The following table summarizes our research and development expenses incurred during the respective periods: Research and development expenses increased by $22.2 million, or 68%, during the year ended December 31, 2019 compared to the same period in 2018. The increase was primarily attributable to higher personnel-related expenses of $8.2 million as a result of additional employee headcount, a $7.0 million increase in product and preclinical development costs primarily associated with efforts to advance ATRC-101 towards an IND application in late 2019, $3.9 million and $2.1 million of increases in facility and lab-related expenses due to expansion of lab facilities and activities. General and Administrative General and administrative expenses increased by $10.8 million, or 153%, during the year ended December 31, 2019 compared to the same period in 2018. The increase consists of a $5.4 million increase in personnel-related expenses, including stock-based compensation, as a result of additional employee headcount, a $1.9 million increase in - 69 - consulting, legal and other services costs primarily due to increasing legal costs related compliance work, and IND filing for ATRC-101 and a $2.3 million increase in other expenses in relation to software subscriptions and employee relations. Other Income Other income is comprised of amounts earned from research and discovery services provided to partners under service agreements. Other income increased by $1.2 million during the year ended December 31, 2019 compared to the same period in 2018 due largely to an increase in the level of services being provided to external partners. Interest Income Interest income increased to $3.2 million during the year ended December 31, 2019 compared to $0.7 million during the year ended December 31, 2018 due to increased interest earned on our cash, cash equivalents and investment balances which were significantly higher in 2019 compared to 2018. Interest Expense Interest expense during the year ended December 31, 2019 and 2018 pertained to the interest portion of payments made on capital leases under which we acquired certain property and equipment. Preferred Stock Warrant Liability Revaluation Preferred stock warrant liability revaluation recognizes changes in the fair value of the preferred stock warrants. We recognized an expense of $123,000 during the year ended December 31, 2019 primarily as a result of an increase in the estimated fair market value of our company during that period. Liquidity and Capital Resources; Plan of Operations Liquidity and Capital Resources As of December 31, 2019, we had cash, cash equivalents and investments totaling $183.4 million. Our cash and cash equivalents primarily consist of bank deposits and money market funds. Our investments consist of U.S. government treasury securities. Due to our significant research and development expenditures, we have generated significant operating losses since inception. We have funded our operations primarily through the sale of convertible preferred stock and common stock. We have also received more than $15 million under our agreement with the Bill & Melinda Gates Foundation to date. In September 2018, we issued and sold 8,941,325 shares of Series C1 convertible preferred stock and Series C2 convertible preferred stock for gross proceeds of approximately $125.0 million. In June 2019, we completed our initial public offering, or IPO, of 6,452,500 shares of our Class A common stock and 2,000,000 shares of our Class B common stock at an offering price of $17.00 per share, including 1,102,500 shares pursuant to the underwriters’ option to purchase additional shares of the Company’s Class A common stock. We received net proceeds of $130.8 million in our IPO, after deducting underwriting discounts and commissions of $10.1 million and offering expenses of $2.8 million. As of December 31, 2019, we had an accumulated deficit of $164.1 million. Our management evaluates whether there are relevant conditions and events that in the aggregate raise substantial doubt about our ability to continue as a going concern and to meet its obligations as they become due within one year from the date that the financial statements are issued. We believe our existing cash, cash equivalents and investments will be sufficient to fund our operating and capital needs for at least the next 12 months. We are subject to risks and uncertainties common to early-stage companies in the biotechnology industry, including, but not limited to, development by competitors of new technological innovations, dependence on key - 70 - personnel, protection of proprietary technology, compliance with government regulations and the ability to secure additional capital to fund operations. Identification and development of product candidates will require significant additional research and development efforts, including extensive preclinical and clinical testing and regulatory approval prior to commercialization. These efforts require significant amounts of additional capital, adequate personnel and infrastructure and extensive compliance-reporting capabilities. Even if our drug development efforts are successful, it is uncertain when, if ever, we will realize significant revenue from product sales. Cash Flows The following table summarizes our cash flows for the periods indicated: Cash Flows from Operating Activities For the year ended December 31, 2019, cash used in operating activities was $58.5 million, which consisted of a net loss of $67.5 million, partially offset by $7.2 million in non-cash charges and a net change of $1.7 million in our net operating assets and liabilities. The non-cash charges consisted of depreciation and amortization of $1.7 million and stock-based compensation of $6.1 million, partially offset by accretion of discount on investments of $0.8 million. The change in operating assets and liabilities was primarily due to increases in accounts payable of $0.8 million and accrued expense of $2.5 million resulting from an increase in personnel-related expenses as a result of additional employee headcount and costs related to contractual manufacturing services, partially offset by an increase in prepaid expenses of $2.4 million as a result of increases in prepaid rent and prepaid insurance, partially offset by decreases in vendor prepayments and deposit. For the year ended December 31, 2018, cash used in operating activities was $34.7 million, which consisted of a net loss of $37.9 million, partially offset by $2.9 million in non-cash charges and a net change of $0.4 in our net operating assets and liabilities. The non-cash charges primarily consisted of stock-based compensation of $1.4 million and depreciation and amortization of $1.4 million. The change in operating assets and liabilities was primarily due to the net effect of an increase in payables and accruals of $1.8 million and an increase in prepaid expenses and other current assets of $1.4 million resulting from the timing of payments made for research and development activities. Cash Flows from Investing Activities For the year ended December 31, 2019, cash used in investing activities of $27.9 million was primarily related to $99.6 million in net purchases of investments and $3.4 million in purchases of property and equipment, partially offset by $75.0 million provided by proceeds from maturities of investments. For the year ended December 31, 2018, cash provided by investing activities of $20.7 million was primarily attributable to maturities of investments totaling $22.4 million, partially offset by investments in property and equipment of $1.8 million. Cash Flows from Financing Activities For the year ended December 31, 2019, cash provided by financing activities was $131.2 million, which primarily related to $133.6 million proceeds from the IPO, net of underwriting discounts and commissions, partially offset by $2.8 million in payments related to IPO costs. - 71 - For the year ended December 31, 2018, cash provided by financing activities was $120.3 million, primarily related to $120.3 million proceeds from issuance convertible preferred stock, net of fees and commissions. Off-Balance Sheet Arrangements Our liquidity is not dependent on the use of off-balance sheet financing arrangements (as that term is defined in Item 303(a) (4) (ii) of Regulation S-K) and as of December 31, 2019, we had no such arrangements. There has been no material change in our contractual obligations other than in the ordinary course of business since our fiscal year ended December 31, 2019. Since inception, we have not engaged in any off-balance sheet arrangements, as defined in the rules and regulations of the SEC. Contractual Obligations and Other Commitments The following table summarizes our contractual obligations as of December 31, 2019: The operating lease obligations noted above represent operating lease obligations related to our currently occupied premises in South San Francisco, California and premises in San Carlos, California, which we are obligated to occupy in the future. These leases expire at various dates through the first half of 2033. In July 2019, we entered into a lease agreement, or the San Carlos Lease, for the lease of approximately 99,557 rentable square feet of office space located in San Carlos, California, which is intended to serve as our permanent headquarters, office and laboratory space following the completion of construction and certain tenant improvements. The term of the San Carlos Lease will commence on the date that the landlord delivers the premises to us for construction of certain tenant improvements, which is estimated to be August 2020, and will end on the date that is 144 months from the first day of the first full month after rent commences. Base rent for the San Carlos Lease is $557,519 per month, with annual increases of 3%. We are obligated to provide a security deposit of $1.1 million in the form of a letter of credit. In July 2019, concurrently with the execution and delivery of the San Carlos Lease, we also entered into a lease agreement, or the Temporary Lease, for the lease of approximately 74,788 rentable square feet of office space located in South San Francisco, California, which is intended to serve as our temporary headquarters, office and laboratory space while our permanent headquarters is under construction. The Temporary Lease commenced in August 2019, and is expected to end 90 days following the substantial completion of certain tenant improvements and construction on the space covered by the San Carlos Lease. Base rent for the Temporary Lease is $280,455 per month, with annual increases of 3%. The capital lease obligations noted above represent certain property and equipment we acquired under capital leases. In 2017, we financed purchases of $226,000 in equipment under a capital lease agreement. Outstanding amounts under the capital lease agreements are generally secured by liens on the related property and equipment. In addition, we enter into contracts in the normal course of business with contract research organizations for preclinical and clinical studies as well as with contract development manufacturing organizations for the manufacture of materials for those studies. These agreements generally provide for termination at the request of either party with less than one-year notice and are, therefore, cancelable contracts and not reflected in the table above. - 72 - 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 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 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. Impairment of Long-Lived Assets In accordance with ASC 360-10, Property, Plant & Equipment-Overall, we review long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of property and equipment may not be recoverable. Determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. In the event that such cash flows are not expected to be sufficient to recover the carrying amount of the assets, we write down the assets to their estimated fair values and recognize the loss in the Consolidated Statements of Operations and Comprehensive Loss. Research and Development Expenses and Accrued Research and Development Costs We expense research and development costs as incurred. Research and development expenses consist of personnel costs for our research and product development employees. Also included are non-personnel costs such as professional fees payable to third parties for preclinical studies, clinical trials and research services, laboratory supplies and equipment maintenance and depreciation, intellectual property licenses and other consulting costs. We estimate preclinical studies, clinical trials and research 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 management and external service providers as to the progress or stage of completion of services and the contracted fees to be paid for such services. We record the estimated costs of research and development activities based upon the estimated amount services provided but not yet invoiced, and include these costs in development expenses. We accrue for these costs based on factors such as estimates of the work completed and in accordance with agreements established with our third party service provides under the service agreements. We make significant judgments and estimates in determining the accrued liabilities balance in each reporting period. As actual costs become known, we adjust our accrued liabilities. We have not experienced any material differences between accrued costs and actual costs incurred. However, the status and timing of actual services performed may vary from our estimates, resulting in adjustments to expense in future periods. Changes in these estimates that result in material changes to our accruals could materially affect our results of operations. Payments associated with licensing agreements to acquire exclusive license to develop, use, manufacture and commercialize products that have not reached technological feasibility and do not have alternate future use are expensed as incurred. 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. We evaluate these payments for current or long-term classification based on when we expect to receive these services. Stock-Based Compensation We maintain a stock-based compensation plan as a long-term incentive for employees, consultants and members of our board of directors. The plan allows for the issuance of non-statutory options, or NSOs, incentive stock options, restricted stock and restricted stock units to employees and NSOs to nonemployees. - 73 - Stock-based payments are measured using fair-value-based measurements and recognized as compensation expense over the service period in which the awards are expected to vest. Our fair-value-based measurements of awards to employees and directors as of the grant date utilize the single-option award-valuation approach, and we use the straight-line method for expense attribution. The valuation model used for calculating the estimated fair value of stock awards is the Black-Scholes option-pricing model. The Black-Scholes model requires us to make assumptions and judgments about the variables used in the calculations, including the expected term (weighted-average period of time that the options granted are expected to be outstanding), the expected volatility of our common stock, the related risk-free interest rate and the expected dividend. We have elected to recognize forfeitures of stock-based payment awards as they occur. For stock-based awards issued to non-employees, we record expense related to stock options based on the fair value of the options calculated using the Black-Scholes option-pricing model over the service performance period. The Black-Scholes option-pricing model requires the use of highly subjective assumptions which 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. The simplified method deems the term to be the average of the time-to-vesting and the contractual life of the stock-based awards. § Expected Volatility. Since we have been privately held and do not have any trading history for our common stock, 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. 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. 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 elected to use this extended transition period for complying with new or revised accounting standards, including but not limited to Topic 842, the new lease accounting standard, that have different effective dates for public and private companies until the earlier of the date that 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 the new or revised accounting pronouncements as of public company effective dates. We early adopted Accounting Standards Update 2014-09, Revenue from Contracts with Customers (Accounting Standards Codification Topic 606), and Accounting Standards Update 2018-07, Improvements to Nonemployee Share-Based Payment Accounting (Accounting Standards Codification Topic 718), as the JOBS Act does not preclude an emerging growth company from early adopting a new or revised accounting standard earlier than the time that such standard applies to private companies. We expect to use the extended transition period for any other new or revised accounting standards during the period in which we remain an emerging growth company. We will remain an emerging growth company until the earliest of (i) December 31, 2024, (ii) the last day of our first fiscal year in which we have total annual gross revenues of at least $1.07 billion, (iii) the date on which we are deemed to be a “large accelerated filer” under the rules of the Securities and Exchange Commission, which means the market value of our voting and non-voting common equity that is held by non-affiliates is equal to or exceeds $700.0 - 74 - million as of the prior June 30th and (iv) 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, Summary of Significant Accounting Policies, in our Notes to Consolidated Financial Statements included in Part I, Item 1 of this Annual Report on Form 10-K for a discussion of recent accounting pronouncements.

<s>[INST] Overview We are a clinicalstage biopharmaceutical company utilizing our differentiated platform to discover and develop novel antibodybased immunotherapeutics to treat a range of solid tumor types. While more traditional oncology drug discovery approaches attempt to generate antibodies against known targets, our approach relies on the human immune system to direct us to unique antibodytarget pairs from patients experiencing a clinically meaningful, active immune response against their tumors. These unique antibodytarget pairs represent a potentially novel and previously unexplored landscape of immunooncology targets. We believe the fact that our approach has the potential to deliver novel, previously unexplored immunooncology targets provides us with a significant competitive advantage over traditional approaches which focus on known targets that many companies are aware of and can pursue. We have utilized our drug discovery approach to identify over 1,600 distinct human antibodies that bind preferentially to tumor tissue from patients who are not the source of the antibody. Our lead product candidate, ATRC101, is a monoclonal antibody with a novel mechanism of action and target derived from an antibody identified using our discovery platform. ATRC101 reacts in vitro with a majority of human ovarian, nonsmall cell lung, colorectal and breast cancer samples from multiple patients. It has demonstrated robust antitumor activity as a single agent in multiple preclinical models, including one model in which PD1 checkpoint inhibitors typically display limited activity. We filed the Investigational New Drug, or IND, application for ATRC101, which was cleared by the U.S. Food and Drug Administration, or FDA, in the fourth quarter of 2019 and have initiated a Phase 1b clinical trial in patients with select solid tumors in which the first patient was dosed in February 2020. Since commencing operations in 2010, we have devoted substantially all our resources to research and development, raising capital, building our management team and building our intellectual property portfolio. We do not have any products approved for marketing or sale and have not generated any revenue from product sales. We have funded our operations to date primarily from the sale of convertible preferred stock. We have also received more than $15 million in payments to date under our service agreement with the Bill & Melinda Gates Foundation. We have incurred significant operating losses since our inception. Our ability to generate product revenue sufficient to achieve or sustain profitability will depend on the successful development, regulatory approval and eventual commercialization of one or more of our current or future product candidates. Our net losses were $67.5 million and $37.9 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $164.1 million. We anticipate that a substantial portion of our capital resources and efforts in the foreseeable future will be focused on discovering, completing the necessary development, obtaining regulatory approval for and preparing for potential commercialization of product candidates. As of December 31, 2019, our cash, cash equivalents and investments were $183.4 million. We expect to continue to incur significant expenses and increasing operating losses for the foreseeable future. Our net losses may fluctuate significantly from period to period, depending on the timing of our planned preclinical 67 studies and clinical trials and expenditures on other research and development activities. We expect our expenses will increase substantially over time as we: § complete clinical trials for ATRC101 and initiate preclinical studies on any additional product candidates that we may pursue in the future; § continue research and development to expand our growing library of more than 1,600 antibodies and develop potential future product candidates from that collection; § continue to invest in advancing our differentiated discovery platform, and the underlying technologies; § seek marketing approvals for product candidates that successfully complete clinical trials; § maintain, protect and expand our portfolio of intellectual property rights, including patents, trade secrets and knowhow; § implement additional operational, financial and management systems; and § attract, hire and retain [/INST] Negative. </s>

IAA, Inc.

2020-03-18

2019-12-29

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 "Selected Financial Data" and the consolidated financial statements and notes thereto included elsewhere in this Annual Report on Form 10-K, as well as the “Statement Regarding Forward-Looking Statements” preceding Part I. On June 27, 2019, the board of directors set our fiscal year to end on the last Sunday in December in each year, consisting of either 52 or 53 weeks. As used in this section, references to the “fiscal year ended December 29, 2019” or “fiscal 2019” refer to the 52-week period that began on December 31, 2018 and ended on December 29, 2019. References to the “fiscal year ended December 30, 2018” or “fiscal 2018” refer to the 52-week period that began on January 1, 2018 and ended on December 30, 2018. References to the “fiscal year ended December 31, 2017” or “fiscal 2017” refer to the 52-week period that began on January 2, 2017 and ended on December 31, 2017. Overview We are a leading provider of auction solutions for total loss, damaged and low-value vehicles in North America and the United Kingdom. Leveraging leading-edge technology and focusing on innovation, our unique multi-channel platform processes approximately 2.5 million total-loss, damaged and low-value vehicles annually. Headquartered near Chicago in Westchester, IL, we have approximately 3,800 talented employees. We serve a global buyer base and a full spectrum of sellers, including insurance companies, dealerships, rental car companies, fleet lease companies and charitable organizations. We offer customers a comprehensive suite of services aimed at maximizing vehicle value, reducing administrative costs, shortening selling cycle time and delivering customers the highest economic returns. Buyers have access to industry leading, innovative vehicle evaluation and bidding tools, enhancing the overall purchasing experience. We currently operate over 200 sites across the United States, Canada and the United Kingdom, representing total acreage of approximately 7,700 gross acres. Most of our properties are leased and used primarily for auction and storage purposes. The Separation On February 27, 2018, KAR announced a plan to pursue the separation and spin off (“the Separation”) of its salvage auction businesses into a separate public company. On June 28, 2019 (the “Separation Date”), KAR completed the distribution of 100% of the issued and outstanding shares of common stock of IAA to the holders of record of KAR’s common stock on June 18, 2019, on a pro rata basis (the “Distribution”). Following the Separation and Distribution, IAA became an independent publicly-traded company. Industry Trends Vehicles deemed a total loss by automobile insurance companies represent the largest category of vehicles sold in the salvage vehicle auction industry. Based on data from CCC Information Services, the percentage of claims resulting in total losses was approximately 19% in 2019, 18% in 2018 and 18% in 2017. There is no central reporting system for the salvage vehicle auction industry that tracks the number of salvage vehicle auction volumes in any given year, which makes estimating industry volumes difficult. Fluctuations in used vehicle and commodity pricing (aluminum, steel, etc.) have an impact on proceeds received in the salvage vehicle auction industry. In times of rising prices, revenue and gross profit are positively impacted. If used vehicle and commodity prices decrease, proceeds, revenue and gross profit at salvage auctions may be negatively impacted, which could adversely affect our level of profitability. The price per ton of crushed auto bodies in North America declined approximately 29% in 2019 as compared to 2018. Sources of Revenues and Expenses A significant portion of our revenue is derived from auction fees and related services associated with our salvage auctions. Approximately two-thirds of our revenue is earned from buyers and represents fees charged based on a tiered structure that increases with the sales price of the vehicle as well as service fees for additional services. In addition, approximately one-third of our revenue is earned from sellers and represents the combination of the inbound tow, processing, storage, titling, enhancing and auctioning of the vehicle. Although auction revenues primarily include the auction services and related fees, our related receivables and payables include the gross value of the vehicles sold. Our operating expenses consist of cost of services, selling, general and administrative and depreciation and amortization. Cost of services is comprised of payroll and related costs, subcontract services, the cost of vehicles purchased, supplies, insurance, property taxes, utilities, service contract claims, maintenance and lease expense related to the auction sites. Cost of services excludes depreciation and amortization. Selling, general and administrative expenses are comprised of payroll and related costs, sales and marketing, information technology services and professional fees. Factors Affecting Comparability of Financial Results Historical KAR Cost Allocations versus IAA as a Stand-alone Company: Our historical consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). The financial statements for periods prior to the Separation include certain expenses of KAR that were allocated to IAA for certain corporate functions including accounting, treasury, tax, internal audit, risk management, human resources, safety, and security, and information technology risk. These costs may not be representative of the costs IAA will incur as an independent, publicly traded company. In addition, our financial information for periods prior to the Separation does not reflect changes that IAA expects to experience as a result of IAA’s separation from KAR, including changes in IAA’s cost structure, personnel needs, tax structure, capital structure, financing and business operations. The consolidated financial statements also do not reflect the assignment of certain assets and liabilities between KAR and IAA. Consequently, the financial information included here may not necessarily reflect IAA’s financial position, results of operations and cash flows in the future or what IAA’s financial position, results of operations and cash flows would have been had IAA been an independent, publicly traded company during the periods prior to the Separation. Debt financing: In connection with the Separation, we entered into a credit agreement on June 28, 2019 with several banks and other financial institutions. We borrowed (i) an aggregate principal amount of $800 million under a seven-year senior secured term loan facility, and (ii) an aggregate principal of $225 million under a five-year revolving credit facility. In connection with the Separation, on June 6, 2019, we also issued $500.0 million aggregate principal amount of 5.50% Senior Notes due 2027 (the "Notes"). We used the net proceeds from the Notes offering, together with borrowings under the term loan facility, to make a cash distribution to KAR and to pay fees and expenses related to the Separation and Distribution. We used the remaining proceeds from the term loan facility for our ongoing working capital needs and general corporate purposes. Acquisitions: On July 31, 2019, we acquired Decision Dynamics, Inc. ("DDI"), a leading electronic lien and title technology firm located in Lexington, South Carolina for $19.2 million which includes the fair value of contingent consideration of $2.5 million. In December 2017, we acquired the assets of POIS, Inc. for approximately $0.9 million. POIS provides loan payoff and lien release technology with a focus on helping insurance companies settle liens faster to improve cycle time/inventory turns. Results of Operations Fiscal 2019 Compared to Fiscal 2018 The table below presents consolidated statements of income for the periods indicated and the dollar change and percentage change between periods. * Exclusive of depreciation and amortization Revenues Revenues for fiscal 2019 increased by $110.0 million as compared to fiscal 2018 primarily due to increased volumes of approximately 3%, and an increase in revenue per vehicle sold of approximately 5%. United States revenues increased $81.0 million due to an increase in volume of 2%, an increase in revenue per vehicle sold of 4%, additional revenues from the DDI acquisition of $4.3 million, and a non-cash adjustment of $3.6 million relating to certain revenue agreements. International revenues increased $29.0 million primarily due to an increase in volume of 12%, including a higher mix of purchased vehicles, and an increase in revenue per unit of 11%, partially offset by an unfavorable foreign currency impact of $4.9 million. Gross profit Gross profit is defined as total consolidated revenues minus cost of services and excludes depreciation and amortization. United States gross profit increased $39.5 million as compared to fiscal 2018 primarily due to the increase in revenues discussed above; partially offset by an increase in our cost of services due to higher volume and an increase in the cost of transportation, reconditioning and processing, labor and occupancy costs. International gross profit increased $3.5 million as compared to fiscal 2018 mainly due to the increase in revenues discussed above; partially offset by an increase in our cost of services for vehicles sold due to higher volume, higher mix of purchased vehicles and an increase in transportation costs. Selling, General and Administrative United States selling, general and administrative expenses for fiscal 2019 increased $19.4 million as compared to fiscal 2018 due to higher employee and severance related costs of $9.9 million, increases in costs related to being a standalone public company due to our spin-off from KAR of $3.5 million, professional services of $1.8 million, additional costs related to the acquisition and integration of DDI of $1.5 million, and higher software maintenance amortization of $1.3 million. International selling, general and administrative expenses for fiscal 2019 decreased $0.8 million as compared to fiscal 2018 mainly due to a recovery of $0.9 million of the previously reserved accounts receivable. Depreciation and Amortization Depreciation and amortization decreased $9.0 million as compared to fiscal 2018 primarily due to the derecognition of fixed assets associated with certain sale leaseback transactions related to the adoption of Topic 842 in the first quarter of 2019. See Note 1 - Basis of Presentation and Nature of Operations in the notes to consolidated financial statements for additional information. Interest Expense. Interest expense for fiscal 2019 increased $17.0 million as compared to fiscal 2018 due to a higher debt balance since the Separation Date. Income Taxes. The effective tax rate for fiscal 2019 was 26.3% as compared to 25.4% for fiscal 2018. Fiscal 2019 effective tax rate was negatively impacted by 0.9% primarily due to adjustments of $0.6 million to our deferred taxes related to our spin-off from KAR and other discrete items. Fiscal 2018 Compared to Fiscal 2017 The table below presents consolidated statements of income for the periods indicated and the dollar change and percentage change between periods. * Exclusive of depreciation and amortization Revenue Revenues for fiscal 2018 increased $107.6 million as compared to fiscal 2017. The increase in revenue was due to an increase in vehicles sold of approximately 5%, an increase in revenue per vehicle sold of 4%, and a favorable currency impact of $1.3 million. United States revenue increased $87.1 million as compared to fiscal 2017. The increase in revenue was due to an increase in vehicles sold of approximately 4% and an increase in revenue per vehicle sold of 3%. International revenue increased $20.5 million as compared to fiscal 2017. The increase in revenue was due to an increase in vehicles sold of approximately 8%, an increase in revenue per vehicle sold of 7%, and a favorable currency impact of $1.3 million. Gross profit United States gross profit for fiscal 2018 increased $54.8 million as compared to fiscal 2017 primarily due to the higher revenues discussed above; partially offset by higher cost of services related to increase in volume of vehicles sold and costs related to catastrophic events. International gross profit for fiscal 2018 increased $9.7 million as compared to fiscal 2017 primarily due to the higher revenues discussed above and fewer vehicles sold under purchase contracts in fiscal 2018; partially offset by higher cost of services related to increase in volume of vehicles sold and higher transportation costs. Selling, General and Administrative United States selling, general and administrative expenses for fiscal 2018 increased $8.7 million as compared to fiscal 2017 mainly due to higher employee related costs of $4.2 million, professional fees related to the Separation of $2.8 million, and bad debt expense of $0.9 million. International selling, general and administrative expenses for fiscal 2019 increased $1.8 million as compared to fiscal 2017 primarily due to bad debt expense of $0.7 million, and employee related costs of $0.6 million. Depreciation and Amortization Depreciation and amortization for fiscal 2018 increased $4.3 million as compared to fiscal 2017. This increase was primarily the result of certain assets placed in service during fiscal 2018 in both segments. Income Taxes. The effective tax rate for fiscal 2018 was 25.4% as compared to 18.1% for fiscal 2017. The effective rate of fiscal 2018 was favorably impacted by a reduction of the US federal corporate income tax rate as a result of the enactment of the Tax Cuts and Jobs Act of 2017 (the “TCJA”). The effective tax rate for fiscal 2017 was impacted by a $37.0 million of tax benefit related to the remeasurement of deferred tax assets and liabilities and $2.2 million of expense associated with a one-time deemed repatriation transition tax on the accumulated unrepatriated and untaxed earnings of our foreign subsidiaries as a result of the TCJA. LIQUIDITY AND CAPITAL RESOURCES We believe that the significant indicators of liquidity for our business are cash on hand, cash flow from operations and working capital. Prior to the Separation, we transferred the cash flow generated by our operations to KAR to support its overall cash management strategy. Cash was transferred daily, based on our balances, to centralized accounts maintained by KAR. As cash was disbursed or received by KAR, it was recognized through Net Parent Investment on our balance sheets, statements of cash flows and statements of stockholders' (deficit) equity. On the Separation Date, our capital structure and sources of liquidity changed significantly. We no longer participate in cash management and funding arrangements with KAR. Subsequent to the Separation Date, our principal source of liquidity consists of cash generated by operations, and our Revolving Credit Facility (as defined below) provides another source of liquidity as needed. Our internally generated cash flow will be used to invest in new products and services, fund capital expenditures and working capital requirements, and is expected to be adequate to service any future debt, and fund future acquisitions, if any. Our ability to fund these capital needs will depend on our ongoing ability to generate cash from operations and to access borrowings under our Revolving Credit Facility and the capital markets. We believe that our cash on hand, future cash from operations, borrowings available under our Revolving Credit Facility and access to the debt and capital markets will provide adequate resources to fund our operating and financing needs for at least the next twelve months. Working Capital A substantial amount of our working capital is generated from the payments received for services provided. The majority of our working capital needs are short-term in nature, usually less than three months in duration. Due to the decentralized nature of the business, payments for most vehicles purchased are received at each auction and branch. Most of the financial institutions place a temporary hold on the availability of the funds deposited that generally can range up to two business days, resulting in cash in our accounts and on our balance sheet that is unavailable for use until it is made available by the various financial institutions. There are outstanding checks (book overdrafts) to sellers and vendors included in current liabilities. Because a portion of these outstanding checks for operations in the United States are drawn upon bank accounts at financial institutions other than the financial institutions that hold the cash, we cannot offset all the cash and the outstanding checks on our balance sheet. Changes in working capital vary from quarter-to-quarter as a result of the timing of collections and disbursements of funds to consignors from auctions held near period end. Approximately $13.9 million of available cash was held by our foreign subsidiaries at December 29, 2019. If funds held by our foreign subsidiaries were to be repatriated, state and local income tax expense and foreign withholding tax expense would need to be recognized, net of any applicable foreign tax credits. Summary of Cash Flows Fiscal 2019 compared to Fiscal 2018 Net cash flow provided by operating activities in fiscal 2019 decreased by $7.0 million as compared to fiscal 2018. The decrease in operating cash flow was primarily attributable to changes in operating assets as a result of the timing of collections from customers and other parties, as well as a net decrease in non-cash item adjustments, partially offset by increased profitability. Net cash used by investing activities was $84.9 million for fiscal 2019 as compared to $66.1 million for fiscal 2018. The increase in net cash used by investing activities was primarily due to the acquisition of DDI in the third quarter of fiscal 2019. Net cash used by financing activities was $182.8 million in fiscal 2019 as compared to $195.1 million in fiscal 2018. The decrease in net cash used by financing activities was primarily attributable to net proceeds from the Notes offering and our Term Loan Facility (as defined below), partially offset by dividends and distributions paid to KAR prior to and at the time of the Separation and a decrease in bank overdrafts during fiscal 2019 as a result of timing of disbursements of to our vendors. Fiscal 2018 compared to Fiscal 2017 Cash flow provided by operating activities was $278.2 million for fiscal 2018 as compared to $201.3 million for fiscal 2017. The increase in operating cash flow was primarily attributable to increased profitability adjusted for non-cash items and changes in operating assets and liabilities as a result of the timing of collections and the disbursement of funds to consignors for auctions held near period-ends. Net cash used by investing activities was $66.1 million for fiscal 2018 as compared to $55.1 million for fiscal 2017. The increase in net cash used by investing activities was primarily attributable to an increase in cash used for capital expenditures. Net cash used by financing activities was $195.1 million in fiscal 2018 as compared to $155.8 million in fiscal 2017. The increase in net cash used by financing activities was primarily attributable to an increase in cash deemed to be remitted to KAR. Our Outstanding Indebtedness In connection with the Separation, on June 28, 2019 we entered into a credit agreement with JPMorgan Chase Bank, N.A., as administrative agent, and the lenders party thereto from time to time (the “Credit Agreement”), which provides for, among other things, a seven year senior secured term loan facility in an aggregate principal amount of $800 million (the “Term Loan Facility”) and a five year revolving credit facility in an aggregate principal amount of $225 million (the “Revolving Credit Facility”). The Revolving Credit Facility also includes a $50 million sub-limit for issuance of letters of credit and a $50 million sublimit for swing line loans, which can be borrowed on same-day notice. As of December 29, 2019, no amounts were outstanding under the Revolving Credit Facility. We were in compliance with the covenants in the Credit Agreement at December 29, 2019. See Note 10 - Debt in the notes to consolidated financial statements for additional information. During the third quarter of fiscal 2019, the Company repaid $12 million of its Term Loan Facility, consisting of $2 million required principal payment and a $10 million optional principal pre-payment. During the fourth quarter of fiscal 2019, the Company made an optional principal pre-payment of $10 million on its Term Loan Facility. As of December 29, 2019, $778 million was outstanding under the Term Loan Facility. On June 6, 2019, we issued $500.0 million aggregate principal amount of 5.500% Senior Notes due 2027. We must pay interest on the Notes in cash on June 15 and December 15 of each year at a rate of 5.500% per annum, with the first interest payment date being December 15, 2019. The Notes will mature on June 15, 2027. The net proceeds from the Notes offering, together with borrowings under our prior senior credit facility, were used to make a cash distribution to KAR and to pay fees and expenses related to the Separation. We were in compliance with the covenants in the indenture governing the Notes at December 29, 2019. See Note 10 - Debt in the notes to consolidated financial statements for additional information. Prior to the Separation Date, we had intercompany debt with KAR totaling $456.6 million. This debt, which was eliminated on the Separation Date, was comprised of three promissory notes, payable on demand, with a weighted average interest rate of 8.27%. Capital Expenditures Capital expenditures for the years ended December 29, 2019 and December 30, 2018, were $68.5 million and $66.7 million, respectively. Capital expenditures were funded primarily from internally generated funds. We continue to invest in our core information technology capabilities and capacity expansion. Approximately half of our 2019 capital expenditures related to technology-based investments, including improvements in information technology systems and infrastructure. Other capital expenditures were primarily attributable to improvements and expansion at our facilities. Future capital expenditures could vary substantially based on capital project timing, the opening of new auction facilities, capital expenditures related to acquired businesses and the initiation of new information systems projects to support our business strategies. Contractual Obligations The table below sets forth a summary of our contractual obligations as of December 29, 2019. Some of the figures included in this table are based on management's estimates and assumptions about these obligations, including their duration, the possibility of renewal and other factors. Because these estimates and assumptions are necessarily subjective, the obligations we may actually pay in future periods could vary from those reflected in the table. The following summarizes our contractual cash obligations as of December 29, 2019 (in millions): ________________________________________ (a) Interest payments on long-term debt are projected based on the contractual rates of the debt securities. Interest rates for the variable rate term debt instruments were held constant at rates as of December 29, 2019. (b) Operating leases are entered into in the normal course of business. We lease most of our auction facilities, as well as other property and equipment under operating leases. Some lease agreements contain options to renew the lease or purchase the leased property. The amounts include the interest portion of the operating leases. Future operating lease obligations would change if the renewal options were exercised and/or if we entered into additional operating lease agreements. (c) We have entered into finance leases for furniture, fixtures, equipment and software. The amounts include the interest portion of the finance leases. Future finance lease obligations would change if we entered into additional finance lease agreements. (d) Related to unrecognized tax benefits recorded under Accounting Standards Codification ("ASC") Topic 740, Income Taxes. Critical Accounting Estimates In preparing the financial statements in accordance with U.S. generally accepted accounting principles, management must often make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures at the date of the financial statements and during the reporting period. Some of those judgments can be subjective and complex. Consequently, actual results could differ from those estimates. Accounting measurements that management believes are most critical to the reported results of our operations and financial condition include: (1) business combinations; (2) goodwill and other intangible assets; and (3) legal proceedings and other loss contingencies. In addition to the critical accounting estimates, there are other items used in the preparation of the consolidated financial statements that require estimation, but are not deemed critical. Changes in estimates used in these and other items could have a material impact on our financial statements. We continually evaluate the accounting policies and estimates used to prepare the consolidated financial statements. In cases where management estimates are used, they are based on historical experience, information from third-party professionals, and various other assumptions believed to be reasonable. In addition, our most significant accounting policies are discussed in Note 2 - Summary of Significant Accounting Policies and elsewhere in the notes to consolidated financial statements for additional information. Business Combinations When we acquire businesses, we estimate and recognize the fair values of tangible assets acquired, liabilities assumed, identifiable intangible assets acquired, and contingent consideration, if any. The excess of the purchase consideration over the fair values of identifiable assets and liabilities is recorded as goodwill. The purchase accounting process requires management to make significant estimates and assumptions in determining the fair values of assets acquired and liabilities assumed, especially with respect to intangible assets and contingent consideration. Critical estimates are often developed using valuation models that are based on historical experience and information obtained from the management of the acquired companies. These estimates can include, but are not limited to, the cash flows that an asset is expected to generate in the future, growth rates, the appropriate weighted-average cost of capital and the cost savings expected to be derived from acquiring an asset. These estimates are inherently uncertain and unpredictable. In addition, unanticipated events and circumstances may occur which could affect the accuracy or validity of such estimates. Depending on the facts and circumstances, we may engage an independent valuation expert to assist in valuing significant assets and liabilities. Goodwill and Other Intangible Assets We assess goodwill for impairment annually during the fourth quarter or more frequently when events or changes in circumstances indicate that impairment may exist. Important factors that could trigger an impairment review include significant under-performance relative to historical or projected future operating results; significant negative industry or economic trends; and our market valuation relative to our book value. When evaluating goodwill for impairment, we may first perform a qualitative assessment to determine whether it is more likely than not that a reporting unit is impaired. If we do not perform a qualitative assessment, or if we determine that a reporting unit’s fair value is not more likely than not greater than its carrying value, then we calculate the estimated fair value of the reporting unit using discounted cash flows and market approaches. When assessing goodwill for impairment, our decision to perform a qualitative impairment assessment for a reporting unit in a given year is influenced by a number of factors, including the size of the reporting unit’s goodwill, the significance of the excess of the reporting unit’s estimated fair value over carrying value at the last quantitative assessment date, the amount of time in between quantitative fair value assessments and the date of acquisition. If we perform a quantitative assessment of a reporting unit’s goodwill, our impairment calculations contain uncertainties because they require management to make assumptions and apply judgment when estimating future cash flows and earnings, including projected revenue growth and operating expenses related to existing businesses, as well as utilizing valuation multiples of similar publicly traded companies and selecting an appropriate discount rate based on the estimated cost of capital that reflects the risk profile of the related business. Estimates of revenue growth and operating expenses are based on internal projections considering the reporting unit’s past performance and forecasted growth, strategic initiatives and changes in economic conditions. These estimates, as well as the selection of comparable companies and valuation multiples used in the market approach are highly subjective, and our ability to realize the future cash flows used in our fair value calculations is affected by factors such as the success of strategic initiatives, changes in economic conditions, changes in our operating performance and changes in our business strategies. In 2019, we performed a qualitative impairment assessment for our reporting units. Based on our goodwill assessments, the Company has not identified a reporting unit for which the goodwill was impaired in 2019, 2018 or 2017. As with goodwill, we assess indefinite-lived tradenames for impairment annually during the fourth quarter or more frequently when events or changes in circumstances indicate that impairment may exist. When assessing indefinite-lived tradenames for impairment using a qualitative assessment, we evaluate if changes in events or circumstances have occurred that indicate that impairment may exist. If we do not perform a qualitative impairment assessment or if changes in events and circumstances indicate that a quantitative assessment should be performed, management is required to calculate the fair value of the tradename asset group. The fair value calculation includes estimates of revenue growth, which are based on past performance and internal projections for the tradename asset group's forecasted growth, and royalty rates, which are adjusted for our particular facts and circumstances. The discount rate is selected based on the estimated cost of capital that reflects the risk profile of the related business. These estimates are highly subjective, and our ability to achieve the forecasted cash flows used in our fair value calculations is affected by factors such as the success of strategic initiatives, changes in economic conditions, changes in our operating performance and changes in our business strategies. We review other intangible assets for possible impairment whenever circumstances indicate that their carrying amount may not be recoverable. If it is determined that the carrying amount of an other intangible asset exceeds the total amount of the estimated undiscounted future cash flows from that asset, we would recognize a loss to the extent that the carrying amount exceeds the fair value of the asset. Management judgment is involved in both deciding if testing for recovery is necessary and in estimating undiscounted cash flows. Our impairment analysis is based on the current business strategy, expected growth rates and estimated future economic conditions. Legal Proceedings and Other Loss Contingencies We are subject to the possibility of various legal proceedings and other loss contingencies, many involving litigation incidental to the business and a variety of environmental laws and regulations. Litigation and other loss contingencies are subject to inherent uncertainties and the outcomes of such matters are often very difficult to predict and generally are resolved over long periods of time. We consider the likelihood of loss or the incurrence of a liability, as well as the ability to reasonably estimate the amount of loss, in determining loss contingencies. Estimating probable losses requires the analysis of multiple possible outcomes that often are dependent on the judgment about potential actions by third parties. Contingencies are recorded in the consolidated financial statements, or otherwise disclosed, in accordance with ASC 450, Contingencies. We accrue for an estimated loss contingency when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. Management regularly evaluates current information available to determine whether accrual amounts should be adjusted. If the amount of an actual loss is greater than the amount accrued, this could have an adverse impact on our operating results in that period. Off-Balance Sheet Arrangements As of December 29, 2019, we had no off-balance sheet arrangements pursuant to Item 303(a)(4) of Regulation S-K under the Exchange Act. New Accounting Standards Refer to Note 2 - Summary of Significant Accounting Policies in the notes to consolidated financial statements for a description of recently issued accounting standards.

<s>[INST] The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the "Selected Financial Data" and the consolidated financial statements and notes thereto included elsewhere in this Annual Report on Form 10K, as well as the “Statement Regarding ForwardLooking Statements” preceding Part I. On June 27, 2019, the board of directors set our fiscal year to end on the last Sunday in December in each year, consisting of either 52 or 53 weeks. As used in this section, references to the “fiscal year ended December 29, 2019” or “fiscal 2019” refer to the 52week period that began on December 31, 2018 and ended on December 29, 2019. References to the “fiscal year ended December 30, 2018” or “fiscal 2018” refer to the 52week period that began on January 1, 2018 and ended on December 30, 2018. References to the “fiscal year ended December 31, 2017” or “fiscal 2017” refer to the 52week period that began on January 2, 2017 and ended on December 31, 2017. Overview We are a leading provider of auction solutions for total loss, damaged and lowvalue vehicles in North America and the United Kingdom. Leveraging leadingedge technology and focusing on innovation, our unique multichannel platform processes approximately 2.5 million totalloss, damaged and lowvalue vehicles annually. Headquartered near Chicago in Westchester, IL, we have approximately 3,800 talented employees. We serve a global buyer base and a full spectrum of sellers, including insurance companies, dealerships, rental car companies, fleet lease companies and charitable organizations. We offer customers a comprehensive suite of services aimed at maximizing vehicle value, reducing administrative costs, shortening selling cycle time and delivering customers the highest economic returns. Buyers have access to industry leading, innovative vehicle evaluation and bidding tools, enhancing the overall purchasing experience. We currently operate over 200 sites across the United States, Canada and the United Kingdom, representing total acreage of approximately 7,700 gross acres. Most of our properties are leased and used primarily for auction and storage purposes. The Separation On February 27, 2018, KAR announced a plan to pursue the separation and spin off (“the Separation”) of its salvage auction businesses into a separate public company. On June 28, 2019 (the “Separation Date”), KAR completed the distribution of 100% of the issued and outstanding shares of common stock of IAA to the holders of record of KAR’s common stock on June 18, 2019, on a pro rata basis (the “Distribution”). Following the Separation and Distribution, IAA became an independent publiclytraded company. Industry Trends Vehicles deemed a total loss by automobile insurance companies represent the largest category of vehicles sold in the salvage vehicle auction industry. Based on data from CCC Information Services, the percentage of claims resulting in total losses was approximately 19% in 2019, 18% in 2018 and 18% in 2017. There is no central reporting system for the salvage vehicle auction industry that tracks the number of salvage vehicle auction volumes in any given year, which makes estimating industry volumes difficult. Fluctuations in used vehicle and commodity pricing (aluminum, steel, etc.) have an impact on proceeds received in the salvage vehicle auction industry. In times of rising prices, revenue and gross profit are positively impacted. If used vehicle and commodity prices decrease, proceeds, revenue and gross profit at salvage auctions may be negatively impacted, which could adversely affect our level of profitability. The price per ton of crushed auto bodies in North America declined approximately 29% in 2019 as compared to 2018. Sources of Revenues and Expenses A significant portion of our revenue is derived from auction fees [/INST] Positive. </s>

DiamondPeak Holdings Corp.

2020-03-25

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 formed under the laws of the State of Delaware on November 13, 2018 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 complete our business combination using cash from the proceeds from our initial public offering, the exercise of over-allotment option and the sale of the private placement warrants, our capital stock, debt or a combination of cash, stock and debt. The issuance of additional shares of our common stock in our business combination: ● may significantly dilute the equity interest of investors in our initial public offering, 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 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 our 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 March 4, 2019 were organizational activities, and those necessary to prepare for our initial public offering, described below. Subsequent to our initial public offering, we have been focused on identifying a target company for our initial business combination. We do not expect to generate any operating revenues until after the completion of our initial business combination. We generate non-operating income in the form of interest income on marketable securities held in our 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 fiscal year ended December 31, 2019, we had net income of $3,016,201, which consisted of interest earned on marketable securities held in our trust account of $4,547,860, offset by general and administrative expenses of $618,608 and a provision for income taxes of $913,051. For the period from November 13, 2018 (inception) to December 31, 2018, we had a net loss of $1,650, which consisted of general and administrative expenses of $1,650. Liquidity and Capital Resources Until the consummation of our initial public offering, our only source of liquidity was an initial purchase of Class B common stock by our sponsor and our anchor investor and loans from our sponsor. On March 4, 2019, we consummated our initial public offering of 25,000,000 units at a price of $10.00 per unit, generating gross proceeds of $250,000,000. Simultaneously with the closing of our initial public offering, we consummated the sale of an aggregate of 4,666,667 private placement warrants to our sponsor and our anchor investor at a price of $1.50 per warrant, generating gross proceeds of $7,000,000. On March 18, 2019, in connection with the underwriters’ election to partially exercise their over-allotment option, we consummated the sale of an additional 3,000,000 units and the sale of an additional 400,000 private placement warrants, generating total gross proceeds of $30,600,000. Following our initial public offering, the partial exercise of the over-allotment option and the sale of the private placement warrants, a total of $280,000,000 was placed in our trust account. We incurred $15,930,162 in transaction costs, including $5,600,000 of underwriting fees, $9,800,000 of deferred underwriting fees and $530,162 of other costs in connection with our initial public offering and the sale of the private placement warrants. For the year ended December 31, 2019, net cash used in operating activities was $1,393,616. Net income of $3,016,201 was offset by interest earned on marketable securities of $4,547,860. Changes in operating assets and liabilities provided $138,043 of cash from operating activities. At December 31, 2019, we had cash and marketable securities held in our trust account of $283,581,860. We intend to use substantially all of the funds held in our trust account, including any amounts representing interest earned on the trust account (less amounts released to us for franchise and income taxes payable and deferred underwriting commissions) to complete our initial business combination. Interest income earned on the balance in the trust account may be available to us to pay taxes. During the year ended December 31, 2019, we withdrew $966,000 of interest earned on the trust account to pay income taxes. 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 post-business combination entity, make other acquisitions and pursue our growth strategies. At December 31, 2019, we had cash of $1,070,048 held outside of our 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, properties 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 our business combination. In order to fund working capital deficiencies or finance transaction costs in connection with our 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 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. Up to $1,500,000 of such loans may be convertible into warrants identical to the private placement warrants, at a price of $1.50 per warrant 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 and consummating our 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 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 our 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. Going Concern 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 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 March 4, 2021. 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 the sponsor a monthly fee of $10,000 for office space, utilities and secretarial and administrative support to the Company. We began incurring these fees on March 1, 2019 and will continue to incur these fees on a monthly basis until the earlier of the completion of our initial business combination and the Company’s liquidation. The underwriters of our initial public offering are entitled to a deferred fee of $0.35 per Unit, or $9,800,000 in the aggregate, which will become payable to the underwriters from the amounts held in the trust account solely in the event that we complete an initial business combination, subject to the terms of the underwriting agreement. A portion of the deferred fees may be paid to third parties who did not participate in our initial public offering (but who are members of FINRA) that assist us in consummating our initial business combination. The election to make such payments to third parties will be solely at the discretion of our management team, and such third parties will be selected by the management team in its sole and absolute discretion; provided, that no single third party (together with its affiliates) may be paid an amount in excess of the portion of the aggregate deferred underwriting commission paid to the underwriter unless the parties otherwise agree. 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 July 2017, the FASB issued Accounting Standards Update (“ASU”) 2017-11, Earnings Per Share (Topic 260), Distinguishing Liabilities from Equity (Topic 480) and Derivatives and Hedging (Topic 815): Part I. Accounting for Certain Financial Instruments with Down Round Features; Part II. Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception. Part I of this update addresses the complexity of accounting for certain financial instruments with down round features. Down round features are features of certain equity-linked instruments (or embedded features) that result in the strike price being reduced on the basis of the pricing of future equity offerings. Also, entities must adjust their basic Earnings Per Share (“EPS”) calculation for the effect of the down round provision when triggered (that is, when the exercise price of the related equity-linked financial instrument is adjusted downward because of the down round feature). That effect is treated as a dividend and as a reduction of income available to common shareholders in basic EPS. An entity will also recognize the effect of the trigger within equity. The guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company adopted this guidance during the quarter ended March 31, 2019. The adoption of this guidance enabled the Company to record the warrants as equity instruments and is not expected to have a material impact on the Company’s financial position, results of operations, cash flows or disclosures moving forward until a trigger event occurs. Part II of this update addresses the difficulty of navigating Topic 480, Distinguishing Liabilities from Equity, because of the existence of extensive pending content in the FASB Accounting Standards Codification. This pending content is the result of the indefinite deferral of accounting requirements about mandatorily redeemable financial instruments of certain nonpublic entities and certain mandatorily redeemable noncontrolling interests. The amendments in Part II of this update are not expected to have an impact on the Company. 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 condensed 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 formed under the laws of the State of Delaware on November 13, 2018 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 complete our business combination using cash from the proceeds from our initial public offering, the exercise of overallotment option and the sale of the private placement warrants, our capital stock, debt or a combination of cash, stock and debt. The issuance of additional shares of our common stock in our business combination: may significantly dilute the equity interest of investors in our initial public offering, 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 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 our 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 [/INST] Negative. </s>

ZUORA INC

2019-04-18

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 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 identified below and those discussed in the section titled “Risk Factors” under Part I, Item 1A in this Form 10-K. Our fiscal year ends January 31. Overview Business Summary Zuora is a leading cloud-based subscription management platform. We provide software that enables companies across multiple industries and geographies to launch, manage or transform to a subscription business model. Architected specifically for dynamic, recurring subscription business models, our cloud-based software functions as an intelligent subscription management hub that automates and orchestrates the entire subscription order-to-revenue process, including billing and revenue recognition. Our solution enables businesses to easily change pricing and packaging for products and services to grow and scale, to efficiently comply with revenue recognition standards, and to build meaningful relationships with their subscribers. We believe we are in the early stages of a multi-decade global shift away from product-based business models, characterized by transactional one-time sales, towards recurring subscription-based business models. This trend, which we refer to as the “Subscription Economy,” is visible everywhere you look. In media and entertainment, consumers are adopting video-on-demand services and digital music streaming services. Commuters are taking advantage of automobile subscription programs and subscription-based ride-sharing services. In the technology space, companies are opting for software-as-a-service applications over on-premise installations. In manufacturing, sensors and connectivity have allowed companies to bundle an array of digital services with their physical products. Digital subscriptions have had a positive effect on the newspaper and publishing industries, with readers increasingly subscribing to digital news and information sources. In addition, the retail space features a growing multitude of subscription services including clothing and accessories, cosmetics and personal care, meals and groceries, vitamins and prescriptions, pet care, and many more. Many of today’s enterprise software systems that businesses use to manage their order-to-revenue processes were built for a product driven economy, and are extremely difficult to re-configure for the dynamic, ongoing nature of subscription services. In traditional business models, order-to-revenue was a linear process-a customer orders a product, is billed for that product, payment is collected, and the revenue recognized. These legacy systems were not specifically designed to handle the complexities and ongoing customer events of recurring relationships and their impact on areas such as billing proration, revenue recognition, and reporting in real-time. Trying to use this software to build a subscription business frequently results in prolonged and complex manual downstream work, hard-coded customizations, a proliferation of stock-keeping units (SKUs), and inefficiency. These new subscription business models are inherently dynamic, with multiple interactions and constantly-changing relationships and events. The capabilities to launch, price, and bill for products, facilitate and record cash receipts, process and recognize revenue, and produce the data required to close their books and drive key decisions are mission critical and particularly complex for companies with subscription business models. As a result, as companies launch or grow a subscription business, they often conclude that legacy systems are inadequate. Our mission is to enable all companies in the Subscription Economy to become successful. Our customers include companies of all sizes, ranging from small businesses to some of the world’s largest enterprises. Customers pay for our platform under a subscription-based model, and this model allows us to grow as the Subscription Economy grows. Fiscal 2019 Business Highlights Key corporate milestones during fiscal 2019 include: • We completed our IPO in which we sold 12.7 million shares of our Class A common stock to the public at a price of $14.00 per share, netting $159.7 million in cash proceeds. • In our third quarter of fiscal 2019, we surpassed 500 customers with ACV exceeding $100,000. • In our fourth quarter of fiscal 2019, we crossed $10 billion in quarterly invoice transaction volume that customers run through our system. For a definition of ACV, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Key Operational and Financial Metrics.” Fiscal 2019 Financial Performance Summary Our financial performance in fiscal 2019, compared to fiscal 2018, reflects the following: • Subscription revenues were $168.8 million, an increase of $48.4 million or 40%, and total revenues were $235.2 million, an increase of $67.3 million or 40%. This growth reflects our acquisition of new customers as well as existing customer retention, increased usage-based fees and sales of new products to our customers. Our growth also reflects the impact of our acquisition of Leeyo in May of 2017. • Total cost of revenue was $116.6 million, or 50% of revenue, in fiscal 2019 compared to $79.9 million, or 48% of revenue, in 2018. During fiscal 2019, we invested additional resources to support the growth in the number of customers as well as the increase in usage from existing customers. • Loss from operations was $75.8 million, or 32% of revenue in fiscal 2019 compared to a loss of $46.3 million, or 28% of revenue, in 2018. During fiscal 2019, we incurred additional costs to grow our business and to support operations as a publicly traded company. Key Operational and Financial Metrics We monitor the following key operational and financial metrics to evaluate our business, measure our performance, identify trends affecting our business, formulate business plans and make strategic decisions: Customers with Annual Contract Value (ACV) Equal to or Greater than $100,000 We believe our ability to enter into larger contracts is indicative of broader adoption of our solution by larger organizations. It also reflects our ability to expand our revenue footprint within our current customer base. We define ACV as the subscription revenue we would contractually expect to recognize from that customer over the next twelve months, assuming no increases or reductions in their subscriptions. We define the number of customers at the end of any particular period as the number of parties or organizations that have entered into a distinct subscription contract with us for which the term has not ended. Each party with which we have entered into a distinct subscription contract is considered a unique customer, and in some cases, there may be more than one customer within a single organization. We have increased the number of customers with ACV equal to or greater than $100,000 to 526 as of January 31, 2019, as compared to 415 as of January 31, 2018 and 292 as of January 31, 2017. Dollar-Based Retention Rate We believe our dollar-based retention rate is a key measure of our ability to retain and expand revenue from our customer base over time. We calculate our dollar-based retention rate as of a period end by starting with the sum of the ACV from all customers as of twelve months prior to such period end, or prior period ACV. We then calculate the sum of the ACV from these same customers as of the current period end, or current period ACV. Current period ACV includes any upsells and also reflects contraction or attrition over the trailing twelve months, but excludes revenue from new customers added in the current period. We then divide the current period ACV by the prior period ACV to arrive at our dollar-based retention rate. Our dollar-based retention rate increased to 112% as of January 31, 2019, as compared to 110% as of January 31, 2018 and 104% as of January 31, 2017. Components of Our Results of Operations Revenue Subscription revenue. Subscription revenue consists of fees for access to, and use of, our products, as well as customer support. We generate subscription fees pursuant to non-cancelable subscription agreements with terms that typically range from one to three years. Subscription revenue is primarily based on fees to access our services platform over the subscription term. We typically invoice customers in advance in either annual or quarterly installments. Customers can also elect to purchase additional volume blocks or products during the term of the contract. We typically recognize subscription revenue ratably over the term of the subscription period, beginning on the date that access to our platform is provided, which is generally on or about the date the subscription agreement is signed. Professional services revenue. Professional services revenue consists of fees for services related to helping our customers deploy, configure, and optimize the use of our solutions. These services include system integration, data migration, process enhancement, and training. Professional services projects generally take three to twelve months to complete. Once the contract is signed, we generally invoice for professional services on a time and materials basis, although we occasionally engage in fixed-price service engagements and invoice for those based upon agreed milestone payments. We recognize revenue as services are performed for time and materials engagements and on a proportional performance method as the services are performed for fixed fee engagements. Impact of ASC 606 Adoption. In May 2014, the FASB issued ASC 606, and has since modified the standard. This standard replaces existing revenue recognition rules with a comprehensive revenue measurement and recognition standard and expanded disclosure requirements. This new revenue standard became effective for public companies for the fiscal year beginning after December 15, 2017, and interim periods within that year. Private companies have an additional year to adopt the standard. The two permitted transition methods under the new standard are the full retrospective method, under which ASC 606 is applied to each prior reporting period presented and the cumulative effect of applying the standard is recognized at the earliest period shown, or the modified retrospective method, under which the cumulative effect of applying ASC 606 is recognized at the date of initial application. We adopted the requirements of ASC 606, effective February 1, 2019, using the full retrospective transition method. The adoption of the new standard is expected to have an impact on revenue and commissions expense for all periods presented. The primary impacts on revenue are an increased number of allocations of arrangement consideration between subscription and professional services and the recognition of discounts evenly across the term for multiple year subscription arrangements. Both of these impacts are primarily due to the elimination of the contingent revenue rule. We also expect an impact due to a change in the recognition of legacy on-premise term deals inherited during our acquisition of Leeyo Software, Inc., which will require more revenue being recognized at the beginning of the license term as opposed to evenly over the term. In addition to impacting the way that the Company recognizes revenue, the new standard will also impact the accounting for incremental commission costs of obtaining subscription contracts. Under the new standard, the Company will defer all incremental commission costs to obtain the contract. The Company expects to amortize these costs on a straight-line basis over the period of economic benefit which has been determined to be five years. Deferred Revenue Deferred revenue consists of customer billings in advance of revenue being recognized from our subscription and support services and professional services arrangements. We primarily invoice our customers for subscription services arrangements annually or quarterly in advance. Amounts anticipated to be recognized within one year of the balance sheet date are recorded as deferred revenue, current portion, and the remaining portion is recorded as deferred revenue, net of current portion in our consolidated balance sheets. Overhead Allocation and Employee Compensation Costs We allocate shared costs, such as facilities costs (including rent, utilities, and depreciation on capital expenditures related to facilities shared by multiple departments), information technology costs, and certain administrative personnel costs to all departments based on headcount and location. As such, allocated shared costs are reflected in each cost of revenue and operating expenses category. Employee compensation costs consist of salaries, bonuses, commissions, benefits, and stock-based compensation. Cost of Revenue, Gross Profit and Gross Margin Cost of subscription revenue. Cost of subscription revenue consists primarily of costs related to hosting our platform and providing customer support. These costs include data center costs and third-party hosting fees, employee compensation costs associated with our cloud-based infrastructure and our customer support organizations, amortization expense associated with capitalized internal-use software and purchased technology, allocated overhead, software and maintenance costs, and outside services associated with the delivery of our subscription services. We intend to continue to invest in our platform infrastructure, including third-party hosting capacity, and support organizations. However, the level and timing of investment in these areas could fluctuate and affect our cost of subscription revenue in the future. Cost of professional services revenue. Cost of professional services revenue consists primarily of costs related to the deployment of our platform. These costs include employee compensation costs for our professional services team, allocated overhead, travel costs, and costs of outside services associated with supplementing our internal staff. Cost of providing professional services, excluding stock-based compensation, has historically been similar to the associated professional services revenue, and we expect this to continue for the foreseeable future. Gross profit and gross margin. Our gross profit and gross margin may fluctuate from period to period as our revenue fluctuates, and as a result of the timing and amount of investments to expand hosting capacity, including through third party cloud providers, our continued efforts to build platform support and professional services teams, as well as the amortization expense associated with capitalized internal-use software and acquired technology. Operating Expenses Research and development. Research and development expense consists primarily of employee compensation costs, allocated overhead, and travel costs. We capitalize research and development costs associated with the development of internal-use software and we amortize these costs over a period of approximately two to three years into cost of subscription revenue. All other research and development costs are expensed as incurred. We believe that continued investment in our platform is important for our growth, and as such, expect our research and development expense to continue to increase in absolute dollars for the foreseeable future but may increase or decrease as a percentage of revenue. Sales and marketing. Sales and marketing expense consists primarily of employee compensation costs, including commissions for our sales personnel, allocated overhead, costs of general marketing and promotional activities, and travel costs. We currently expense sales commissions in the period of sale. Effective February 1, 2019 under ASC 606, commissions will be amortized in sales and marketing expense over the period of benefit, which is expected to be five years. While our sales and marketing expense as a percentage of total revenue has decreased in recent periods, we expect to continue to make significant investments as we expand our customer acquisition and retention efforts. Therefore, we expect that sales and marketing expense will increase in absolute dollars but may vary as a percentage of total revenue for the foreseeable future. General and administrative. General and administrative expense consists primarily of employee compensation costs, allocated overhead, and travel costs for finance, accounting, legal, human resources, and recruiting personnel. In addition, general and administrative expense includes non-personnel costs, such as accounting fees, legal fees, charitable contributions and all other supporting corporate expenses not allocated to other departments. We incurred additional costs as a result of operating as a public company in fiscal 2019, including costs related to compliance and reporting obligations of public companies, and increased costs for insurance, investor relations, and professional services. We expect many of these costs to continue for the full year of fiscal 2020. As a result, we expect our general and administrative expense to continue to increase in absolute dollars for the foreseeable future but decrease as a percentage of revenue. Interest and Other (Expense) Income, net Interest and other (expense) income, net primarily consists of interest income from our investment holdings, interest expense associated with our Debt Agreement, and foreign exchange fluctuations. Income Tax Provision Income tax provision consists primarily of income taxes related to foreign and state jurisdictions in which we conduct business. We maintain a full valuation allowance on our federal and state deferred tax assets as we have concluded that it is more likely than not that the deferred assets will not be utilized. Results of Operations The following tables set forth our consolidated results of operations data for the periods presented in dollars and as a percentage of our total revenue: (1) Includes stock-based compensation expense as follows: Note: Percentages in the table above may not sum due to rounding. Fiscal Years Ended January 31, 2019 and 2018 Revenue Subscription revenue increased by $48.4 million, or 40%, for fiscal 2019 compared to fiscal 2018. The increase in subscription revenue was primarily attributable to new customers acquired during the period and an increase in usage and sales of additional products to our existing customers. Additionally, as a result of our acquisition of Leeyo in May 2017, we recognized more subscription revenue in fiscal 2019 compared to fiscal 2018 due to the impact of purchase accounting from the acquisition and recognizing a full year of revenue from Zuora RevPro. Professional services revenue increased by $18.8 million, or 40%, for fiscal 2019 compared to fiscal 2018, primarily due to increased revenue from customer deployments of our products. Cost of Revenue and Gross Margin Cost of subscription revenue increased by $11.9 million, or 38%, for fiscal 2019 compared to fiscal 2018, primarily due to an increase of $4.4 million in data center costs, $3.4 million in employee compensation costs related to increased headcount, $1.6 million of professional services, $1.1 million in software license costs, $1.0 million in allocated overhead including facilities expansions, and $0.3 million related to the amortization of purchased technology and amortization of internal-use software. The increase in these costs is driven by the growth in the number of customers as well as the increase in usage from existing customers. Cost of professional services revenue increased by $24.8 million, or 51%, for fiscal 2019 compared to fiscal 2018, primarily due to an increase of $16.6 million in employee compensation costs related to increased headcount, $4.4 million in allocated overhead including facilities expansions, $1.7 million in professional services, $1.7 million in travel costs, and $0.3 million in software license costs. Our gross margin for subscription services improved to 75% for fiscal 2019 from 74% for fiscal 2018 as a result of the impact of purchase accounting from the acquisition of Leeyo that resulted in higher subscription revenue recognition relative to costs for fiscal 2019 as compared to fiscal 2018. Our gross margin for professional services decreased to (11)% for fiscal 2019 compared to (3)% for fiscal 2018, primarily from the increase in deployment capacity. Some of this incremental investment in headcount was not fully utilized during fiscal 2019 due to ramp-up time for new hires, and is expected to be realized in future periods. Operating Expenses Research and Development Research and development expense increased by $15.8 million, or 41%, for fiscal 2019 compared to fiscal 2018, primarily due to an increase of $12.0 million in employee compensation costs due to increased headcount, $2.3 million in allocated overhead including facilities expansions, $0.8 million in professional services, $0.7 million in travel costs, $0.6 million in data center costs, and $0.4 million in software license costs, partially offset by a decrease of $1.1 million in costs related to higher capitalized internal-use software costs. The increase in headcount was driven by our continued investment in technology, innovation, and new products. Sales and Marketing Sales and marketing expense increased by $27.7 million, or 38%, for fiscal 2019 compared to fiscal 2018, primarily due to an increase of $17.0 million in employee compensation costs related to increased headcount, $4.0 million in allocated overhead including facilities expansions, $3.4 million in marketing and event costs and $2.6 million in travel costs. The increase in headcount was driven by our continued investment to acquire new customers and to grow our revenue from existing customers. General and Administrative General and administrative expense increased by $16.7 million, or 74%, for fiscal 2019 compared to fiscal 2018, primarily due to an increase of $7.3 million in employee compensation costs related to increased headcount, $3.8 million in professional services primarily related to accounting, tax and legal costs, $2.0 million in allocated overhead including facilities expansions, $1.0 million in donations of our Class A common stock to a charitable foundation, $1.0 million in software license costs, $1.0 million in other administrative costs and $0.4 million in travel costs. The increase in these costs was primarily driven by investment required to support our growth as well as operations as a public company. Interest and Other Income (Expense), net Interest and other income (expense), net decreased by $0.7 million for fiscal 2019 compared to fiscal 2018, due to an increase of $2.6 million in net losses related to revaluing cash, accounts receivable and payables recorded in a foreign currency, partially offset by an increase of $1.3 million in net interest income as a result of invested cash balances and an increase of $0.6 million from accretion on short-term investments. Income Tax Provision We are subject to federal and state income taxes in the United States and taxes in foreign jurisdictions. For fiscal 2019 and fiscal 2018 we recorded a tax provision of $1.4 million and $1.1 million on losses before income taxes of $76.2 million and $46.0 million, respectively. The effective tax rate for fiscal 2019 and fiscal 2018 was (1.8)% and (2.5)%, respectively. The effective tax rates differ from the statutory rate primarily as a result of providing no benefit on pretax losses incurred in the United States. For fiscal 2019 and fiscal 2018, we maintained a full valuation allowance on our U.S. federal and state net deferred tax assets as it was more likely than not that those deferred tax assets will not be realized. Fiscal Years Ended January 31, 2018 and 2017 Revenue Subscription revenue increased by $30.5 million, or 34%, for fiscal 2018 compared to fiscal 2017. Approximately 29% of the increase in subscription revenue in fiscal 2018 was attributable to new customers acquired during the period, and the remainder was attributable to an increase in usage and sales of additional products to our existing customers. Subscription revenue for fiscal 2017 did not include revenue attributable to our Zuora RevPro product. Professional services revenue increased by $24.4 million, or 105%, for fiscal 2018 compared to fiscal 2017, primarily due to fiscal 2017 not including professional services revenue attributable to our Zuora RevPro product and higher revenue from customer deployments compared to fiscal 2017. Cost of Revenue and Gross Margin Cost of subscription revenue increased by $8.2 million, or 36%, for fiscal 2018 compared to fiscal 2017, primarily due to an increase of $2.5 million in employee compensation costs related to higher headcount, an increase of $2.4 million in third-party data center costs, an increase of $2.0 million related to the amortization of purchased technology and amortization of internal-use software, an increase of $0.6 million in software license costs, and an increase of $0.4 million in allocated overhead. Cost of subscription revenue for fiscal 2017 did not include costs attributable to our Zuora RevPro product. Our gross margin for subscription revenue decreased from 75% for fiscal 2017 to 74% for fiscal 2018 due to investments in international markets and the impact of our Zuora RevPro product, partially offset by higher efficiencies from greater scale. Cost of professional services revenue increased by $23.5 million for fiscal 2018 compared to fiscal 2017, due to a greater number of customer deployments. Cost of professional services for fiscal 2017 did not include costs attributable to our Zuora RevPro product. Our gross margin for professional services revenue increased from (9%) for fiscal 2017 to (3%) for fiscal 2018, primarily attributable to our Zuora RevPro product. Operating Expenses Research and Development Research and development expense increased by $12.3 million, or 47%, for fiscal 2018 compared to fiscal 2017, primarily due to an increase of $7.4 million in employee compensation costs due to higher headcount, an increase of $2.4 million in allocated overhead, an increase of $1.1 million in costs due to lower capitalized internal-use software costs in 2018, an increase of $0.6 million in data center costs, and an increase of $0.4 million in travel costs. Research and development expense for fiscal 2017 did not include costs attributable to our Zuora RevPro product. Sales and Marketing Sales and marketing expense increased by $10.7 million, or 17%, for fiscal 2018 compared to fiscal 2017, primarily due to an increase of $9.2 million in employee compensation costs related to higher headcount, an increase of $0.7 million in allocated overhead costs, an increase of $0.4 million in travel costs, and an increase of $0.4 million in marketing and event costs. Sales and marketing expense for fiscal 2017 did not include costs attributable to our Zuora RevPro product. General and Administrative General and administrative expense increased by $7.4 million, or 49%, for fiscal 2018 compared to fiscal 2017, primarily due to an increase of $4.0 million in employee compensation costs related to higher headcount, an increase of $2.6 million in professional services, comprised primarily of legal, accounting, and consulting fees, an increase of $0.5 million in allocated overhead costs, and an increase of $0.3 million in software licenses. General and administrative expense for fiscal 2017 did not include costs attributable to our Zuora RevPro product. Interest and Other Income (Expense), Net Interest and other income (expense), net increased by $33,000 for fiscal 2018 compared to fiscal 2017. The increase was primarily due to an increase of $0.5 million in currency translation gains resulting from foreign operations, partially offset by an increase of $0.5 million in interest expense related to the term loan facility under our Debt Agreement, which we drew down on in June 2017. Income Tax Provision Our provision for income tax increased $0.8 million in fiscal 2018 compared to fiscal 2017 primarily due to taxes on foreign income. Our effective tax rate decreased from (0.7)% in fiscal 2017 to (2.5)% in fiscal 2018. This change was primarily due to taxes incurred by foreign subsidiaries. The material changes in fiscal 2018 compared to fiscal 2017 within the tax rate reconciliation in the notes to our consolidated financial statements primarily relate to the impact of the Tax Cuts and Jobs Act of 2017 (Tax Reform Act). As a result of the Tax Reform Act, we remeasured our deferred tax assets which resulted in an increase to the provision and this was included within the change in tax rate line item in the tax rate reconciliation in the notes to our consolidated financial statements. The Tax Reform Act also impacts the state income tax, net of federal benefit resulting in an increased benefit as compared to the prior year. Additionally, this was offset by a corresponding decrease in our valuation allowance. On a total basis, these items resulted in a net impact of zero on the provision. Quarterly Results of Operations The following table sets forth our unaudited quarterly consolidated statement of operations data for each of the eight quarters in the period ended January 31, 2019. The unaudited consolidated statement of operations data set forth below has been prepared on the same basis as our audited consolidated financial statements and, in the opinion of management, reflect all adjustments, consisting only of normal recurring adjustments, that are necessary for the fair presentation of such data. Our historical results are not necessarily indicative of the results that may be expected in the future and the results for any quarter are not necessarily indicative of results to be expected for a full year or any other period. The following quarterly financial data should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this filing: (1) Includes stock-based compensation expense as follows: 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. Note: Percentages in the table above may not sum due to rounding. Quarterly Revenue Trends Our quarterly subscription revenue increased sequentially in each of the periods presented primarily due to increases in the number of customers as well as sales of blocks of transaction volume and sales of additional products. We have historically entered into more subscription agreements in the fourth quarter of our fiscal year, though this seasonality is sometimes not apparent in our subscription revenue because we recognize subscription revenue over the term of the contract. The growth in quarterly professional services revenue in absolute dollars was primarily attributable to our Zuora RevPro product and our customers requiring additional services in connection with their adoption of ASC 606, as well as larger implementations of new Zuora billing customers. Quarterly Cost of Revenue and Gross Margin Trends Our quarterly gross margin from subscription revenue has generally been consistent over the fiscal quarters presented. This reflects our increased investment in data center operations and our support organization. Our quarterly gross margin from professional services has generally decreased sequentially, primarily due to continuing investment in headcount and related expenses, including stock-based compensation, in order to support a greater number of customer deployments. Some of this incremental investment in headcount was not fully utilized during the three months ended January 31, 2019, due to ramp-up time for new hires, and is expected to be realized in future periods. Quarterly Operating Expenses Trends Total operating expenses have generally increased sequentially for the fiscal quarters presented, primarily due to the addition of personnel in connection with the expansion of our business. Our sales and marketing expense increased primarily due to continued investment in expanding our customer acquisition and retention efforts. The increase in sales and marketing expense beginning in the second quarter of fiscal 2018 was the result of our acquisition of Leeyo, which occurred in the quarter ended July 31, 2017. Our sales and marketing expense can also fluctuate between quarters due to the timing of our annual sales kick-off and our annual user conferences, which are typically held in the first and second quarter of the fiscal year, respectively. Our research and development expense increased primarily due to continued investment in developing our solutions. The increase in research and development expense beginning in the second quarter of fiscal 2018 was the result of our acquisition of Leeyo, which occurred in the quarter ended July 31, 2017. Our general and administrative expense increased primarily due to higher headcount to support our growth and the additional costs associated with operating as a public company. General and administrative expense included legal fees in the second quarter of fiscal 2018 attributable to our acquisition of Leeyo and expenses in fiscal 2019 related to operating as a public company. In the fourth quarter of fiscal 2019, we donated $1.0 million of our common stock to a charitable foundation, which increased general and administrative expense by that amount. Liquidity and Capital Resources As of January 31, 2019, we had cash and cash equivalents, and short-term investments of $175.8 million. Since inception, we have financed our operations primarily through the net proceeds we received through private sales of equity securities, payments received from customers for subscription and professional services, and borrowings from our Debt Agreement. Additionally, in April 2018, we completed our IPO, in which we issued and sold an aggregate of 12.7 million shares of Class A common stock at a price of $14.00 per share. We received aggregate net proceeds of $159.7 million from the IPO, after underwriting discounts and commissions and payments of offering costs as of January 31, 2019. We believe our existing cash and cash equivalents, and short-term investment balances, funds available under our Debt Agreement, and cash provided by subscriptions to our platform and related professional services will be sufficient to meet our working capital and capital expenditure needs for at least the next 12 months. Our future capital requirements will depend on many factors, including the rate of our 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 introduction of new and enhanced product offerings, and the continuing market adoption of our platform. We may in the future enter into arrangements to acquire or invest in complementary businesses, services, and technologies, including intellectual property rights. We may elect to or may be required to seek additional equity or debt financing. Sales of additional equity could result in dilution to our stockholders. 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 or generate cash flows necessary to expand our operations and invest in new technologies, it could reduce our ability to compete successfully and harm our results of operations. Debt Agreement See Note 9. Debt of the notes to our consolidated financial statements included in this Form 10-K for more information about our Debt Agreement. Cash Flows The following table summarizes our cash flows for the periods indicated: Operating Activities Our largest source of operating cash is cash collections from our customers for subscription and professional services. Our primary uses of cash in operating activities are for employee-related expenditures, marketing expenses, third-party consulting expenses, and third-party hosting costs. For fiscal 2019, net cash used in operating activities was $23.6 million, which consisted of a net loss of $77.6 million adjusted for non-cash charges of $38.7 million and net cash inflows of $15.3 million provided by changes in our operating assets and liabilities. Non-cash charges, which primarily consisted of stock-based compensation, depreciation and amortization of property and equipment and intangible assets and provision for doubtful accounts, increased compared to the same period last year primarily as a result of growth in our business operations. Specifically, stock-based compensation increased $16.4 million in fiscal 2019 compared to fiscal 2018 as a result of new equity grants and enrollments in our ESPP, which was adopted in April 2018. The changes in operating assets and liabilities were primarily due to a $24.6 million increase in deferred revenue, offset by a $12.4 million increase in accounts receivable, net, resulting primarily from increased subscription arrangements as many of our customers are invoiced in advance for annual subscriptions. Additionally, the changes in operating assets and liabilities were due to a net increase of $9.1 million in accounts payable, accrued expenses and other liabilities, offset by an increase in prepaid expenses and other assets of $5.9 million reflecting the growth in our business and the timing of billings and payments. For fiscal 2018, net cash used in operating activities was $24.8 million, which consisted of a net loss of $47.2 million, adjusted for non-cash charges of $18.8 million and net cash inflows of $3.5 million provided by changes in our operating assets and liabilities. Non-cash charges primarily consisted of stock-based compensation and depreciation and amortization of property and equipment and intangible assets. The changes in operating assets and liabilities were primarily due to a $21.3 million increase in deferred revenue, offset by a $21.0 million increase in accounts receivable, net, resulting primarily from increased subscription arrangements as a majority of our customers are invoiced in advance for annual subscriptions. Additionally, the change in operating assets and liabilities was due to a decrease of $3.8 million in accounts payable and an increase of $3.2 million in prepaid expenses and other current assets, offset by an increase of $10.3 million in accrued expenses and other liabilities. For fiscal 2017, net cash used in operating activities was $25.0 million, which consisted of a net loss of $39.1 million, adjusted for non-cash charges of $12.0 million and net cash inflows of $2.1 million provided by changes in our operating assets and liabilities. Non-cash charges primarily consisted of stock-based compensation, depreciation and amortization of property and equipment and intangible assets and provision for doubtful accounts. The changes in operating assets and liabilities were primarily due to a $7.9 million increase in deferred revenue, offset by a $7.6 million increase in accounts receivable, net, resulting primarily from increased subscription arrangements as a majority of our customers are invoiced in advance for annual subscriptions. Additionally, the change in operating assets and liabilities was due to an increase of $3.3 million in accrued employee liabilities partially offset by an increase of $1.1 million in prepaid expenses and other current assets. Investing Activities Net cash used in investing activities for fiscal 2019 was $121.1 million, primarily due to $107.5 million in purchases of short-term investments and $13.4 million in purchases of property and equipment and capitalized internal-use software. Net cash used in investing activities for fiscal 2018 was $16.1 million, primarily due to $11.4 million in cash paid to investors in connection with our acquisition of Leeyo and $4.7 million in purchases of property and equipment and capitalized internal-use software. Net cash used in investing activities for fiscal 2017 was $3.7 million, primarily due to $3.8 million in purchases of capital equipment and the capitalization of internal-use software. Financing Activities Cash provided by financing activities for fiscal 2019 was $161.4 million, primarily due to $164.7 million in net IPO proceeds, $5.3 million in proceeds from issuance of common stock under the ESPP, $11.5 million in stock option exercise proceeds and $1.3 million in net proceeds from related party loans, partially offset by $12.6 million in payments to investors related to our acquisition of Leeyo, $4.4 million in deferred offering costs payments, $3.6 million in payments made on leased equipment and $0.8 million of debt payments. Cash provided by financing activities for fiscal 2018 was $15.4 million, primarily the result of $15.0 million drawn down under our Debt Agreement, and $4.5 million in proceeds from the exercise of stock options, net of repurchases, offset by payments of $2.1 million related to capital leases, $1.3 million in payments under related party notes receivable, and payments of $0.6 million related to deferred offering costs. Cash used in financing activities for fiscal 2017 of $0.4 million was primarily the result of payments of $2.0 million related to capital leases partially offset by $1.5 million in proceeds from the exercise of stock options and warrants, net of repurchases. Off-Balance Sheet Arrangements As of January 31, 2019, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Obligations and Other Commitments Our principal commitments consist of obligations under our operating leases for office space and our Debt Agreement. The following table summarizes our contractual obligations as of January 31, 2019 (in thousands): _________________________________ (1) We lease our facilities under long-term operating leases which expire on varying dates through April 2024. The lease agreements often contain provisions which require us to pay taxes, insurance, and maintenance costs. (2) Debt principal and interest includes amounts owed under our Debt Agreement with Silicon Valley Bank including principal, interest and a $0.2 million facility fee on the term loan. Interest payments were calculated using the applicable rate as of January 31, 2019. See Note 9. Debt of the notes to our consolidated financial statements included in this Form 10-K for more information about our Debt Agreement. (3) As of January 31, 2019, our only other material contractual obligation was to purchase $4.0 million in web hosting services from one of our vendors by September 30, 2019. In the ordinary course of business, we enter into agreements of varying scope and terms pursuant to which we agree to indemnify customers, vendors, lessors, business partners, and other parties with respect to certain matters, including, but not limited to, losses arising out of the breach of such agreements, services to be provided by us, or from data breaches or intellectual property infringement claims made by third parties. In addition, we have entered into indemnification agreements with our directors and certain officers and employees that will require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors, officers, or employees. No demands have been made upon us to provide indemnification under such agreements and there are no claims that we are aware of that could have a material effect on our consolidated balance sheets, consolidated statements of operations and comprehensive loss, or consolidated statements of cash flows. As of January 31, 2019, we had accrued liabilities related to uncertain tax positions, which are reflected in our consolidated balance sheets. These accrued liabilities are not reflected in the table above since it is unclear when these liabilities will be repaid. In March 2019, we entered into a new operating lease agreement for approximately 100,000 square feet of office space located in Redwood Shores, California that will replace our existing headquarters in San Mateo, California. See Note 17. Subsequent Events of the notes to our consolidated financial statements included in this Form 10-K for more information about the lease of our new headquarters. Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with U.S. GAAP. The preparation of these consolidated financial statements requires our management to make estimates, assumptions, and judgments 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 revenue and expenses during the applicable periods. We base our estimates, assumptions, and judgments on historical experience and on various other factors that we believe to be reasonable under the circumstances. Different assumptions and judgments would change the estimates used in the preparation of our consolidated financial statements, which, in turn, could change the results from those reported. We evaluate our estimates, assumptions, and judgments on an ongoing basis. The critical accounting estimates, assumptions, and judgments that we believe have the most significant impact on our consolidated financial statements are described below. Revenue Recognition We generate revenue primarily from two sources: (1) subscription services which is comprised of revenue from subscription fees from customers accessing our cloud-based software and (2) professional services and other revenue which consists primarily of fees from consultation services to support business process mapping, configuration, data migration, integration, and training. Subscription services revenue is recognized on a ratable basis over the related subscription period beginning on the date the customer is first given access to the system (i.e. provision date). We recognize professional services revenue once the revenue recognition criteria have been met based on a proportional performance method for fixed price engagements or as the service is being provided for time and material-based contracts. In most cases, the customers do not have the contractual right to take possession of our software. However, certain contracts assumed with our acquisition of Leeyo do give the customer the right to install our software on the customer’s premises. Certain other Leeyo contracts give the customer the right to receive the source code of our software upon the occurrence of certain events such as our bankruptcy, insolvency, or failure to provide technical support for software. See “Summary of Business and Significant Accounting Policies-Leeyo On-Premise Arrangements” in Note 2. Summary of Significant Accounting Policies and Recent Accounting Pronouncements of the notes to our consolidated financial statements for more information. We commence revenue recognition when all of the following conditions are met: • there is persuasive evidence of an arrangement; • the service is being provided to the customer; • the collection of the fees is reasonably assured; and • the amount of fees to be paid by the customer is fixed or determinable. Revenue from new customers is often generated under subscription agreements with multiple elements, comprised of subscription services fees from customers accessing our software and professional services associated with consultation services. We evaluate each element in a multiple-element arrangement to determine whether it represents a separate unit of accounting. An element constitutes a separate unit of accounting when the delivered item has stand-alone value and delivery of the undelivered element is probable and within our control. Subscription services have stand-alone value because they are routinely sold separately by us. Professional services have stand-alone value because we have sold professional services separately and there are several third-party vendors that routinely contract directly with the customer and provide these services to the customer on a stand-alone basis. For cloud-based software subscription services revenue and professional services revenue, we allocate revenue to each element in an arrangement based on a selling price hierarchy. The selling price for an element is based on its vendor-specific objective evidence (VSOE) if available; third-party evidence (TPE) if VSOE is not available; or estimated selling price (ESP) if neither VSOE nor TPE is available. We determine whether VSOE can be established for elements of our arrangements by reviewing the prices at which such elements are sold in stand-alone arrangements. Through January 31, 2019, we have not established VSOE or TPE for any of the elements of our arrangements. Therefore, we utilize the ESP for all our elements. We establish ESP for both our cloud-based subscription services and professional services elements primarily by considering the actual sales prices of the element when sold on a stand-alone basis or when sold together with other elements. The consideration allocated to subscription services is typically recognized as revenue over the noncancelable contract period on a straight-line basis. The consideration allocated to professional services is typically recognized as revenue once the revenue recognition criteria have been met based on a proportional performance method for fixed price engagements or as the service is being provided for time and material-based contracts. Amounts that have been invoiced are recorded in accounts receivable and in deferred revenue or revenue, depending on whether the revenue recognition criteria have been met. Arrangements with customers do not provide the customer with the right to take possession of the software supporting the on-demand application service. Sales and other taxes collected from customers to be remitted to government authorities are reported on a net basis and, therefore, excluded from revenue. We classify reimbursements received from clients for out-of-pocket expenses as professional services revenue as incurred. Subscription agreements generally have terms ranging from one to three years and are generally invoiced annually or quarterly in advance over the term. The professional services component of the arrangements is generally earned during the first year of the subscription period depending on the size and complexity of the business utilizing the platform service. The subscription agreements occasionally provide service-level uptime commitments per period, excluding scheduled maintenance. The failure to meet this level of service availability may require us to credit qualifying customers up to the value of an entire month of their platform fees. Based on our historical experience of meeting our service-level commitments, we do not currently have any reserves for these commitments. Capitalized Internal-Use Software Costs We capitalize costs related to developing new functionality for our suite of products that are hosted by us and accessed by our customers on a subscription basis. We also capitalize costs related to specific upgrades and enhancements when it is probable the expenditures will result in additional functionality. Costs incurred in the preliminary stages of development are expensed as incurred. Once an application has reached the development stage, internal and external costs, if direct and incremental, are capitalized until the software is substantially complete and ready for its intended use. Capitalized costs are recorded as part of property and equipment, net in our consolidated balance sheets. Maintenance and training costs are expensed as incurred. Internal-use software is amortized on a straight-line basis over its estimated useful life, generally three years. We evaluate the useful lives of these assets on an annual basis and test for impairment whenever events or changes in circumstances occur that could impact the recoverability of these assets. There were no impairments to internal-use software during fiscal 2019, fiscal 2018 and fiscal 2017. Stock-Based Compensation We have granted stock-based awards, consisting of stock options, restricted stock, and RSUs, to our employees, certain consultants, and certain members of our board of directors. All stock-based compensation, including purchase rights issued under the ESPP, is measured based on the fair value of the awards on the date of grant. This fair value is recognized as an expense following the straight-line attribution method over the requisite service period of the entire award for stock options, RSUs and restricted stock; and over the offering period for the purchase rights issued under the ESPP. Prior to the IPO, we estimated the fair value of our common stock at the time of grant. After the IPO, we used the closing market price of our Class A common stock on the date of grant. We use the Black-Scholes option pricing model to measure the fair value of its stock options and the purchase rights under the ESPP. This requires the input of highly subjective assumptions, including the fair value of our underlying common stock, the expected term of stock options, the expected volatility of the price of our common stock, risk-free interest rates, and the expected dividend yield of our common stock. The assumptions used in our option-pricing model represent our best estimates. These estimates involve inherent uncertainties and the application of management’s judgment. If factors change and different assumptions are used, our stock-based compensation expense could be materially different in the future. The resulting fair value, net of estimated forfeitures, is recognized on a straight-line basis over the period during which an employee is required to provide service in exchange for the award. These assumptions used in the Black-Scholes option-pricing model, other than the fair value of our common stock, are estimated as follows: • Expected volatility. We estimate the expected volatility based on the volatility of similar publicly-held entities (referred to as “guideline companies”) over a period equivalent to the expected term of the awards. In evaluating the similarity of guideline companies to us, we considered factors such as industry, stage of life cycle, size, and financial leverage. We intend to continue to consistently apply this process using the same or similar guideline companies to estimate the expected volatility until sufficient historical information regarding the volatility of the share price of our Class A common stock becomes available. • Expected term. We determine the expected term of awards which contain only service conditions using the simplified approach, in which the expected term of an award is presumed to be the mid-point between the vesting date and the expiration date of the award, as we do not have sufficient historical data relating to stock-option exercises. For awards granted which contain performance conditions, we estimate the expected term based on the estimated dates that the performance conditions will be satisfied. • Risk-free interest rate. The risk-free interest rate is based on the United States Treasury yield curve in effect during the period the options were granted corresponding to the expected term of the awards. • Estimated dividend yield. The estimated dividend yield is zero, as we have not declared dividends in the past and do not currently intend to declare dividends in the foreseeable future. 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 expense for our awards. Our forfeiture rate is based on an analysis of our actual forfeitures. We will continue to evaluate the appropriateness of the forfeiture rate based on actual forfeiture experience, analysis of employee turnover, and other factors. Changes in the estimated forfeiture rate can have a significant impact on our stock-based compensation expense as the cumulative effect of adjusting the rate is recognized in the period the forfeiture estimate is changed. If a revised forfeiture rate is higher than the previously estimated forfeiture rate, an adjustment is made that will result in a decrease to the stock-based compensation expense recognized in our financial statements. If a revised forfeiture rate is lower than the previously estimated forfeiture rate, an adjustment is made that will result in an increase to the stock-based compensation expense recognized in our financial statements. We will continue to use judgment in evaluating the expected volatility, expected term and estimated forfeiture rate utilized in our stock-based compensation expense calculations on a prospective basis. As we continue to accumulate additional data related to our common stock, we may refine our estimates of expected volatility, expected term, and estimated forfeiture rates, which could materially impact our future stock-based compensation expense. We estimate the fair value of our restricted stock and RSU grants based on the grant date fair value of our common stock. The resulting fair value, net of estimated forfeitures, is recognized on a straight-line basis over the period during which an employee is required to provide service in exchange for the award, which is generally four years. Estimated forfeitures are based upon our historical experience and we revise our estimates, if necessary, in subsequent periods if actual forfeitures differ from initial estimates. Recent Accounting Pronouncements See “Summary of Significant Accounting Policies and Recent Accounting Pronouncements” in Note 2. Summary of Significant Accounting Policies and Recent Accounting Pronouncements of our accompanying consolidated financial statements for more information.

<s>[INST] Overview Business Summary Zuora is a leading cloudbased subscription management platform. We provide software that enables companies across multiple industries and geographies to launch, manage or transform to a subscription business model. Architected specifically for dynamic, recurring subscription business models, our cloudbased software functions as an intelligent subscription management hub that automates and orchestrates the entire subscription ordertorevenue process, including billing and revenue recognition. Our solution enables businesses to easily change pricing and packaging for products and services to grow and scale, to efficiently comply with revenue recognition standards, and to build meaningful relationships with their subscribers. We believe we are in the early stages of a multidecade global shift away from productbased business models, characterized by transactional onetime sales, towards recurring subscriptionbased business models. This trend, which we refer to as the “Subscription Economy,” is visible everywhere you look. In media and entertainment, consumers are adopting videoondemand services and digital music streaming services. Commuters are taking advantage of automobile subscription programs and subscriptionbased ridesharing services. In the technology space, companies are opting for softwareasaservice applications over onpremise installations. In manufacturing, sensors and connectivity have allowed companies to bundle an array of digital services with their physical products. Digital subscriptions have had a positive effect on the newspaper and publishing industries, with readers increasingly subscribing to digital news and information sources. In addition, the retail space features a growing multitude of subscription services including clothing and accessories, cosmetics and personal care, meals and groceries, vitamins and prescriptions, pet care, and many more. Many of today’s enterprise software systems that businesses use to manage their ordertorevenue processes were built for a product driven economy, and are extremely difficult to reconfigure for the dynamic, ongoing nature of subscription services. In traditional business models, ordertorevenue was a linear processa customer orders a product, is billed for that product, payment is collected, and the revenue recognized. These legacy systems were not specifically designed to handle the complexities and ongoing customer events of recurring relationships and their impact on areas such as billing proration, revenue recognition, and reporting in realtime. Trying to use this software to build a subscription business frequently results in prolonged and complex manual downstream work, hardcoded customizations, a proliferation of stockkeeping units (SKUs), and inefficiency. These new subscription business models are inherently dynamic, with multiple interactions and constantlychanging relationships and events. The capabilities to launch, price, and bill for products, facilitate and record cash receipts, process and recognize revenue, and produce the data required to close their books and drive key decisions are mission critical and particularly complex for companies with subscription business models. As a result, as companies launch or grow a subscription business, they often conclude that legacy systems are inadequate. Our mission is to enable all companies in the Subscription Economy to become successful. Our customers include companies of all sizes, ranging from small businesses to some of the world’s largest enterprises. Customers pay for our platform under a subscriptionbased model, and this model allows us to grow as the Subscription Economy grows. Fiscal 2019 Business Highlights Key corporate milestones during fiscal 2019 include: We completed our IPO in which we sold 12.7 million shares of our Class A common stock to the public at a price of $14.00 per share, netting $159.7 million in cash proceeds. In our third quarter of fiscal 2019, we surpassed 500 customers with ACV exceeding $100,000. In our fourth quarter of fiscal 2019, we crossed $10 billion in quarterly invoice transaction volume that customers run through our system. For a definition of ACV, see “Management’s Discussion and Analysis of Financial Condition and Results of OperationsKey Operational and Financial Metrics.” Fiscal 2019 Financial Performance Summary Our financial performance in fiscal 2019, compared to fiscal 2018, reflects the following: Subscription revenues were $168.8 million, an increase of $48.4 million or 40%, and total revenues were $235.2 million, an increase of $6 [/INST] Positive. </s>

ProSight Global, Inc.

2020-02-24

2019-12-31

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 should be read in conjunction with the audited consolidated financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K. Certain restatements have been made to historical information to give effect to the merger and related transactions. See Note 1 - Background in the notes to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K. 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 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 on this Form 10-K. See “Special Note Regarding Forward-Looking Statements.” References to the "Company," "ProSight," "we," "us," and "our" are to ProSight Global, Inc. and its consolidated subsidiaries unless the context otherwise requires. References to “insurance subsidiaries” are to New York Marine and General Insurance Company (“New York Marine”), Gotham Insurance Company (“Gotham”) and Southwest Marine and General Insurance Company (“Southwest Marine”) unless the context otherwise requires. Overview We are an entrepreneurial specialty insurance company that since our founding in 2009 has built products, services and solutions with the goal of significantly improving the experience and value proposition for our customers. We founded ProSight, with capital commitments from affiliates of each of The Goldman Sachs Group, Inc. (“Goldman Sachs”) and TPG Global, LLC (“TPG”) as a different type of insurer that leverages customized technology infrastructure, underwriting expertise and unique niche focus to develop products, services and solutions that deliver distinct value to customers in the manner they prefer. Our Company is led by a highly experienced and entrepreneurial team with decades of insurance leadership experience at ProSight and other leading insurers. We write property and casualty insurance with a focus on underwriting specialty risks by partnering with a select number of distributors, often on an exclusive basis. We have a diverse business mix covering specialty niches within the eight customer segments in which we operate. We market and distribute our insurance product offerings in all 50 states on both an admitted and non-admitted basis. We are focused on delivering consistent underwriting profitability with low volatility of underwriting results. In November of 2011, we formed a Bermuda holding company structure and acquired several entities in the U.K. to build our own Lloyd’s syndicate. Our principal objective was to achieve greater capital and tax efficiency for our growing U.S. niche business. We also considered opportunities to use this as a platform to extend our niche strategy to the U.K. and Europe. By 2015, however, we determined that we would not be able to profitably achieve our objectives due to two principal factors. Firstly, a significant driver of the success of our U.S. sourced business is the extensive control and oversight of our niche specialized internal and external underwriters. In contrast, in the UK, the regulatory framework required us to operate the syndicate as an independent entity, largely excluded from oversight by the U.S. management team. As a result, our Group Chief Underwriting Officer could not serve on the board of directors of the U.K. entities nor have final underwriting authority for non-U.S. sourced business. In addition, given the growing predominance of the U.S. underwritten business in the syndicate, the syndicate was required to develop an organic and independent growth strategy for U.K. sourced business. The independently underwritten U.K. business did not execute upon our niche strategy, and generated unacceptable loss ratios and acquisition costs. Secondly, while we had success in writing and reinsuring profitable U.S. sourced business into our syndicate, the U.S. business had become a disproportionately high percentage of the total syndicate book, and therefore our U.S. underwriting entity was treated as an independent Lloyd’s coverholder. As such, we were required to deploy redundant control and underwriting resources in the U.K. to oversee our U.S. book. This resulted in an unacceptable increase in the syndicate expense ratio. Given the uneconomic loss and expense costs associated with operating in Lloyd’s, in 2015 we began evaluating an exit from the Lloyd’s market and the repatriation of our U.S. business. The exit timeframes were extended due to capital constraints in our U.S. underwriting entity and protracted exit negotiations. In 2017, we entered into a two-phase sale transaction, which closed in October 2017 and March 2018. Accordingly, the financial results of the U.K. produced business are presented as discontinued operations in our consolidated financial statements. The financial results within the following discussion and analysis are attributable to our continuing operations. Initial Public Offering On July 29, 2019, the Company completed its initial public offering (“IPO”) with the sale of 7,857,145 shares of the Company’s common stock, including the issuance and sale by the Company of 4,285,715 shares of the Company’s common stock and the sale by ProSight Parallel Investment LLC and ProSight Investment LLC (“PI”) (collectively, the “GS Investors”) and ProSight TPG, L.P., TPG PS 1, L.P., TPG PS 2, L.P., TPG PS 3, L.P. and TPG PS 4, L.P. (collectively the “TPG Investors” and together with the GS Investors, the “Principal Stockholders”) of 3,571,430 shares of the Company’s common stock. Shares of the Company’s common stock were initially offered to the public by the underwriters in the IPO at a per-share price of $14.00. The Company did not receive any of the proceeds from the sale of the shares of the Company’s common stock sold by the Principal Stockholders in the IPO. Following the IPO, the GS Investors held approximately 40.9% of the Company’s outstanding common stock and the TPG Investors held approximately 39.4% of the Company’s outstanding common stock. On August 15, 2019 the Principal Stockholders completed the sale of 1,178,570 shares of the Company’s common stock at a price of $14.00 per share less the underwriting discount pursuant to the underwriters’ exercise of their over-allotment option granted in connection with the IPO. The Company did not receive any of the proceeds from the sale of the shares of common stock of the Company sold by the Principal Stockholders in this offering. Following this offering, the GS Investors held approximately 39.5% of the Company’s outstanding common stock and the TPG Investors held approximately 38.0% of the Company’s outstanding common stock. The offer and sale of all shares sold in the IPO, including those sold in connection with the underwriters’ exercise of their over-allotment option, were registered pursuant to a registration statement filed on Form S-1, which the Securities and Exchange Commission (“SEC”) declared effective on July 24, 2019. After deducting underwriting discounts and commissions and estimated offering expenses (including expenses related to the offering pursuant to the underwriters’ exercise of their overallotment option), the net proceeds to the Company from the IPO were approximately $50.8 million. Our Business We currently write insurance coverage in eight customer segments across a broad range of specialty lines of business. Our customer segments currently include: Media and Entertainment, Real Estate, Professional Services, Transportation, Construction, Consumer Services, Marine and Energy and Sports. Within each customer segment, we have multiple niches which represent similar groups of customers. For a description of niches served in each of these customer segments, see “Business - Our Customer Segments and Niches.” We believe having deep expertise in these niches across our organization is critical and therefore, we have aligned various functional areas at the niche level, including underwriting, operations and claims. We focus on small- and medium-sized customers, a market segment which we believe has been, and will continue to be, less affected by intense competitive dynamics of the broader property and casualty insurance industry. Over time, the composition of business within our customer segments evolves as we identify certain niches that present opportunities to develop distinct customer solutions with attractive profit potential and others that were at one time attractive but may become less so. The tables below set forth the gross written premiums (“GWP”), gross written commission ratios, and gross loss and allocated loss adjustment expense (“ALAE”) ratios by customer segment for the years ended December 31, 2019, 2018, and 2017. We have one reportable segment, Specialty Insurance. “Other” includes GWP from (i) primary and excess workers’ compensation coverage for exited Self-Insured Groups, (ii) niches exited prior to 2018, many with a concentration in commercial auto, (iii) certain fronting arrangements in which all premium written is ceded to a third party (iv) participation in industry pools, and (v) emerging new business. GWP Gross Written Commission Ratio Gross Loss and ALAE Ratio, excluding Unallocated Loss Adjustment Expense (“ULAE”) Ratio Components of Our Results of Operations Gross written and earned premiums GWP are the amounts received or to be received for insurance policies written by us during a specific period of time without reduction for policy acquisition costs, reinsurance costs or other deductions. The volume of our GWP in any given period is generally influenced by: · Expansion or retraction of business within existing niches; · Entrance into new customer segments or niches; · Exit from customer segments or niches; · Average size and premium rate of newly issued and renewed policies; and · The amount of policy endorsements, audit premiums, and cancellations. We earn insurance premiums on a pro rata basis over the term of the policy. Our insurance policies generally have a term of one year. Net earned premiums represent the earned portion of our GWP, less that portion of our GWP that is earned and ceded to third-party reinsurers under our reinsurance agreements. Ceded written and earned premiums Ceded written premiums are the amount of GWP ceded to reinsurers. We actively use ceded reinsurance across our book of business to reduce our overall risk position and to protect our capital. Ceded written premiums are earned over the reinsurance contract period in proportion to the period of risk covered and the underlying policies. The volume of our ceded written premiums is impacted by the level of our GWP and any decision we make to increase or decrease retention levels. Net investment income We earn investment income on our portfolio of cash and invested assets. Our cash and invested assets are primarily comprised of debt securities, and may also include cash and cash equivalents, short-term investments, and alternative investments. The principal factors that influence net investment income are the size of our investment portfolio and the yield on that portfolio. As measured by amortized cost (which excludes changes in fair value, such as changes in interest rates and credit spreads), the size of our investment portfolio is mainly a function of our invested equity capital along with premiums we receive from our insureds less payments on policyholder claims and operating expenses. Realized investment gains and losses Realized investment gains and losses are a function of the difference between the amount received by us on the sale of a security and the security’s amortized cost, as well as any “other-than-temporary” impairments recognized in earnings. Losses and Loss Adjustment Expenses (“LAE”) Losses and LAE are a function of the amount and type of insurance contracts we write, the loss experience associated with the underlying coverage, and the expenses incurred in the handling of the losses. In general, our losses and LAE are affected by: · Frequency of claims associated with the particular types of insurance contracts that we write; · Trends in the average size of losses incurred on a particular type of business; · Mix of business written by us; · Changes in the legal or regulatory environment related to the business we write; · Trends in legal defense costs; · Wage inflation; and · Inflation in medical costs. Losses and LAE are based on an actuarial analysis of the paid and estimated outstanding losses, including losses incurred during the period and changes in estimates from prior periods. Losses and LAE may be paid out over a number of years. Underwriting, acquisition and insurance expenses Underwriting, acquisition and insurance expenses include policy acquisition costs and other underwriting expenses. Policy acquisition costs are principally comprised of the commissions we pay our distribution partners and ceding commissions we receive on business ceded under certain reinsurance contracts, as well as taxes we pay to the states in which we write business, generally based on premium volume. Policy acquisition costs that are directly related to the successful acquisition of those policies are deferred. The amortization of such policy acquisition costs is charged to expense in proportion to premium earned over the policy life. Other underwriting expenses represent the general and administrative expenses of our insurance business including employment costs, telecommunication and technology costs, the costs of our leases, and legal and auditing fees. Income tax expense Substantially all of our income tax expense relates to U.S. federal income taxes. Our insurance companies are generally not subject to income taxes in the states in which they operate; however, our non-insurance subsidiaries are subject to state income taxes. The amount of income tax expense or benefit recorded in future periods will depend on the jurisdictions in which we operate and the tax laws and regulations in effect. Among other things, the Tax Cuts and Jobs Act (“TCJA”) lowered the U.S. federal corporate tax rate from 35% to 21% starting January 1, 2018. Our income tax expense for periods beginning in 2018 is based on the U.S. federal corporate income tax rate of 21%. Key Metrics We discuss certain key metrics, described below, which provide useful information about our business and the operational factors underlying our financial performance. Net income is the amount of profit or loss remaining after deducting all incurred expenses, including income taxes, from the total earned revenues for an accounting period. Underwriting income is calculated by subtracting losses and LAE and underwriting, acquisition and insurance expenses from net earned premiums. Adjusted operating income is net income excluding net realized investment gains and losses, expenses relating to various transactions that we consider to be unique and non-recurring in nature (net of estimated tax impact), and excluding the income tax expense resulting from implementation of TCJA. Loss and LAE ratio, expressed as a percentage, is the ratio of losses and LAE, allocated and unallocated, to net earned premiums, net of the effects of reinsurance. Expense ratio, expressed as a percentage, is the ratio of underwriting, acquisition and insurance expenses to net earned premiums. Combined ratio is the sum of the loss and LAE ratio and the expense ratio. A combined ratio under 100% indicates an underwriting profit. A combined ratio over 100% indicates an underwriting loss. Adjusted loss and LAE ratio is the loss and LAE ratio excluding the effects of the WAQS (as defined below). Adjusted expense ratio is the expense ratio excluding the effects of the WAQS. Adjusted combined ratio is the combined ratio excluding the effects of the WAQS. Return on equity is net income expressed on an annualized basis as a percentage of average beginning and ending stockholders’ equity during the period. Adjusted operating return on equity is adjusted operating income expressed on an annualized basis as a percentage of average beginning and ending stockholders’ equity during the period. Net retention ratio is the ratio of net written premiums to GWP. Underwriting income, adjusted operating income, adjusted loss and LAE ratio, adjusted expense ratio, adjusted combined ratio and adjusted operating return on equity are non-generally accepted accounting principles (“GAAP”) financial measures. See “- Reconciliation of Non-GAAP Financial Measures” for a reconciliation of net income in accordance with GAAP to underwriting income and adjusted operating income. See “- Factors Affecting Our Results of Operations - The WAQS” for additional detail on the impact of the WAQS on our results of operations. Factors Affecting Our Results of Operations The WAQS In connection with the divestment of our U.K. business, New York Marine as reinsured entered into the whole account quota share reinsurance agreements (the “WAQS”) with third party reinsurers to maintain reasonable underwriting leverage within New York Marine and its subsidiary insurance companies during a transition period following the U.K. divestment. The effective date of the WAQS was April 1, 2017. The reinsurers’ ceding participation is an aggregate 26.0%. A provisional ceding commission of 30.0% to 30.5% is received as a reduction in the amount of ceded premium. Subject to limits, these ceding commissions will vary in subsequent periods based on contractual ultimate loss ratios. During 2018 and following the transition of the U.S. business back to New York Marine, the WAQS were terminated. Previously ceded written and unearned premium, net of the ceding commission, was reversed. Loss reserves on premium earned prior to the cut-off termination remain ceded loss reserves. The ceded loss reserves under the WAQS were $33.1 million and $43.7 million as of December 31, 2019 and December 31, 2018, respectively. Loss reserve development on the reserves ceded under the WAQS is included in continuing operations. The effect of the WAQS on our results of operations is primarily reflected in our ceded written premiums, losses and LAE, as well as our underwriting, acquisition and insurance expenses. The following tables summarize the effect of the WAQS on our underwriting income for the years ended December 31, 2019, 2018 and 2017: (1) Net retention is a non-GAAP measure. We define net retention as the ratio of net written premiums to gross written premiums. (2) Underwriting income is a non-GAAP measure. See “Reconciliation of Non-GAAP Financial Measures.” (3) Adjusted loss and LAE ratio, adjusted expense ratio and adjusted combined ratio are non-GAAP financial measures. We define adjusted loss and LAE ratio, adjusted expense ratio and adjusted combined ratio as the corresponding ratio excluding the effects of the WAQS. We use these adjusted ratios as internal performance measures in the management of our operations because we believe they give our management and other users of our financial information useful insight into our results of operations and our underlying business performance. Our adjusted loss and LAE ratio, adjusted expense ratio and adjusted combined ratio should not be viewed as substitutes for our loss and LAE ratio, expense ratio and combined ratio, respectively. Our results of operations may be difficult to compare from year to year due to the origination and termination of the WAQS. In light of the impact of the WAQS on our results of operations, we internally evaluated our financial performance both including and excluding the effects of the WAQS. Results of Operations Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 (1) Underwriting income, adjusted operating income and adjusted operating return on equity are non-GAAP financial measures. See “- Reconciliation of Non-GAAP Financial Measures” for reconciliations of net income in accordance with GAAP to underwriting income and adjusted operating income. (2) Adjusted loss and LAE ratio, adjusted expense ratio and adjusted combined ratio are non-GAAP financial measures. We define adjusted loss and LAE ratio, adjusted expense ratio and adjusted combined ratio as the corresponding ratio excluding the effects of the WAQS. For additional detail on the impact of the WAQS on our results of operations see “- Factors Affecting Our Results of Operations - The WAQS.” Net Income Net income from continuing operations was $45.5 million for the year ended December 31, 2019 compared to $53.7 million for the year ended December 31, 2018, a decrease of $8.2 million, or 15.3%. The decrease in net income primarily resulted from an increase in interest and other expenses of $16.7 million, and a decrease in underwriting income of $8.0 million, partially offset by an increase in net investment income of $12.9 million. Premiums GWP were $968.0 million for the year ended December 31, 2019 compared to $895.1 million for the year ended December 31, 2018, an increase of $72.9 million, or 8.1%. The following table presents the GWP by customer segment for the years ended December 31, 2019 and 2018: Premium growth in 2019 was primarily driven by new business and increased renewals within previously existing niches combined with entry into new niches, primarily within Real Estate, Consumer Services and Transportation customer segments. Excluding the decline of GWP within “Other,” premiums for the year ended December 31, 2019 increased 16.7% compared to the year ended December 31, 2018. The changes in GWP were most notable in the following customer segments and niches: · Real Estate GWP increased by 26.3% to $167.6 million for the year ended December 31, 2019 compared to $132.7 million for the year ended December 31, 2018. The premium growth is primarily due to increases in the Metrobuilders and Builders Risk niches. Premium growth in these niches is driven by an increase in new business of $13.0 million and $8.0 million, respectively compared to 2018. · Consumer Services GWP increased by 24.8% to $133.7 million for the year ended December 31, 2019 compared to $107.1 million for the year ended December 31, 2018. The premium growth is due to continued maturity of the Auto Dealers niche, as well as the addition of the new Parking Facilities niche partially offset by declines in premium within the Social Services and Professional Employer Organizations niches. Auto Dealers, a new niche in 2018, increased $24.7 million during 2019 driven by new business growth in addition to a renewal book of premium. Parking Facilities is a new niche in 2019 which produced $14.8 million of new business during the year. In the Professional Employer Organization and Social Services niches, premiums declined during 2019 by $8.8 million and $6.7 million, respectively, when compared to 2018, where new business growth and renewal premium retention were limited by unfavorable pricing conditions in primary workers’ compensation. · Transportation GWP increased by 21.7% to $112.2 million for the year ended December 31, 2019 compared to $92.2 million for the year ended December 31, 2018. The premium growth is due to high premium retention and increased rate (7.3%) within the Taxi niche and new business growth within the Charter Bus and Intermodal niches. Net written premiums increased by $2.1 million, or 0.2%, to $852.1 million for the year ended December 31, 2019 from $850.1 million for the year ended December 31, 2018. The increase in net written premiums was due to an increase in gross written premiums of $72.9 million, partially offset by an increase in ceded written premium of $70.8 million, an increase of 157.3% from the year ended December 31, 2018, primarily due to the termination of the WAQS. The termination of the WAQS resulted in a reversal of $58.9 million of ceded premiums for the year ended December 31, 2018. Our net retention ratio excluding the WAQS was 88.0% and 88.4% for the years ended December 31, 2019 and 2018, respectively. Net earned premiums increased by $77.1 million, or 10.5%, to $807.9 million for the year ended December 31, 2019 from $730.8 million for the year ended December 31, 2018. The increase in net earned premiums was directly related to the growth in written premiums. Excluding the effects of the WAQS, net earned premiums for the year ended December 31, 2019 were $807.9 million, compared to $745.3 million for the year ended December 31, 2018, an increase of 8.4%. Loss and LAE ratio Our loss and LAE ratio was 62.0% for the year ended December 31, 2019 compared to 59.5% for the year ended December 31, 2018. The increase is primarily due to an increase in the current accident year (excluding catastrophe losses) ratio combined with an unfavorable change in prior period development. For the year ended December 31, 2019 the current accident year (excluding catastrophe losses) was 61.2%, compared to 59.7% for the year ended December 31, 2018. For the year ended December 31, 2019, before adjusting for the WAQS, we incurred unfavorable prior period development of $3.2 million as compared to favorable development of $5.0 million for the year ended December 31, 2018. After adjusting for the WAQS, we incurred favorable development in both 2019 and 2018. Included within our 62.0% loss and LAE ratio for the year ended December 31, 2019 is $0.4% of catastrophe losses, a decrease of 0.1%, from $3.6 million, or 0.5% for the year ended December 31, 2018. Catastrophe losses for the years ended December 31, 2019 related to a midwestern tornado and 2018 was primarily California wildfires. The following tables summarize the effect of the factors indicated above on the loss and LAE ratios and adjusted loss and LAE ratios for the years ended December 31, 2019 and 2018: The following table presents the loss and LAE ratio before and after the effects of reinsurance, for the years ended December 31, 2019 and 2018: Expense ratio Our expense ratio was 36.0% for the year ended December 31, 2019 compared to 37.2% for the year ended December 31, 2018. This reduction is primarily due to the increase in net earned premiums exceeding the increase in underwriting and insurance expenses combined with a slight reduction in the net policy acquisition expense ratio. The following table summarizes the components of the expense ratio for the years ended December 31, 2019 and 2018: (1) Underwriting, acquisition and insurance expenses is calculated based on the net earned premiums excluding the effects of the WAQS for the years ended December 31, 2019 and 2018. Underwriting income Underwriting income was $16.4 million for the year ended December 31, 2019 compared to $24.4 million for the year ended December 31, 2018, a decrease of $8.0 million, or 32.9%. Excluding the WAQS, underwriting income was $16.4 million for the year ended December 31, 2019, compared to $25.5 million for the year ended December 31, 2018. The change in underwriting income for the year ended December 31, 2019 compared to 2018 was due to an increase in the loss and LAE ratio, partially offset by a decrease in the expense ratio. Combined ratio Our combined ratio was 98.0% for the year ended December 31, 2019 compared to 96.7% for the year ended December 31, 2018. Our adjusted combined ratio was 98.0% for the year ended December 31, 2019 compared to 96.6% for the year ended December 31, 2018. Investing results Our net investment income increased by 23.1% to $68.9 million for the year ended December 31, 2019 from $56.0 million for the year ended December 31, 2018. Our average invested assets increased 15.3% from $1.7 billion for the year ended December 31, 2018, to $2.0 billion for the year ended December 31, 2019. Net investment yield increased by 0.2 percentage points, to 3.4% as of December 31, 2019 compared to 3.2% as of December 31, 2018. Gross investment income increased by $13.1 million to $71.2 million for the year ended December 31, 2019 compared to $58.1 million for the year ended December 31, 2018. Realized investment gains (losses), net increased by $2.3 million due to non-recurring realized gains on the sale of certain securities as part of the repositioning of the investment portfolio, calls, and corporate actions during a favorable price environment for the year ended December 31, 2019. The following table summarizes the components of net investment income and realized investment gains (losses), net for the years ended December 31, 2019 and 2018: The weighted average duration of our fixed income portfolio, including cash equivalents, was 3.4 years at December 31, 2019 and 2.9 years at December 31, 2018. Interest and other expenses, net Our interest and other expenses, net increased by $16.7 million to $28.4 million for the year ended December 31, 2019 compared to $11.7 million for the year ended December 31, 2018. Included in interest and other expenses in 2019 is $12.1 million of interest expenses primarily related to senior debt obligations, $8.0 million of expenses related to the transition of our former CEO and $7.1 million of expenses related to the vesting of restricted stock units granted during the IPO. Income tax expense Our effective tax rate for the year ended December 31, 2019 was 21.1% compared to 20.0% for the year ended December 31, 2018. On December 22, 2017, the TCJA was signed into law, which reduced the Company’s statutory corporate tax rate from 35% to 21% beginning with the 2018 tax year. Our income tax expense was $12.1 million and $13.4 million for the years ended December 31, 2019 and 2018. Adjusted operating income Adjusted operating income was $57.6 million for the year ended December 31, 2019, an increase of $2.4 million, or 4.3% from the adjusted operating income of $55.3 million for the year ended December 31, 2018. Adjusted operating return on equity Our adjusted operating return on equity was 12.4% for the year ended December 31, 2019, a decrease of 2.0% percentage points from 14.4% for the year ended December 31, 2018. Year Ended December 31, 2018 Compared to Year Ended December 31, 2017 The following table summarizes the results of continuing operations for the years ended December 31, 2018 and 2017: (1) Underwriting income, adjusted operating income and adjusted operating return on equity are non-GAAP financial measures. See “- Reconciliation of Non-GAAP Financial Measures” for reconciliations of net income in accordance with GAAP to underwriting income and adjusted operating income. (2) Adjusted loss and LAE ratio, adjusted expense ratio and adjusted combined ratio are non-GAAP financial measures. We define adjusted loss and LAE ratio, adjusted expense ratio and adjusted combined ratio as the corresponding ratio excluding the effects of the WAQS. For additional detail on the impact of the WAQS on our results of operations see “- Factors Affecting Our Results of Operations - The WAQS.” Net Income (Loss) Net income was $53.7 million for the year ended December 31, 2018 compared to a net loss of $6.9 million for the year ended December 31, 2017, an increase of $60.6 million, or 878.2%. The increase in net income primarily resulted from an increase in underwriting income of $22.2 million, a $19.8 million increase in net investment income, and a decrease in income tax expense of $24.8 million. Premiums GWP were $895.1 million for the year ended December 31, 2018 compared to $836.3 million for the year ended December 31, 2017, an increase of $58.8 million, or 7.0%. The following table presents the GWP by customer segment for the years ended December 31, 2018 and 2017: Premium growth in 2018 was primarily driven by the expansion of our business within the existing niches, including expanded product offerings. Excluding the decline of GWP within “Other,” premiums for the year ended December 31, 2018 increased 8.1% compared to the year ended December 31, 2017. The changes in GWP were most notable in the following customer segments and niches: · Construction GWP increased by 38.8% to $101.9 million for the year ended December 31, 2018 compared to $73.4 million for the year ended December 31, 2017. The majority of premium growth is due to increases in the Luxury Home Builders and Scaffolding niches. Luxury Home Builders premium growth was primarily driven by an increase in new business of $3.8 million and an increase in renewal premium retention of $4.0 million when compared to 2017. Scaffolding premium growth was primarily driven by an increase in renewal premium retention of $9.9 million when compared to 2017. · Consumer Services GWP increased by 13.5% to $107.1 million for the year ended December 31, 2018 compared to $94.4 million for the year ended December 31, 2017. The premium growth is due to an increase in the Auto Dealers niche partially offset by smaller declines in premium within the Restaurants, Bars & Taverns, Social Services and Professional Employer Organizations niches. Auto Dealers was a new niche in 2017 which increased $23.2 million during 2018, primarily related to new business. The decline in Restaurants, Bars and Taverns of $4.9 million was driven by the strategic decision to shift distribution to ProSight Specialty Insurance Brokerage in an effort to reduce acquisition costs and leverage affinity and association distribution relationships. In the Social Services and Professional Employer Organization niches, premiums declined by $4.7 million and $1.9 million during 2018 when compared to 2017, respectively. New business growth and renewal premium retention were limited by unfavorable pricing conditions in primary workers’ compensation. · Transportation GWP increased by 8.3% to $92.2 million for the year ended December 31, 2018 compared to $85.1 million for the year ended December 31, 2017. The majority of premium growth is due to increases in renewal premium retention within the School Bus niche and rate increases across all niches within the Transportation customer segment. The School Bus niche increased renewal premium retention by $6.8 million in 2018, when compared to 2017. Net written premiums increased by $289.8 million, or 51.7%, to $850.1 million for the year ended December 31, 2018 from $560.3 million for the year ended December 31, 2017. The increase in net written premiums was directly related to a reduction in ceded written premiums of $231.0 million, a decrease of 83.7% from the year ended December 31, 2017, due to the termination of the WAQS. Excluding the effects of the WAQS, net written premiums for the year ended December 31, 2018 were $791.2 million, an increase of 9.7%, from the year ended December 31, 2017. Our net retention ratio excluding the WAQS was 88.4% and 86.2% for the years ended December 31, 2018 and 2017, respectively. Net earned premiums increased by $121.0 million, or 19.8%, to $730.8 million for the year ended December 31, 2018 from $609.8 million for the year ended December 31, 2017. The increase in net earned premiums was directly related to the growth in written premiums and a reduction in ceded earned premiums due to the impact of the WAQS of $72.8 million, a decrease of 83.3% from the year ended December 31, 2017. Excluding the effects of the WAQS, net earned premiums for the year ended December 31, 2018 were $745.3 million, an increase of 6.9% from the year ended December 31, 2017. Loss and LAE ratio Our loss and LAE ratio was 59.5% for the year ended December 31, 2018 compared to 64.6% for the year ended December 31, 2017. The improvement is due to a change in prior period development. For the year ended December 31, 2018, we incurred favorable prior period development of $5.0 million as compared to unfavorable development of $20.3 million for the year ended December 31, 2017. Included within our 59.5% loss and LAE ratio for the year ended December 31, 2018 is 0.5% of catastrophe losses primarily from the California wildfires. This is a decrease of 1.0% of losses for the year ended December 31, 2018, from 1.5% for the year ended December 31, 2017. The following tables summarize the effect of the factors indicated above on the loss and LAE ratios and adjusted loss and LAE ratios for the years ended December 31, 2018 and 2017: The following table presents the loss and LAE ratio before and after the effects of reinsurance, for the years ended December 31, 2018 and 2017: Expense ratio Our expense ratio was 37.2% for the year ended December 31, 2018 compared to 35.1% for the year ended December 31, 2017. This is primarily due to non-recurring expense items including the net benefit of litigation recoveries in 2017 of $4.6 million and cost of additional short-term incentive compensation expense of $6.8 million in 2018. The following table summarizes the components of the expense ratio for the years ended December 31, 2018 and 2017: (1) Underwriting, acquisition and insurance expenses is calculated based on the net earned premiums excluding the effects of the WAQS for the years ended December 31, 2018 and 2017. Underwriting income Underwriting income was $24.4 million for the year ended December 31, 2018 compared to an underwriting loss of $2.2 million for the year ended December 31, 2017, an increase of $22.2 million, or 1,009.0%. Excluding the WAQS, underwriting income was $25.5 million for the year ended December 31, 2018, compared to underwriting income of $8.1 million for the year ended December 31, 2017. Combined ratio Our combined ratio was 96.7% for the year ended December 31, 2018 compared to 99.7% for the year ended December 31, 2017. Our adjusted combined ratio was 96.6% for the year ended December 31, 2018 compared to 98.8% for the year ended December 31, 2017. Investing results Our net investment income increased by 54.6% to $56.0 million for the year ended December 31, 2018 from $36.2 million for the year ended December 31, 2017. In connection with our divestment of the U.K. business, we repositioned the portfolio to align the assets returned from the U.K. with our U.S. investment strategy and generate an increased yield. We also identified certain alternative investment opportunities which further diversified our portfolio and enhanced yield. Gross investment yield increased by 0.9 percentage points, to 3.4% as of December 31, 2018 compared to 2.5% as of December 31, 2017. Gross investment income increased by $20.0 million to $58.1 million for the year ended December 31, 2018 compared to $38.1 million for the year ended December 31, 2017. Realized investment (losses) gains, net decreased by $5.8 million or 137.0% due to non-recurring realized gains on the sale of certain securities as part of the repositioning of the investment portfolio in 2017 and $1.5 million of other-than- temporary impairments for the year ended December 31, 2018. The following table summarizes the components of net investment income and realized investment (losses) gains, net for the years ended December 31, 2018 and 2017: The weighted average duration of our fixed income portfolio, including cash equivalents, was 2.9 years at December 31, 2018 and 3.9 years at December 31, 2017. Interest and other expenses, net Our interest and other expenses, net increased by $0.4 million to $11.7 million for the year ended December 31, 2018 compared to $11.3 million for the year ended December 31, 2017. Income tax expense Our effective tax rate for the year ended December 31, 2018 was 20.0% compared to 122.0% for the year ended December 31, 2017. On December 22, 2017, the TCJA was signed into law, which reduced the Company’s statutory corporate tax rate from 35% to 21% beginning with the 2018 tax year. The Company revalued its 2017 deferred tax assets and liabilities in response to this reduction which resulted in a $25.1 million charge to income in 2017. Our income tax expense was $13.4 million and $38.2 million for the years ended December 31, 2018 and 2017. Adjusted operating income Adjusted operating income was $55.3 million for the year ended December 31, 2018, an increase of $41.3 million, or 295.1% from the adjusted operating income of $14.0 million for the year ended December 31, 2017. Adjusted operating return on equity Our adjusted operating return on equity was 14.4% for the year ended December 31, 2018, an increase of 10.7 percentage points from 3.7% for the year ended December 31, 2017. Liquidity and Capital Resources Sources and Uses of Funds We are organized as a holding company with our operations primarily conducted by our wholly-owned insurance subsidiaries, New York Marine and Gotham, which are domiciled in New York, and Southwest Marine, which is domiciled in Arizona. Accordingly, the holding company may receive cash through; (i) loans from banks; (ii) draws on a revolving loan agreement; (iii) issuance of equity and debt securities; (iv) corporate service fees from our operating subsidiaries; (v) payments from our subsidiaries pursuant to our consolidated tax allocation agreement and other transactions; and (vi) subject to certain limitations discussed below, dividends from our insurance subsidiaries. We also may use the proceeds from these sources to contribute funds to the insurance subsidiaries in order to support premium growth, reduce our reliance on reinsurance, pay dividends and taxes and for other business purposes. We receive corporate service fees from the operating subsidiaries to reimburse us for most of the operating expenses that we incur. These reimbursements are based on the actual costs that we expect to incur, with no mark-up above our expected costs. We file a consolidated U.S. federal income tax return with our subsidiaries, and under our corporate tax allocation agreement, each participant is charged or refunded taxes according to the amount that the participant would have paid or received had it filed on a separate return basis with the Internal Revenue Service (“IRS”). State insurance laws restrict the ability of the insurance subsidiaries to declare stockholder dividends without prior regulatory approval. State insurance regulators require insurance companies to maintain specified levels of statutory capital and surplus. No insurance subsidiary may declare or distribute any dividend to stockholders which, together with all dividends declared or distributed by it during the preceding twelve months, exceeds the lesser of ten percent of its surplus to policyholders or 100 percent of adjusted net investment income. The maximum amount of dividends the insurance subsidiaries can pay us during 2020 without regulatory approval is $54.7 million. Insurance regulators have broad powers to ensure that statutory surplus remains at adequate levels, and there is no assurance that dividends of the maximum amount calculated under any applicable formula would be permitted. In the future, state insurance regulatory authorities that have jurisdiction over the payment of dividends by the insurance subsidiaries may adopt statutory provisions more restrictive than those currently in effect. The insurance subsidiaries did not pay any dividends to us during 2019, 2018 or 2017. Management believes that the Company has sufficient liquidity available to meet its operating cash needs and obligations and committed capital expenditures for the next 12 months. Cash Flows Our most significant source of cash is from premiums received from our insureds, which, for most policies, we receive at the beginning of the coverage period and net of the related commission amount for the policies. Our most significant cash outflow is for claims that arise when a policyholder incurs an insured loss. Because the payment of claims occurs after the receipt of the premium, often years later, we invest the cash in various investment securities that generally earn interest and dividends. We also use cash to pay for operating expenses such as salaries, rent and taxes and capital expenditures such as technology systems. As described under “- Reinsurance” below, we use reinsurance to manage the risk that we take on our policies. We cede, or pay out, part of the premiums we receive to our reinsurers and collect cash back when losses subject to our reinsurance coverage are paid. Our total assets and liabilities increased in the years ended December 31, 2019, 2018 and 2017, reflecting the underlying increase in premiums and related loss reserves and unearned premiums. The casualty-focused nature of our products, and limited property exposures, enabled significant operating cash flow generation. The timing of our cash flows from operating activities can vary among periods due to the timing by which payments are made or received. Some of our payments and receipts, including loss settlements and subsequent reinsurance receipts, can be significant, and as a result their timing can influence cash flows from operating activities in any given period. Management believes that cash receipts from premiums, proceeds from investment sales and investment income are sufficient to cover cash outflows in the foreseeable future. Our cash flows for the years ended December 31, 2019, 2018 and 2017 were: The increase in cash provided by operating activities in 2019, 2018 and 2017 was due primarily to the timing of premium receipts, claim payments and reinsurance activity. Cash flows from operations in each of the past three years were used primarily to fund investing activities. For the year ended December 31, 2019, net cash used in investing activities was $288.6 million, a decrease of $9.3 million from 2018, and primarily reflected purchases of fixed income securities. For the year ended December 31, 2019, net cash provided by financing activities was $32.1 million, primarily reflecting net proceeds from the IPO and payment of $18.0 million on our credit facility. A significant portion of the funds received from the IPO were ultimately contributed to our insurance subsidiary, New York Marine, and additional amounts were used to repay outstanding debt under the revolving facility. Revolving Loan Agreement On January 29, 2018, ProSight entered into a revolving loan agreement with certain lenders and Citizens Bank, N.A., as agent, providing for a revolving loan facility of up to $25.0 million. On March 15, 2019, the Company entered into an amended and restated revolving loan agreement, which increased the facility to $50.0 million (as amended, the “revolving facility”). The maturity date of the revolving facility is the earlier of (i) March 15, 2022, or (ii) 91 days before the maturity of the senior notes due November 2020 or, if such senior notes are amended or replaced, 91 days before the maturity of such amendment or replacement. Borrowings under the revolving facility accrue interest, at our option, at a rate equal to either; (a) a base rate determined by reference to the highest of; (i) the administrative agent’s prime lending rate; (ii) the federal funds effective rate plus 0.50%; and (iii) the LIBOR rate for a one-month interest period plus 1.00%, in each case plus 2.00% or (b) the LIBOR rate for the interest period relevant to such borrowing plus the applicable margin. The applicable margins range from 1.75% to 3.00% based on our financial strength ratings and credit ratings. In addition, the revolving facility provides for a fee ranging from 0.20% to 0.75%, also based on our financial strength ratings and credit ratings, on the amount of undrawn commitments thereunder. The revolving facility provides for mandatory prepayment of outstanding loans upon the occurrence of certain change of control events that result in a downgrade of the ratings assigned to the notes described below. The revolving facility also permits us, at any time or from time to time, to voluntarily prepay loans. The revolving facility includes certain covenants, including restrictions on the disposition of assets, restrictions on the incurrence of liens and indebtedness, restrictions on making restricted payments and requirements to maintain specified liquidity levels. On August 8, 2019, the Company used IPO proceeds to repay $18.0 million in complete satisfaction of the outstanding debt under the revolving facility. As of December 31, 2019, there were no amounts outstanding and the revolving facility had a borrowing capacity of $50.0 million. Senior Debt In November 2013, ProSight issued $140.0 million of 7.5% Senior Unsecured Notes due November 2020 and in January 2015, issued an additional $25.0 million of 6.5% Senior Notes due November 2020. The notes provide for semi-annual interest payments and mature on November 26, 2020. We may prepay the notes in whole or in part (provided that at least 10% of the outstanding amount of the applicable series of notes is so prepaid), at any time or from time to time, at 100% of the principal amount of the notes prepaid plus a make-whole amount, as set forth in the documents governing the notes (the “Note Purchase Agreements”), plus accrued and unpaid interest on the principal amount of the notes being prepaid to, but excluding, the prepayment date. The Note Purchase Agreements require us, upon the occurrence of certain change of control events that result in a downgrade of the ratings assigned to the notes, to offer to each holder to prepay such holder’s notes at a price equal to 100% of the principal amount thereof plus any accrued interest. The Note Purchase Agreements also include certain covenants that restrict our ability to incur indebtedness, make restricted payments, incur liens, and require that we maintain specified liquidity levels. Interest payments of $12.1 million per annum were made in each of the years ended December 31, 2019, 2018 and 2017. Reinsurance We actively use ceded reinsurance across our book of business to reduce our overall risk position and to protect our capital. Reinsurance involves a primary insurance company transferring, or “ceding”, a portion of its premium and losses in order to limit its exposure. The ceding of liability to a reinsurer does not relieve the obligation of the primary insurance to the policyholder. The primary insurer remains liable for the entire loss if the reinsurer fails to meet its obligations under the reinsurance agreement. Our reinsurance is primarily contracted under excess of loss agreements. In excess of loss reinsurance, the reinsurer agrees to assume all or a portion of the ceding company’s losses, in excess of a specified amount. In excess of loss reinsurance, the premium payable to the reinsurer is negotiated by the parties based on their assessment of the amount of risk being ceded to the reinsurer because the reinsurer does not share proportionately in the ceding company’s losses. We use quota share and facultative reinsurance in selected niches, on a limited basis. In quota share reinsurance, the reinsurer agrees to assume a specified percentage of the ceding company’s losses arising out of a defined class of business in exchange for a corresponding percentage of premiums, net of a ceding commission. Facultative coverage refers to a reinsurance contract on individual risks as opposed to a group or class of business. It is used for a variety of reasons, including supplementing the limits provided by the treaty coverage or covering risks or perils excluded from treaty reinsurance. Our largest quota share reinsurance agreements were the WAQS. In connection with the divestment of our U.K. business, New York Marine as reinsured entered into the WAQS with third party reinsurers to maintain reasonable underwriting leverage within New York Marine and its subsidiary insurance companies during a transition period following the U.K. divestment. During 2018, and following the transition of the U.S. business back to New York Marine, the WAQS were terminated. The following is a summary of our significant excess of loss reinsurance programs as of December 31, 2019: (1) Our excess of loss reinsurance reduces the financial impact of a loss occurrence. Our excess of loss reinsurance includes reinstatement provisions, inuring relationships, and other clauses that may impact the amount recovered on a loss occurrence. At each annual renewal, we consider any plans to change the underlying insurance coverage we offer, as well as updated loss activity, the level of our capital and surplus, changes in our risk appetite and the cost and availability of reinsurance treaties. For the years ended December 31, 2019, 2018 and 2017, property insurance represented 13.0%, 12.2% and 10.8%, respectively, of our GWP. When we write property insurance, we buy reinsurance to significantly mitigate our risk. We use third-party computer models to analyze the risk of severe losses from weather-related events, earthquakes and terrorist attacks. We measure exposure to such catastrophe losses and LAE in terms of Probable Maximum Loss (“PML”), which is an estimate of the level of loss we would expect to experience in a windstorm or earthquake event occurring once in every 100 or 250 years. We manage this PML by purchasing catastrophe reinsurance coverage. Effective June 15, 2019, we purchased catastrophe reinsurance coverage of $195.0 million per event in excess of our $5.0 million per event retention, which was an increase of $90.0 million of catastrophe reinsurance coverage per event from the coverage we purchased in 2018. We purchased adverse development reinsurance contracts (together, the “ADC”) in 2018, 2017 and 2016 that limit the amount of future development on primary and excess workers’ compensation reserves reported for accident years 2017 and prior. The expected cost of the ADC contract is fully expensed at the inception of the contract. As of December 31, 2018, there have been no losses ceded to the ADC. Reinsurance contracts do not relieve us from our obligations to policyholders. Failure of the reinsurer to honor its obligations could result in losses to us, and therefore, we establish allowances for amounts considered uncollectible. At December 31, 2019, 2018 and 2017, the allowance for uncollectible reinsurance was $10.9 million, $10.0 million, and $7.0 million, respectively. As of December 31, 2019, 84.8% of our reinsurance recoverables were with reinsurers with A.M. Best financial strength ratings of  “A-” (Excellent) or better. The remaining 15.2%, or $29.5 million, of our reinsurance recoverables were with non-rated reinsurers, including $26.7 million from a fronting reinsurance arrangement with an authorized self-insurer from our Excess Workers’ Compensation niche, the Alabama Truckers Association, and fully collateralized through funds held and letters of credit. At December 31, 2019, 2018 and 2017, the net reinsurance receivable (defined as the sum of paid and unpaid reinsurance recoverables and ceded unearned premiums, less reinsurance payables) from our top three reinsurers represented 46.5%, 46.7% and 55.7%, respectively, of the total balance. Ratings ProSight and its insurance subsidiaries have a financial strength rating of “A-” (Excellent) from A.M. Best. A.M. Best assigns 16 ratings to insurance companies, which currently range from “A++” (Superior) to “F” (In Liquidation). The “A-” (Excellent) rating is assigned to insurers that have, in A.M. Best’s opinion, an excellent ability to meet their ongoing obligations to policyholders. This rating is intended to provide an independent opinion of an insurer’s ability to meet its obligation to policyholders and is not an evaluation directed at investors. See also Item 1A. “Risk Factors - Risks Related to Our Business” on this Annual Report on Form 10-K. A decline in our financial strength rating may adversely affect the amount of business we write. The financial strength ratings assigned by A.M. Best have an impact on the ability of the insurance subsidiaries to attract and retain our distribution partners and on the risk profiles of the submissions for insurance that the insurance subsidiaries receive. The “A-” (Excellent) rating affirmed by A.M. Best on November 22, 2019, is consistent with our business plan and allows us to actively pursue relationships with the distribution partners identified in our marketing plan. Contractual Obligations and Commitments The following table illustrates our contractual obligations and commercial commitments by due date as of December 31, 2019: (1) Amounts represent the principal balance and are not necessarily the carrying value of the Company’s debt on the balance sheet, which includes unamortized debt issuance costs. (2) Amounts represent anticipated cash interest payments and commitment fees related to the Company’s senior debt and credit agreements. Reserves for losses and LAE represent our best estimate of the ultimate cost of settling reported and unreported claims and related expenses. Estimating reserves for losses and LAE is based on various complex and subjective judgments. Actual losses and settlement expenses paid may deviate, perhaps substantially, from the reserve estimates reflected in our financial statements. Similarly, the timing for payment of our estimated losses is not fixed and is not determinable on an individual or aggregate basis. The assumptions used in estimating the payments due by period are based on industry and peer group claims payment experience. Due to the uncertainty inherent in the process of estimating the timing of such payments, there is a risk that the amounts paid in any period will be significantly different than the amounts disclosed above. Amounts disclosed above are gross of anticipated amounts recoverable from reinsurers. Reinsurance balances recoverable on reserves for losses and LAE are reported separately as assets, instead of being netted with the related liabilities, since reinsurance does not discharge us of our liability to policyholders. Reinsurance balances recoverable on reserves for paid and unpaid losses and LAE totaled $197.4 million, $197.7 million and $218.4 million at December 31, 2019, 2018 and 2017, respectively. These recoverable balances include $33.1 million and $43.7 million related to the WAQS at December 31, 2019 and 2018, respectively. Financial Condition Stockholders’ equity At December 31, 2019, total stockholders’ equity was $543.0 million and tangible stockholders’ equity was $513.8 million compared to total stockholders’ equity of $389.8 million and tangible stockholders’ equity of $360.6 million at December 31, 2018. The increase in both total and tangible stockholders’ equity was primarily due to net income of $38.9 million, net increase in accumulated other comprehensive income of $59.8 million, and proceeds from common stock sold in the initial public offering of $50.8 million for the year ended December 31, 2019. At December 31, 2018, total stockholders’ equity was $389.8 million and tangible stockholders’ equity was $360.6 million compared to total stockholders’ equity of $376.0 million and tangible stockholders’ equity of $346.7 million at December 31, 2017. The increase in both total and tangible stockholders’ equity was primarily due to net income of $54.5 million and partially offset by the increase in unrealized losses of $42.7 million related to available-for-sale securities, net of taxes for the year ended December 31, 2018. Tangible stockholders’ equity is a non-GAAP financial measure. We define tangible stockholders’ equity as stockholders’ equity less goodwill and net intangible assets. Our definition of tangible stockholders’ equity may not be comparable to that of other companies, and it should not be viewed as a substitute for stockholders’ equity calculated in accordance with GAAP. We use tangible stockholders’ equity internally to evaluate the strength of our balance sheet and to compare returns relative to this measure. Stockholders’ equity at December 31, 2019, 2018 and 2017, reconciles to tangible stockholders’ equity as follows: Equity-based compensation 2019 Equity Incentive Plan In connection with, and prior to the completion of the IPO, the Company’s Amended and Restated 2010 Equity Incentive Plan (the “2010 Plan”) was terminated. Immediately prior to the merger, P Shares granted under the 2010 Plan prior to the IPO, were cancelled, and all outstanding RSUs granted under the 2010 Plan were converted into RSUs based on the shares of common stock of the Company. On July 24, 2019, the Company’s 2019 Equity Incentive Plan (the “2019 Plan”) became effective immediately prior to the effectiveness of the registration statement filed in connection with the IPO. The 2019 Plan provides for the grant of stock options, stock appreciation rights, restricted stock, RSUs, dividend equivalent rights, performance-based shares and other cash-based or share-based awards. The 2019 Plan is administered by the compensation committee of the Company’s Board of Directors. Subject to the provisions of the 2019 Plan, the compensation committee determines in its discretion, the persons to whom and the times at which awards are granted, the size of awards (subject to certain limitations set forth in the compensation committee charter) and the terms and conditions of awards. A total of 4,500,000 shares of common stock are initially authorized and reserved for issuance under the 2019 Plan, including shares underlying RSUs granted under the 2010 Plan. The following is a summary of the post-offering compensation included in the 2019 Plan, including the number of common stock shares granted to each award mentioned below: (i) 181,118 annual long-term incentive awards in respect of 2019, 90,559 of which are time-vesting RSUs and 90,559 of which are performance-vesting RSUs, were granted to management on July 25, 2019 in connection with the IPO. Time-vesting RSUs are subject to vesting as follows: one-third annual installments on each anniversary of grant date, subject to continued service. Performance-vesting RSUs are subject to vesting as follows: cliff vesting on the third anniversary of the grant date to the extent performance metrics are met, subject to continued service. The fair value of such awards is $2.5 million at grant date. (ii) 1,267,912 supplemental RSU awards, 100% of which are time-vesting RSUs, was granted to management on July 25, 2019 in connection with the IPO and subject to vesting as follows: 25% vested at grant date, 25% will vest on the second anniversary of the grant date, subject to continued service and 50% will vest on the third anniversary of the grant date, subject to continued service. The fair value of the supplemental RSUs is $17.8 million. (iii) 250,000 founders grant awards in the form of time-vesting RSUs with a fair value of $3.5 million at grant date, July 25, 2019. These awards will cliff vest on the third anniversary of the grant date. (iv) 33,839 non-employee director RSU awards, 26,399 of which were granted on July 25, 2019 and 7,440 of which were granted on November 15, 2019, with a fair value of $0.5 million at grant date. These awards are fully vested on grant date. (v) 668,170 RSUs initially granted under the 2010 Plan that were converted into RSUs based on shares of the Company’s common stock upon the consummation of the merger. Stock-based compensation expense was $8.6 million, $0.9 million and $1.5 million for the years ended December 31, 2019, 2018 and 2017, respectively. The tax benefit recognized for the same was $1.8 million, $0.2 million and $0.5 million for the years ended December 31, 2019, 2018 and 2017, respectively. Vested RSUs awaiting conversion into common stock were 906,182 for the year ended December 31, 2019, 548,292 for the year ended December 31, 2018 and 517,446 for the year ended December 31, 2017, respectively. The Company began recognizing stock-based compensation expense relating to its 2019 Plan upon its inception and initial stock grants in July 2019. All stock-based compensation expense recognized during the year ended December 31, 2019 relates to the 2019 Plan except $0.1 million of expense relating to the 2010 Plan. The following table summarizes RSU transactions for the 2019 Plan for the years ended December 31, 2019 and 2018: As of December 31, 2019, The Company had approximately $14.5 million of total unrecognized stock-based compensation expense related to the RSUs expected to be recognized over a weighted-average period of 2.4 years. 2019 Employee Stock Purchase Plan On July 24, 2019, the 2019 Employee Stock Purchase Plan (the “2019 ESPP”) became effective immediately prior to the effectiveness of the registration statement filed in connection with the IPO. A total of 1,000,000 shares of the Company’s common stock are reserved and available for sale under the 2019 ESPP. The compensation committee of the Board of Directors administers the 2019 ESPP and have full authority to interpret the terms of the 2019 ESPP. There was no expense recognized related to the 2019 ESPP for the year ended December 31, 2019. Dividend declarations We did not declare any dividends in the years ended December 31, 2019, 2018 and 2017. Investment portfolio Our cash and invested assets consist of debt securities, cash and cash equivalents, short-term investments and alternative investments. At December 31, 2019, the majority of the portfolio, or $2.0 billion, was comprised of securities that are classified as available-for-sale and carried at fair value with unrealized gains and losses on these securities, net of applicable taxes, reported as a separate component of accumulated other comprehensive income. Also included in our investments were $216.2 million of alternative investments carried at fair value. Our securities, including cash equivalents, had a weighted average duration of 3.4 years and an average rating of “A” at December 31, 2019. At December 31, 2019 and 2018, the amortized cost and fair value on fixed-maturity securities were as follows: The table below presents the credit quality of total bonds at December 31, 2019 and 2018, as rated by Standard & Poor’s Financial Services, LLC (“Standard & Poor’s”) or Equivalent Designation: The amortized cost and fair value of our available-for-sale investments in fixed maturity securities presented by contractual maturity as of December 31, 2019 and 2018, were as follows: Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties, and the lenders may have the right to put the securities back to the borrower. Restricted investments In order to conduct business in certain states, we are required to maintain letters of credit or assets on deposit to support state-mandated insurance regulatory requirements and to comply with certain third-party agreements. Assets held on deposit or in trust accounts are primarily in the form of cash or certain high-grade securities. The fair value of our restricted assets was $577.9 million at December 31, 2019. This includes $127.2 million of funds in trust for the mutual benefit of our insurance companies due to participation in our intercompany policy agreement. Restricted investments increased 5.6%, or $30.8 million, when compared to December 31, 2018 primarily due to state deposits and market appreciation from fixed income securities. Off-balance sheet arrangements We do not have any material off-balance sheet arrangements as of December 31, 2019. As part of the 2017 sale transaction to divest our U.K. business, we entered into Aggregate Stop-Loss and 100% Quota Share reinsurance agreements as reinsurer, with Lloyd’s Syndicate 1110 as our reinsured and committed to fund Lloyd’s Syndicate 1110’s “Funds at Lloyd’s” requirements until June 30, 2020, though such Funds at Lloyd’s obligations would effectively terminate when the 2017 Year of Account completes a “Reinsurance to Close” transaction, which is expected by March 2020. We entered into a Letter of Credit facility arranged to fulfill a portion of these requirements. The facility has a principal amount of $23.2 million and contains certain covenants that require us, among other items, to maintain a minimum net worth, to remain within maximum leverage ratios, meet a minimum risk-based capital ratio and maintain specified liquidity levels. Reconciliation of Non-GAAP Financial Measures Reconciliation of underwriting income Underwriting income is a non-GAAP financial measure that we believe is useful in evaluating our underwriting performance without regard to investment income. Underwriting income represents the pre-tax profitability of our insurance operations and is derived by subtracting losses and LAE and underwriting, acquisition and insurance expenses from net earned premiums. We use underwriting income as an internal performance measure in the management of our operations because we believe it gives us and users of our financial information useful insight into our results of operations and our underlying business performance. Underwriting income should not be considered in isolation or viewed as a substitute for net income calculated in accordance with GAAP, and other companies may calculate underwriting income differently. Net income from continuing operations for the years ended December 31, 2019, 2018 and 2017, reconciles to underwriting income as follows: Reconciliation of adjusted operating income Adjusted operating income is a non-GAAP financial measure that we use as an internal performance measure in the management of our operations because we believe it gives our management and other users of our financial information useful insight into our results of operations and underlying business performance, by excluding items that are not part of our underlying profitability drivers or likely to re-occur in the foreseeable future. Adjusted operating income should not be considered in isolation or viewed as a substitute for our net income calculated in accordance with GAAP. Other companies may calculate adjusted operating income differently. Adjusted operating income for the years ended December 31, 2019, 2018 and 2017, reconciles to net income from continuing operations as follows: Critical Accounting Estimates We identified the accounting estimates which are critical to the understanding of our financial position and results of operations. Critical accounting estimates are defined as those estimates that are both important to the portrayal of our financial condition and results of operations and require us to exercise significant judgment. We use significant judgment concerning future results and developments in applying these critical accounting estimates and in preparing our consolidated financial statements. These judgments and estimates affect our reported amounts of assets, liabilities, revenues and expenses and the disclosure of our material contingent assets and liabilities. Actual results may differ materially from the estimates and assumptions used in preparing the consolidated financial statements. We evaluate our estimates regularly using information that we believe to be relevant. For a detailed discussion of our accounting policies, see Note 2. Summary of Significant Accounting Policies in Item 8. Financial Statement and Supplementary Data on this Annual Report on Form 10-K. Reserves for unpaid losses and LAE The reserves for unpaid losses and LAE are the largest and most complex estimate in our consolidated balance sheets. The reserves for unpaid losses and LAE represent our estimated ultimate cost of all unreported and reported but unpaid insured claims and the cost to adjust these losses that have occurred as of or before the balance sheet date. The loss reserves are not discounted, with the exception of certain workers’ compensation claims loss reserves. The amounts of discount related to workers’ compensation reserves were $47.4 million, $37.0 million and $34.2 million at December 31, 2019, 2018 and 2017, respectively. Those estimates are based on our historical information blended with industry and peer group information and our estimates of future trends in variable factors such as loss severity, loss frequency and other factors such as inflation. We review our estimates quarterly and adjust them as necessary as experience develops or as new information becomes known to us. Even after such adjustments, ultimate liability may exceed or be less than the revised estimates. Accordingly, the ultimate settlement of losses and LAE may vary significantly from the estimate included in our consolidated financial statements. We categorize our reserves for unpaid losses and LAE into two types: case reserves and incurred but not reported (“IBNR”). Our gross reserves for losses and LAE at December 31, 2019 were $1.5 billion, and of this amount, 70.6% related to IBNR. Our net reserves for losses and LAE at December 31, 2019 were $1.3 billion, and of this amount, 69.4% related to IBNR. Our gross reserves for losses and LAE at December 31, 2018 were $1.4 billion, and of this amount, 69.8% related to IBNR. Our net reserves for losses and LAE at December 31, 2018 were $1.2 billion, and of this amount, 67.8% related to IBNR. Our gross reserves for losses and LAE at December 31, 2017 were $1.3 billion, and of this amount, 65.5% related to IBNR. Our net reserves for losses and LAE at December 31, 2017 were $1.1 billion, and of this amount, 63.6% related to IBNR. The following tables present our gross and net reserves for unpaid losses and LAE at December 31, 2019, 2018, and 2017: Case reserves are established for individual claims that have been reported to us. We are notified of losses by our insureds or their brokers. Based on the information provided, we establish case reserves by estimating the ultimate losses from the claim, including defense costs associated with the ultimate settlement of the claim. Our claims department personnel use their knowledge of the specific claim along with advice from internal and external experts, including underwriters and legal counsel, to estimate the expected ultimate losses. We utilize the services of two Third Party Administrators (“TPAs”) to assist in the adjustment of workers’ compensation claims and one TPA to assist in the adjustment of builders’ risk claims within the Real Estate customer segment. Our TPAs are not affiliated with our distribution partners. Other than in limited cases, our managing general underwriters (“MGUs”) do not handle claims. Our internal claims managers oversee TPA and MGU claims-related activities and monitor their individual claim handling activities to prescribed ProSight standards. Our IBNR reserves are developed in accordance with Actuarial Standards of Practice promulgated by the American Academy of Actuaries. Our reserve review utilizes several accepted loss reserving methods to arrive at our best estimate of loss reserves. We give consideration to the relative strengths and weaknesses of each of the methods in deriving our actuarial best estimate of the liabilities. Where we have limited years of loss experience compared to the period over which we expect losses to be reported, we use industry and/or peer-group data in addition to our own data as a basis for selecting the parameters underlying our reserving methods. We monitor loss emergence monthly. We carefully consider other internal or external factors such as underwriting, claims handling, economic, or environmental changes that could adversely affect the accuracy of the assumptions underlying our standard actuarial methods and when necessary we will adjust these assumptions, methods, and/or procedures to ensure that they appropriately reflect these changing conditions. The average duration of loss reserves is 5.2 years, as of December 31, 2019. Our Reserve Committee includes our Chief Actuary, Chief Executive Officer, Chief Financial Officer, Chief Underwriting and Risk Officer, and Chief Claims Officer. The Reserve Committee meets quarterly to review the actuarial reserving recommendations made by the Chief Actuary. In establishing the actuarial recommendation for the reserves for losses and LAE, our actuary’s estimate of the current Initial Expected Loss Ratio (“IELR”) is derived from the pricing IELR at the niche level, policy year, and reserving group. Our reserve estimate is derived from our proprietary reserving model that calculates a point estimate for our ultimate losses. Although we believe that our assumptions and methodology are reasonable, our ultimate payments may vary, potentially materially, from the estimates we have made. In addition, we retain an independent external actuarial firm to perform an annual loss reserve analysis. The independent actuarial firm is not involved in the establishment and recording of our loss reserve. The independent actuarial firm prepares its own estimate of our reserves for loss and LAE, and we review their estimate to the reserves for losses and LAE reviewed and approved by the Reserve Committee. The table below quantifies the impact of potential reserve deviations from our carried reserve at December 31, 2019. We applied sensitivity factors to incurred losses for the three most recent accident years and to the carried reserve for all prior accident years combined. In the selection of the volatility factors, we have considered the potential impact of changes in current loss trends, pricing trends, and other actuarial reserving assumptions. The aggregate development depicted in the sensitivity analysis is consistent with the average development in recent calendar periods and a reasonable depiction of the potential volatility of the reserve estimates for the current calendar period. We believe that potential changes such as these would not have a material impact on our liquidity. (1) In 2019, the effective rate was consistent with the U.S. corporate income tax rate of 21% and is used to estimate the potential impact to stockholders’ equity. Reserve development The amount by which estimated losses differ from those originally reported for a period is known as “development.” Development is unfavorable when the losses ultimately settle for more than the amount reserved or subsequent estimates indicate a basis for reserve increases on unresolved claims. Development is favorable when losses ultimately settle for less than the amount reserved or subsequent estimates indicate a basis for reducing loss reserves on unresolved claims. We reflect favorable or unfavorable development of loss reserves in the results of operations in the period the estimates are changed. During the year ended December 31, 2019 our reserve for unpaid losses and loss adjustment expenses for accident years 2018 and prior developed unfavorably by $3.2 million driven primarily by unfavorable development of $16.4 million in Commercial Multiple Peril and $11.3 million in General Liability, partially offset by favorable development of $22.8 million in Workers’ Compensation. The unfavorable development in Commercial Multiple Peril was primarily from the Media and Entertainment customer segment in accident years 2013 through 2016 from a longer development trend than that underlying the historical performance of premises liability. The unfavorable development in General Liability primarily related to 2013 through 2016 accident years due to increased severities in the Real Estate customer segment and run off components within the Other customer segment. The favorable development in Workers Compensation derived from lower than expected claims severity across all customer segments primarily in accident years 2013 through 2015 and accident year 2017. In addition, the Company incurred $14.9 million of loss and loss adjustment expenses related to premium earned during the year ended December 31, 2019, attributable to accident year 2018. During the year ended December 31, 2018, our reserve for unpaid losses and loss adjustment expenses for accident years 2017 and prior developed favorably by $5.0 million. Favorable development of  $5.0 million for the year ended December 31, 2018, was driven primarily by favorable development of  $14.4 million in Workers’ Compensation, $15.6 million in Commercial Auto and $4.1 million from Marine Liability within the All Other Lines category, partially offset by $16.5 million adverse development in General Liability and $12.2 million adverse development in Commercial Multiple Peril. Lower than expected claim severity was the main driver of the favorable development in Workers’ Compensation of which $6.2 million came from 2014, 2015 and 2016 accident years in primary Workers’ Compensation and $8.2 million came from 2014 and 2015 accident years in excess Workers’ Compensation. Favorable development in Commercial Auto was driven mainly by the 2013, 2015 and 2016 accident years where severity trends of the previous two calendar year periods improved during 2018 across multiple niches. Marine Liability is a low frequency, high severity line of business and as a result, development often varies significantly from the average expectation. The $16.5 million adverse development in General Liability primarily related to 2013, 2014 and 2015 accident years due to increased severities in the Construction customer segment from reduced effectiveness of risk transfer from our general contractor insureds to subcontractors. The $12.2 million in adverse development in Commercial Multiple Peril is primarily from the Media and Entertainment customer segment driven by a longer development trend than that underlying the historic performance of premises liability. During the year ended December 31, 2017, our reserve for unpaid losses and loss adjustment expenses for accident years 2016 and prior developed adversely by $20.3 million. Adverse development of $20.3 million was driven primarily by unfavorable development of $33.2 million in Commercial Auto which consisted of several niches that are now terminated. Adverse development in Commercial Auto was driven primarily by higher than expected frequency and severity. The Commercial Auto experience were likely a result of industry trends such as an improving economy resulting in more drivers on the roads, the hiring of less experienced drivers, the use of personal technology while in transit and litigation of bodily-injury claims, which resulted in unexpected adverse experience from historical performance patterns. The adverse development was offset by favorable development in Workers’ Compensation of $12.4 million due to lower than expected claim severity for accident years 2016 and prior, including a decline in the frequency of large loss activity. Investments Fair value measurements The Company has established a framework for valuing financial assets and financial liabilities. The framework is based on a hierarchy of inputs used in valuation and gives the highest priority to quoted prices in active markets and requires that observable inputs be used in the valuations when available. The disclosure of fair value estimates in the hierarchy is based on whether the significant inputs into the valuation are observable. In determining the level of the hierarchy in which the estimate is disclosed, the highest priority is given to unadjusted quoted prices in active markets and the lowest priority to unobservable inputs that reflect the Company’s significant market assumptions. The standard describes three levels of inputs that may be used to measure fair value and categorize the assets and liabilities within the hierarchy: Level 1 - Fair value is based on unadjusted quoted prices in active markets that are accessible to the Company for identical assets or liabilities. These prices generally provide the most reliable evidence and are used to measure fair value whenever available. Active markets are defined as having the following for the measured asset/liability: (i) many transactions, (ii) current prices, (iii) price quotes not varying substantially among market makers, (iv) narrow bid/ask spreads and (v) most information publicly available. Level 2 - Fair value is based on significant inputs, other than Level 1 inputs, that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the asset through corroboration with observable market data. Level 2 inputs include quoted market prices in active markets for similar assets, nonbinding quotes in markets that are not active for identical or similar assets and other market observable inputs (e.g., interest rates, yield curves, prepayment speeds, default rates, loss severities, etc.). Level 3 - Fair value is based on at least one or more significant unobservable inputs that are supported by little or no market activity for the asset. These inputs reflect the Company’s understanding about the assumptions market. The Company generally obtains valuations from third-party pricing services and/or security dealers for identical or comparable assets or liabilities by obtaining nonbinding broker quotes (when pricing service information is not available) in order to determine an estimate of fair value. The Company bases all of its estimates of fair value for assets on the bid price as it represents what a third-party market participant would be willing to pay in an arm’s-length transaction. Impairment Management reviews fixed income securities for other-than-temporary impairments (“OTTI”) based upon quantitative and qualitative criteria that include, but are not limited to, downgrades in rating agency levels for securities, the duration and extent of declines in fair value of the security below its cost or amortized cost, interest rate trends, the Company’s intent to sell or hold the security, market conditions, and the regulatory environment for the security’s issuer. The Company may also consider cash flow models and matrix analyses in connection with its OTTI evaluation. The Company will record credit impairment in the consolidated statements of operations and comprehensive income (loss) when the present value of cash flows expected to be collected from the debt security is less than the amortized cost basis of the security. In addition, any portion of such decline to arise from factors other than credit is recorded as a component of other comprehensive income (“OCI”). Deferred income taxes We record deferred income taxes as assets or liabilities on our balance sheet to reflect the net tax effect of the temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and their respective tax bases. Deferred tax assets and liabilities are measured by applying enacted tax rates in effect for the years in which such differences are expected to reverse. Our deferred tax assets result from temporary differences primarily attributable to loss reserves, unearned premium reserves and net adjusted operating losses from prior periods. Our deferred tax liabilities result primarily from unrealized gains in the investment portfolio and deferred acquisition costs. We review the need for a valuation allowance related to our deferred tax assets each quarter. We reduce our deferred tax assets by a valuation allowance when we determine that it is more likely than not that some portion or all of the deferred tax assets will not be realized. The assessment of whether or not a valuation allowance is needed requires us to use significant judgment. See Note 12 Income Taxes in Item 8. Financial Statements and Supplementary Data on this Annual Report on Form 10-K for further discussion regarding our deferred tax assets and liabilities. On December 22, 2017, the President of the United States signed into law the TCJA. The legislation significantly changes U.S. tax law by, among other things, lowering corporate income tax rates from 35% to 21%, effective January 1, 2018. U.S. GAAP requires companies to recognize the effect of tax law changes in the period of enactment. The SEC staff 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 income tax effects of the TCJA. The TCJA did not specify the application of certain elements of the legislation and the U.S. Treasury has yet to issue interpretive guidance to specify the loss payment patterns and the corporate bond yield curve under the new law for 2018. The Company has recognized a provisional tax impact of $9.0 million related to the transition adjustment for loss discounting which has been included in its components of deferred tax assets and liabilities as part of its consolidated financial statements for the year ended December 31, 2017. The ultimate impact may differ from these provisional amounts due to, among other things, additional analysis, changes in interpretations and assumptions the Company has made, additional regulatory guidance that may be issued, and actions the Company may take as a result of the TCJA. The accounting is expected to be complete when the U.S. Treasury issues further guidance. Reinsurance The Company’s insurance subsidiaries participate in various reinsurance agreements. The Company uses various types of reinsurance, including quota share, excess of loss and facultative agreements, to spread the risk of loss among several reinsurers and to limit its exposure from losses on any one occurrence. Any recoverable due from reinsurers is recorded in the period in which the related gross liability is established. Reinsurance reinstatement premiums are incurred by the Company based upon the provisions of the reinsurance contracts. In the event of a loss, the Company may be obligated to pay additional reinstatement premiums under its excess of loss reinsurance treaties. In such instances, the respective reinstatement premium is expensed immediately. The Company accounts for reinsurance receivables and prepaid reinsurance premiums as assets. The Company maintains an allowance for doubtful accounts, which includes amounts in dispute, amounts due from insolvent or financially impaired companies and other balances deemed uncollectible. Management continually reviews and updates such estimates. Profit commission revenue derived from reinsurance transactions is recognized when such amounts become earned as provided in the treaties with the respective reinsurers.

<s>[INST] References to the "Company," "ProSight," "we," "us," and "our" are to ProSight Global, Inc. and its consolidated subsidiaries unless the context otherwise requires. References to “insurance subsidiaries” are to New York Marine and General Insurance Company (“New York Marine”), Gotham Insurance Company (“Gotham”) and Southwest Marine and General Insurance Company (“Southwest Marine”) unless the context otherwise requires. Overview We are an entrepreneurial specialty insurance company that since our founding in 2009 has built products, services and solutions with the goal of significantly improving the experience and value proposition for our customers. We founded ProSight, with capital commitments from affiliates of each of The Goldman Sachs Group, Inc. (“Goldman Sachs”) and TPG Global, LLC (“TPG”) as a different type of insurer that leverages customized technology infrastructure, underwriting expertise and unique niche focus to develop products, services and solutions that deliver distinct value to customers in the manner they prefer. Our Company is led by a highly experienced and entrepreneurial team with decades of insurance leadership experience at ProSight and other leading insurers. We write property and casualty insurance with a focus on underwriting specialty risks by partnering with a select number of distributors, often on an exclusive basis. We have a diverse business mix covering specialty niches within the eight customer segments in which we operate. We market and distribute our insurance product offerings in all 50 states on both an admitted and nonadmitted basis. We are focused on delivering consistent underwriting profitability with low volatility of underwriting results. In November of 2011, we formed a Bermuda holding company structure and acquired several entities in the U.K. to build our own Lloyd’s syndicate. Our principal objective was to achieve greater capital and tax efficiency for our growing U.S. niche business. We also considered opportunities to use this as a platform to extend our niche strategy to the U.K. and Europe. By 2015, however, we determined that we would not be able to profitably achieve our objectives due to two principal factors. Firstly, a significant driver of the success of our U.S. sourced business is the extensive control and oversight of our niche specialized internal and external underwriters. In contrast, in the UK, the regulatory framework required us to operate the syndicate as an independent entity, largely excluded from oversight by the U.S. management team. As a result, our Group Chief Underwriting Officer could not serve on the board of directors of the U.K. entities nor have final underwriting authority for nonU.S. sourced business. In addition, given the growing predominance of the U.S. underwritten business in the syndicate, the syndicate was required to develop an organic and independent growth strategy for U.K. sourced business. The independently underwritten U.K. business did not execute upon our niche strategy, and generated unacceptable loss ratios and acquisition costs. Secondly, while we had success in writing and reinsuring profitable U.S. sourced business into our syndicate, the U.S. business had become a disproportionately high percentage of the total syndicate book, and therefore our U.S. underwriting entity was treated as an independent Lloyd’s coverholder. As such, we were required to deploy redundant control and underwriting resources in the U.K. to oversee our U.S. book. This resulted in an unacceptable increase in the syndicate expense ratio. Given the uneconomic loss and expense costs associated with operating in Lloyd’s, in 2015 we began evaluating an exit from the Lloyd’s market and the repatriation of our U.S. business. The exit timeframes were extended due to capital constraints in our U.S. underwriting entity and protracted exit negotiations. In 2017, we entered into a twophase sale transaction, which closed in October 2017 and March 2018. Accordingly, the financial results of the U.K. produced business are presented as discontinued operations in our consolidated financial statements. The financial results within the following discussion and analysis are attributable to our continuing operations. Initial Public Offering On July 29, 2019, the Company completed its initial [/INST] Positive. </s>

Postal Realty Trust, Inc.

2020-03-27

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis is based on, and should be read in conjunction with, the Consolidated and Combined Consolidated Financial Statements and the related notes thereto of the Company and the Company’s accounting Predecessor as of and for the years ended December 31, 2019 and December 31, 2018. As used in this section, unless the context otherwise requires, references to “we,” “our,” “us,” and “our company” refer to Postal Realty Trust, Inc., a Maryland corporation, together with our consolidated subsidiaries, including Postal Realty LP, a Delaware limited partnership (“our Operating Partnership”), of which we are the sole general partner and which we refer to in this section as our Operating Partnership. Prior to the closing of our IPO on May 17, 2019, Andrew Spodek, our chief executive officer and a member of our board of directors (the “Board”), directly or indirectly controlled 190 properties owned by the Predecessor that were contributed as part of the Formation Transactions (as defined below). Of these 190 properties, 140 were held indirectly by our Predecessor through a series of holding companies, which we refer to collectively as “UPH.” The remaining 50 properties were owned by Mr. Spodek through 12 limited liability companies and one limited partnership, which we refer to collectively as the “Spodek LLCs.” References to our Predecessor consist of UPH, the Spodek LLCs and Nationwide Postal Management, Inc., a property management company whose management business we acquired in the Formation Transactions (as defined below), collectively. This management’s discussion and analysis of financial condition and results of operations contains forward-looking statements that involve risks, uncertainties and assumptions. See “Cautionary Statement Regarding Forward-Looking Statements” for a discussion of the risks, uncertainties and assumptions associated with those statements. Our actual results may differ materially from those expressed or implied in the forward-looking statements as a result of various factors, including, but not limited to, those in “Risk Factors” and included in other portions of this report. Overview Company We were formed as a Maryland corporation on November 19, 2018 and commenced operations upon completion of our IPO on May 17, 2019 and the related formation transactions (the “Formation Transactions”). We conduct our business through a traditional UPREIT structure in which our properties are owned by our Operating Partnership directly or through limited partnerships, limited liability companies or other subsidiaries. At the completion of our IPO and the Formation Transactions, we owned a portfolio of 271 postal properties located in 41 states comprising approximately of 872,000 net leasable interior square feet, all of which were leased to the USPS. From May 17, 2019 to December 31, 2019, we acquired 195 postal properties leased to the USPS for approximately $57.5 million. As of December 31, 2019, our portfolio consisted of 466 owned postal properties, located in 44 states and comprising approximately 1.4 million net leasable interior square feet. The following charts show certain statistics of our portfolio as of December 31, 2019: We are the sole general partner of our Operating Partnership through which our postal properties are directly or indirectly owned. As of March 25, 2020, we owned approximately 66.0% of the outstanding common units of limited partnership interest in the Operating Partnership (each , an “OP Unit,” and collectively, the “OP Units”) including long term incentive units of the Operating Partnership (each, an “LTIP Unit” and collectively, the “LTIP Units). Our Board oversees our business and affairs. Initial Public Offering On May 17, 2019, we completed our IPO, pursuant to which we sold 4,500,000 shares of our Class A common stock, par value $0.01 per share (our “Class A common stock”), at a public offering price of $17.00 per share. We raised $76.5 million in gross proceeds, resulting in net proceeds to us of approximately $71.1 million after deducting approximately $5.4 million in underwriting discounts and before giving effect to $6.4 million in other expenses relating to our IPO. Our Class A common stock began trading on the New York Stock Exchange (the “NYSE”) under the symbol “PSTL” on May 15, 2019. In connection with our IPO and the Formation Transactions, we also issued 1,333,112 OP Units, 637,058 shares of Class A common stock and 27,206 shares of Class B common stock, par value $0.01 per share (our “Class B common stock” or “Voting Equivalency stock”), to Mr. Spodek and his affiliates in exchange for the Predecessor properties and interests. Executive Overview We are an internally managed REIT with a focus on acquiring and managing properties leased to the USPS. We believe the overall opportunity for consolidation that exists in the sector is very attractive. We continue to execute our strategy to acquire and consolidate postal properties that will generate strong earnings for our shareholders. Emerging Growth Company We are an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”) and we are eligible to take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not “emerging growth companies,” including not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved. In addition, the JOBS Act also provides that an “emerging growth company” can take advantage of the extended transition period provided in the Securities Act of 1933, as amended (the “Securities Act”), for complying with new or revised accounting standards. In other words, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have availed ourselves of these exemptions; although, subject to certain restrictions, we may elect to stop availing ourselves of these exemptions in the future even while we remain an “emerging growth company.” We will remain an “emerging growth company” until the earliest to occur of (i) the last day of the fiscal year during which our total annual revenue equals or exceeds $1.07 billion (subject to periodic adjustment for inflation), (ii) the last day of the fiscal year following the fifth anniversary of our IPO, (iii) the date on which we have, during the previous three-year period, issued more than $1.0 billion in non-convertible debt or (iv) the date on which we are deemed to be a “large accelerated filer” under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We are also a “smaller reporting company” as defined in Regulation S-K under the Securities Act and have elected to take advantage of certain scaled disclosures available to smaller reporting companies. We may continue to be a smaller reporting company even after we are no longer an “emerging growth company.” We will elect to be treated as a REIT under the Code beginning with our short taxable year ending December 31, 2019. As long as we qualify as a REIT, we generally will not be subject to federal income tax to the extent that we distribute our taxable income for each tax year to our stockholders. Factors That May Influence Future Results of Operations The USPS We are substantially dependent on the USPS’s financial and operational stability. The USPS is currently facing a variety of circumstances that are threatening its ability to fund its operations and other obligations as currently conducted without intervention by the federal government. The USPS is constrained by laws and regulations that restrict revenue sources, mandate certain expenses and cap its borrowing capacity. As a result, the USPS is unable to fund its mandated expenses and continues to be subject to mandated payments to its retirement system and health benefits for current workers and retirees. The USPS has taken the position that productivity improvements and cost reduction measures alone without legislative and regulatory intervention will not be sufficient to maintain the ability to meet all of its existing obligations when due. Revenues We derive revenues primarily from rent and tenant reimbursements under leases with the USPS for our properties, and fee and other income under the management agreements with respect to the postal properties owned by Mr. Spodek, his family members and their partners managed by PRM, our TRS. Rental income represents the lease revenue recognized under leases with the USPS. Tenant reimbursements represent payments made by the USPS under the leases to reimburse us for the majority of real estate taxes paid at each property. Fee and other income principally represent revenue PRM receives from postal properties owned by Mr. Spodek, his family members and their partners pursuant to the management agreements and typically is a percentage of the lease revenue for the managed property. As of December 31, 2019, all properties leased to the USPS had an average remaining lease term of 2.92 years. Factors that could affect our rental income, tenant reimbursement and fee and other income in the future include, but are not limited to: (i) our ability to renew or replace expiring leases and management agreements; (ii) local, regional or national economic conditions; (iii) an oversupply of, or a reduction in demand for, post office space; (iv) changes in market rental rates; (v) changes to the USPS’s current property leasing program or form of lease; and (vi) our ability to provide adequate services and maintenance at our properties and managed properties. Operating Expenses We lease our properties to the USPS. The majority of our leases are modified double-net leases, whereby the USPS is responsible for utilities, routine maintenance and the reimbursement of property taxes and the landlord is responsible for insurance and roof and structure. Thus, an increase in costs related to the landlord’s responsibilities under these leases could negatively influence our operating results. Operating expenses generally consist of real estate taxes, property operating expenses, which consist of insurance, repairs and maintenance (other than those for which the tenant is responsible), property maintenance-related payroll and depreciation and amortization. Factors that may affect our ability to control these operating costs include but are not limited to: the cost of periodic repair, renovation costs, the cost of re-leasing space and the potential for liability under applicable laws. Recoveries from the tenant are recognized as revenue on an accrual basis over the periods in which the related expenditures are incurred. Tenant reimbursements and operating expenses are recognized on a gross basis, because (i) generally, we are the primary obligor with respect to the real estate taxes and (ii) we bear the credit risk in the event the tenant does not reimburse the real estate taxes. The expenses of owning and operating a property are not necessarily reduced when circumstances, such as market factors and competition, cause a reduction in income from the property. If revenues drop, we may not be able to reduce our expenses accordingly. Costs associated with real estate investments generally will not be materially reduced even if a property is not fully occupied or other circumstances cause our revenues to decrease. As a result, if revenues decrease in the future, static operating costs may adversely affect our future cash flow and results of operations. General and Administrative General and administrative expenses include employee compensation costs (including equity-based compensation), professional fees, legal fees, insurance, consulting fees, portfolio servicing costs and other expenses related to corporate governance, filing reports with the United States Securities and Exchange Commission (the “SEC”) and the NYSE, and other compliance matters. Our Predecessor was privately owned and historically did not incur costs that we incur as a public company. In addition, while we expect that our general and administrative expenses will continue to rise as our portfolio grows, we expect that such expenses as a percentage of our revenues will decrease over time due to efficiencies and economies of scale. Depreciation and Amortization Depreciation and amortization expense relate primarily to depreciation on properties and improvements and to amortization of certain lease intangibles. Indebtedness and Interest Expense Interest expense for our Predecessor related primarily to three mortgage loans payable and related party interest-only promissory notes, See Note 6. Debt and Note 7. Loans Payable - Related Party to the Notes of the Consolidated and Combined Consolidated Financial Statements. As a result of the Formation Transactions, we assumed certain indebtedness of the Predecessor, a portion of which was repaid without penalty using a portion of the net proceeds from our IPO. On September 27, 2019, we entered into a credit agreement (the “Credit Agreement”) with People’s United Bank, National Association, individually and as administrative agent, BMO Capital Markets Corp., as syndication agent, and certain other lenders. The Credit Agreement provides for a senior revolving credit facility (the “Credit Facility”) with revolving commitments in an aggregate principal amount of $100.0 million and, subject to customary conditions, the option to increase the aggregate lending commitments under the agreement by up to $100.0 million (the “Accordion Feature”). On January 30, 2020, we exercised a portion of the Accordion Feature to increase the maximum amount available under the Credit Facility to $150.0 million. We intend to use the Credit Facility for working capital purposes, which may include repayment of indebtedness, property acquisitions and other general corporate purposes. Consistent with the method adopted by our Predecessor, we amortize on a non-cash basis the deferred financing costs associated with its debt to interest expense using the straight-line method, which approximates the effective interest rate method over the terms of the related loans. Any changes to the debt structure, including debt financing associated with property acquisitions, could materially influence the operating results depending on the terms of any such indebtedness. Income Tax Benefit (Expense) As a REIT, we generally will not be subject to federal income tax on our net taxable income that we distribute currently to our stockholders. Under the Code, REITs are subject to numerous organizational and operational requirements, including a requirement that they distribute each year at least 90% of their REIT taxable income, determined without regard to the deduction for dividends paid and excluding any net capital gains. If we fail to qualify for taxation as a REIT in any taxable year and do not qualify for certain statutory relief provisions, our income for that year will be taxed at regular corporate rates, and we would be disqualified from taxation as a REIT for the four taxable years following the year during which we ceased to qualify as a REIT. Even if we qualify as a REIT for federal income tax purposes, we may still be subject to state and local taxes on our income and assets and to federal income and excise taxes on our undistributed income. Additionally, any income earned by PRM and any other TRS we form in the future, will be subject to federal, state and local corporate income tax. Lease Renewal As of December 31, 2019, 20 of our leases were either in holdover status or expired on December 31, 2019. See “Item 2. Properties- Lease Expiration Schedule”. As of March 25, 2020, 32 leases were in holdover status representing $1.1 million of annual rental revenue for the year ended December 31, 2019. We might not be successful in renewing the leases that are in holdover status or that are expiring in 2020, or obtaining positive rent renewal spreads, or even renewing the leases on terms comparable to those of the expiring leases. If we are not successful, we will likely experience reduced occupancy, traffic, rental revenue and net operating income, which could have a material adverse effect on our financial condition, results of operations and ability to make distributions to shareholders. Results of Operations Comparison of the year ended December 31, 2019 and December 31, 2018 Our results of operations for the year ended December 31, 2019 include our consolidated results for the period from May 17, 2019 through December 31, 2019 and combined consolidated results of our Predecessor for the period from January 1, 2019 through May 16, 2019. The year ended December 31, 2018 reflects the results of our Predecessor and accordingly may not be directly comparable thereto. We incurred a net loss of $2.0 million since our IPO on May 17, 2019, which includes a loss on early extinguishment of our Predecessor’s debt of $0.2 million and equity-based compensation of approximately $1.0 million. In the discussion below, we have highlighted the impact of our IPO and the Formation Transactions, where applicable. Revenues Total revenues increased by $3.6 million for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase in revenue is attributable to the 81 properties that were acquired in connection with the Formation Transactions, as well as the 195 properties that were acquired since our IPO. Rental income - Rental income increased by $3.2 million year over year and is made up of $2.1 million related to the properties purchased by our Predecessor and the properties acquired as part of the Formation Transactions as well as $1.1 million for the 195 properties that were acquired since our IPO. Tenant reimbursements - Tenant reimbursements increased $0.4 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to the acquisition of the 81 properties in connection with the Formation Transactions and the 195 properties that were acquired since our IPO. Operating Expense Real estate taxes - Real estate taxes increased by $0.4 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 as a result of acquiring 81 properties in connection with the Formation Transactions and the 195 properties that we acquired since the completion of our IPO. Property operating expenses - Property operating expenses increased by $0.3 million to $1.2 million for December 31, 2019 from $0.9 million for the year ended December 31, 2018. Property management expenses are included within property operating expenses and increased by $0.04 million to $0.7 million for the year ended December 31, 2019 from $0.7 million for the year ended December 31, 2018. The remainder of the increase of $0.2 million is related to expenses related to repairs and maintenance and insurance for the 81 properties that were acquired as part of the Formation Transactions, and the 195 properties that we have acquired since our IPO. General and administrative - General and administrative expenses increased by $3.4 million to $4.8 million for the year ended December 31, 2019 from $1.4 million for the year ended December 31, 2018, primarily due to higher professional fees, increased personnel and investor relations expenses as a result of being a public company. In addition, $0.5 million of the general and administrative expense is attributable to non-recurring acquisition transaction related costs for our properties that were acquired since our IPO and equity-based compensation of $1.0 million related to stock awards that were issued in connection with our IPO. Our Predecessor did not have any equity-based compensation expense. Depreciation and amortization - Depreciation and amortization expense increased by $2.0 million to $3.8 million for the year ended December 31, 2019 from $1.8 million for the year ended December 31, 2018, and is primarily related to the 81 properties that we acquired as part of the Formation Transactions and the 195 properties that were acquired since our IPO. Interest Expense During the year ended December 31, 2019, we incurred interest expense of $1.5 million compared to $1.5 million for the year ended December 31, 2018. The increase in interest expense is primarily due to the write-off of deferred financing of $0.1 million in connection with our Credit Facility and a loss on early extinguishment of debt of $0.2 million related to a repayment of debt of the Predecessor. This increase is offset by a reduction in contractual interest expense on our mortgage debt due a repayment of indebtedness in connection with our IPO. Cash Flows Comparison of the year ended December 31, 2019 and the year ended December 31, 2018 The Company had cash of $12.5 million as of December 31, 2019 compared to $0.3 million as of December 31, 2018. Cash flow from operating activities - Net cash provided by operating activities increased by $0.2 million to $2.9 million for the year ended December 31, 2019 compared to $2.7 million for the same period in 2018. The increase is primarily due to the addition of postal properties that were acquired as part of the Formation Transactions and our IPO, all of which have generated additional rental income and related changes in working capital. Cash flow to investing activities - Net cash used in investing activities increased by $69.8 million to $72.7 million for the year ended December 31, 2019 compared to $2.9 million for the same period in 2018. The increase was primarily due to the acquisition of 81 post office properties in connection with the Formation Transactions and 195 properties we acquired since the completion of our IPO. Cash flow from financing activities - Net cash provided by financing activities increased by $81.8 million to $82.1 million for the year ended December 31, 2019 compared to $0.3 million provided by the same period in 2018. This increase is primarily due to $64.7 million in net proceeds from the IPO and $54.0 million outstanding under the Credit Facility which is offset by the repayment of debt in connection with the IPO. Liquidity and Capital Resources Analysis of Liquidity and Capital Resources We had approximately $12.5 million of cash and $0.7 million of escrows and reserves as of December 31, 2019. On September 27, 2019, we entered into the Credit Agreement with People’s United Bank, National Association, individually and as administrative agent, BMO Capital Markets Corp., as syndication agent, and certain other lenders. The Credit Agreement provides for the senior revolving Credit Facility with revolving commitments in an aggregate principal amount of a $100.0 million and a maturity date of September 27, 2023. The Credit Agreement provides that, subject to customary conditions, including obtaining lender commitments and compliance with its financial maintenance covenants under the Credit Agreement, we may seek to increase the aggregate lending commitments under the Credit Agreement by up to $100.0 million, with such increase in total lending commitments to be allocated to increasing the revolving commitments. The interest rates applicable to loans under the Credit Facility are, at our option, equal to either a base rate plus a margin ranging from 0.7% to 1.4% per annum or LIBOR plus a margin ranging from 1.7% to 2.4% per annum, each based on a consolidated leverage ratio. In addition, we will pay, for the period through and including the calendar quarter ending March 31, 2020, an unused facility fee on the revolving commitments under the Credit Facility of 0.75% per annum for the first $100.0 million and 0.25% per annum for the portion of revolving commitments exceeding $100.0 million, and for the period thereafter, an unused facility fee of 0.25% per annum for the aggregate unused revolving commitments, with both periods utilizing calculations of daily unused commitments under the Credit Facility. We are permitted to prepay all or any portion of the loans under the Credit Facility prior to maturity without premium or penalty, subject to reimbursement of any LIBOR breakage costs of the lenders. As of December 31, 2019, we had $54.0 million outstanding under our Credit Facility. On January 30, 2020, we exercised the accordion feature on the Credit Facility to increase permitted borrowings to $150.0 million from $100.0 million. We intend to use our Credit Facility for working capital purposes, which may include repayment of indebtedness, property acquisitions and other general corporate purposes. The Credit Facility is guaranteed, jointly and severally, by the Company and certain indirect subsidiaries of the Company (the “Subsidiary Guarantors”) and includes a pledge of equity interests in the Subsidiary Guarantors. The Credit Agreement contains customary covenants that, among other things, restrict, subject to certain exceptions, the ability to incur indebtedness, grant liens on assets, make certain types of investments, engage in acquisitions, mergers or consolidations, sell assets, enter into hedging transactions, enter into certain transactions with affiliates and make distributions. The Credit Agreement requires compliance with consolidated financial maintenance covenants to be tested quarterly, including a maximum consolidated secured indebtedness ratio, maximum consolidated leverage ratio, minimum consolidated fixed charge coverage ratio, minimum consolidated tangible net worth, maximum dividend payout ratio, maximum consolidated unsecured leverage ratio, and minimum debt service coverage ratio. The Credit Agreement also contains certain customary events of default, including the failure to make timely payments under the Credit Facility, any event or condition that makes other material indebtedness due prior to its scheduled maturity, the failure to satisfy certain covenants and specified events of bankruptcy and insolvency. Our short-term liquidity requirements primarily consist of operating expenses and other expenditures associated with our properties, distributions to our limited partners and distributions to our stockholders required to qualify for REIT status, capital expenditures and, potentially, acquisitions. We expect to meet our short-term liquidity requirements through net cash provided by operations, cash, borrowings under our Credit Facility and the potential issuance of securities. Our long-term liquidity requirements primarily consist of funds necessary for the repayment of debt at maturity, property acquisitions and non-recurring capital improvements. We expect to meet our long-term liquidity requirements with net cash from operations, long-term indebtedness including our Credit Facility and mortgage financing, the issuance of equity and debt securities and proceeds from select sales of our properties. We also may fund property acquisitions and non-recurring capital improvements using our Credit Facility pending permanent property-level financing. We believe we have access to multiple sources of capital to fund our long-term liquidity requirements, including the incurrence of additional debt and the issuance of additional equity securities. However, in the future, there may be a number of factors that could have a material and adverse effect on our ability to access these capital sources, including unfavorable conditions in the overall equity and credit markets, our degree of leverage, our unencumbered asset base, borrowing restrictions imposed by our lenders, general market conditions for REITs, our operating performance, liquidity and market perceptions about us. The success of our business strategy will depend, to a significant degree, on our ability to access these various capital sources. In addition, we continuously evaluate possible acquisitions of postal properties, which largely depend on, among other things, the market for owning and leasing postal properties and the terms on which the USPS will enter into new or renewed leases. To maintain our qualification as a REIT, we must make distributions to our stockholders aggregating annually at least 90% of our REIT taxable income determined without regard to the deduction for dividends paid and excluding capital gains. As a result of this requirement, we cannot rely on retained earnings to fund our business needs to the same extent as other entities that are not REITs. If we do not have sufficient funds available to us from our operations to fund our business needs, we will need to find alternative ways to fund those needs. Such alternatives may include, among other things, divesting ourselves of properties (whether or not the sales price is optimal or otherwise meets our strategic long-term objectives), incurring indebtedness or issuing equity securities in public or private transactions, the availability and attractiveness of the terms of which cannot be assured. Consolidated Indebtedness as of December 31, 2019 As of December 31, 2019, we had approximately $57.2 million of outstanding consolidated principal indebtedness. The following table sets forth information as of December 31, 2019 and 2018 with respect to the outstanding indebtedness of the Company and its Predecessor: Explanatory Notes: (1) On September 27, 2019, we entered into our Credit Agreement, which provides for revolving commitments in an aggregate principal amount of a $100.0 million and an accordion feature that permits us to borrow up to $200.0 million, subject to customary conditions. As of December 31, 2019, $100.0 million in aggregate principal amount under the Credit Facility was authorized and $54.0 million was drawn. Our ability to borrow under the Credit Facility is subject to ongoing compliance with a number of customary affirmative and negative covenants. As of December 31, 2019, we were in compliance with all of the Credit Facility’s debt covenants. (2) As of December 31, 2019, the one-month LIBOR rate was 1.76%. (3) As of December 31, 2018, the loan was collateralized by first mortgage liens on 26 properties and a personal guarantee of payment by Mr. Spodek. In connection with the IPO, we repaid approximately $13.8 million of outstanding indebtedness and five properties remain collateralized under this loan as of December 31, 2019 with Mr. Spodek as the guarantor. On September 8, 2021 and every five years thereafter, the interest rate will reset at a variable annual rate of Wall Street Journal Prime Rate (“Prime”) + 0.5%. (4) The loan is collateralized by first mortgage liens on four properties and a personal guarantee of payment by Mr. Spodek. Interest rate resets on December 31, 2022 to Prime + 0.25%. (5) The loan is collateralized by first mortgage liens on one property and a personal guarantee of payment by Mr. Spodek. Interest rate resets on January 31, 2023 to Prime + 0.5%. (6) In connection with the acquisition of a property, we obtained seller financing secured by the property in the amount $0.4 million requiring five annual payments of principal and interest of $0.1 million with the first installment due on January 2, 2021 based on a 6.0% interest rate per annum through January 2, 2025. (7) In connection with the IPO, we repaid approximately $17.1 million of outstanding indebtedness with a portion of our net proceeds. (8) In connection with the IPO, we repaid approximately $0.7 million of outstanding indebtedness with a portion of our net proceeds. Secured Borrowings as of December 31, 2019 As of December 31, 2019, we had approximately $3.2 million of secured borrowings outstanding, all of which is fixed rate debt with a weighted average interest rate of 4.61% per annum. During the year ended December 31, 2019, we obtained seller financing in the amount of $0.4 million in connection with the purchase of a property. Historically, our Predecessor’s equity capital was principally provided by Mr. Spodek as the majority equity owner of the Predecessor entities and its debt capital was principally provided through first mortgage loans on the properties owned by the Predecessor and promissory notes payable to related parties. Following the completion of our IPO and the Formation Transactions, we repaid approximately $31.7 million of indebtedness of the Predecessor using a portion of the net proceeds from our IPO. We believe that the completion of our IPO improved our financial position by reducing our outstanding indebtedness and providing us various sources of financing that would not have been available to us as a privately owned company. Contractual Obligations and Other Long-Term Liabilities The following table provides information with respect to our commitments as of December 31, 2019, including any guaranteed or minimum commitments under contractual obligations. Explanatory Notes: (1) The amounts shown relate to (i) interest on the $54.0 million outstanding under the Credit Facility as of December 31, 2019 at LIBOR plus 1.70%, (ii) assuming the amount outstanding under the Credit Facility remains at the December 31, 2019 level of $54.0 million, an unused facility fee under the Credit Facility of 0.75% through March 31, 2020 and 0.25% through the remainder of the term and (iii) interest on the outstanding mortgage loans. (2) Operating lease obligations relate to the lease for our corporate headquarters. Dividends To qualify and maintain our qualification as a REIT, we are required to pay dividends to stockholders at least equal to 90% of our REIT taxable income determined without regard to the deduction for dividends paid and excluding net capital gains. During the year ended December 31, 2019, we paid cash dividends of $0.203 per share. On January 30, 2020, our Board of Directors declared a fourth quarter common stock dividend of $0.17 per share which was paid on February 28, 2020 to stockholders of record on February 14, 2020. 2020 Real Estate Acquisitions Subsequent to December 31, 2019, we closed on two separate portfolios. On January 10, 2020, we closed on the acquisition of 21 properties leased to the USPS located in various states for approximately $13.5 million, which includes 483,333 of OP units valued at $17.00 per unit (the stock price on the date of closing was $16.39.) On January 29, 2020, we closed on the acquisition of 42 properties leased to the USPS for $8.7 million. In addition, we have acquired 20 postal properties in individual transactions for approximately $8.0 million. Acquisition Pipeline As of March 25, 2020, we had entered into definitive agreements to acquire 17 properties leased to the USPS for approximately $11.5 million. Formal due diligence has been completed and the transactions are expected to close in the second or third quarter of 2020, subject to the satisfaction of customary closing conditions. We continue to identify, and are in various stages of reviewing, additional postal properties for acquisition and believe there are strong opportunities to continue growing our pipeline. Off-Balance Sheet Arrangements As of December 31, 2019, we did not have any off-balance sheet arrangements. Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations are based upon the historical consolidated and combined consolidated financial statements of the Company and our Predecessor that have been prepared in accordance with GAAP. The preparation of these financial statements requires us to exercise our best judgment in making estimates that affect the reported amounts of assets, liabilities, revenues and expenses. We base our estimates on historical experience and other assumptions that we believe to be reasonable under the circumstances. We evaluate our estimates on an ongoing basis, based upon current available information. Actual results could differ from these estimates. Our Consolidated Financial Statements are prepared in conformity with GAAP and the rules and regulations of the SEC. In preparing the Consolidated Financial Statements, management is required to exercise judgment and make assumptions and estimates that may impact the carrying value of assets and liabilities and the reported amounts of revenues and expenses. Actual results could differ from those estimates. Set forth below is a summary of our accounting policies that we believe are critical to the preparation of our Consolidated Financial Statements. Our accounting policies are more fully discussed in Note 3. Summary of Significant Accounting Policies in the Notes to the Consolidated and Combined Consolidated Financial Statements. As an “emerging growth company,” we intend to avail ourselves of the extended transition periods for adopting new or revised accounting standards that would otherwise apply to us as a public reporting company, although, subject to certain restrictions we may elect to stop availing ourselves of these exceptions in the future even while we remain an “emerging growth company.” As a result, our financial statements may not be comparable to those of other public reporting companies that either are not emerging growth companies or that are emerging growth companies but have opted not to avail themselves of these provisions of the JOBS Act and investors may deem our securities a less attractive investment relative to those other companies, which could adversely affect our stock price. Basis of Presentation The accompanying Consolidated and Combined Consolidated Financial Statements include the financial position and results of operations of the Company, its Predecessor, the Operating Partnership and its wholly owned subsidiaries. The Predecessor represents a combination of certain entities holding interests in real estate that were commonly controlled prior to the Formation Transactions. Due to their common control, the financial statements of the separate Predecessor entities which owned the properties and the management company are presented on a combined consolidated basis. The effects of all significant intercompany balances and transactions have been eliminated. We have consolidated the Operating Partnership, a VIE in which we are considered the primary beneficiary. The primary beneficiary is the entity that has (i) the power to direct the activities that most significantly impact the entity’s economic performance and (ii) the obligation to absorb losses of the VIE or the right to receive benefits from the VIE that could be significant to the VIE. A non-controlling interest is defined as the portion of the equity in an entity not attributable, directly or indirectly, to us. Non-controlling interests are required to be presented as a separate component of equity in the Consolidated Balance Sheets. Accordingly, the presentation of net income (loss) reflects the income attributed to controlling and non-controlling interests. 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 and the reported amounts of revenues and expenses during the reporting period. Although management believes its estimates are reasonable, actual results could differ from those estimates. Investments in Real Estate Upon the acquisition of real estate, the purchase price is allocated based upon the relative fair value of the assets acquired and liabilities assumed. The allocation of the purchase price to the relative fair value of the tangible assets of an acquired property is derived by valuing the property as if it were vacant. All real estate acquisitions in the periods presented qualified as asset acquisitions and, as such, acquisition-related fees and acquisition-related expenses related to these asset acquisitions are capitalized as part of the acquisition. Investments in real estate generally include land, buildings, tenant improvements and identified intangible assets, such as in-place lease intangibles and above or below-market lease intangibles. Direct and certain indirect costs clearly associated with the development, construction, leasing or expansion of real estate assets are capitalized as a cost of the property. Repairs and maintenance costs are expensed as incurred. Revenue Recognition We have operating lease agreements with tenants, some of which contain provisions for future rental increases. Rental income is recognized on a straight-line basis over the term of the lease. In addition, certain lease agreements provide for reimbursements from tenants for real estate taxes and other recoverable costs, which are recorded on an accrual basis as “Tenant reimbursement revenue” on our Consolidated and Combined Consolidated Statement of Operations. Fee and other income primarily consist of property management fees. These fees arise from contractual agreements with entities that are affiliated with our CEO. Management fee income is recognized as earned under the respective agreements. Non-controlling Interests Non-controlling interests represent common units of limited partnership interest of the Operating Partnership (“OP Units”) held by the Predecessor’s prior investors and certain sellers of acquisition portfolios and long-term incentive units of the Operating Partnership (“LTIP Units”) primarily held by our CEO. Upon completion of the IPO and the Formation Transactions, the Operating Partnership issued 1,333,112 OP Units to the Predecessor’s prior investors as partial consideration for the contribution of their interest in the Predecessor to the Operating Partnership and 114,706 LTIP Units to our CEO. In addition, during the year ended December 31, 2019, we issued 824,350 OP Units to certain sellers in connection with a portfolio acquisition and 5,298 LTIP Units to an employee. New Accounting Pronouncements For a discussion of our adoption of new accounting pronouncements, please see Note 3 of our Consolidated and Combined Consolidated Financial Statements. Inflation Because most of our leases provide for fixed annual rental payments without annual rent escalations, our rental revenues are fixed while our property operating expenses are subject to inflationary increases. A majority of our leases provide for tenant reimbursement of real estate taxes and thus the tenant must reimburse us for real estate taxes. We believe that if inflation increases expenses over time, increases in lease renewal rates will materially offset such increase.

<s>[INST] As used in this section, unless the context otherwise requires, references to “we,” “our,” “us,” and “our company” refer to Postal Realty Trust, Inc., a Maryland corporation, together with our consolidated subsidiaries, including Postal Realty LP, a Delaware limited partnership (“our Operating Partnership”), of which we are the sole general partner and which we refer to in this section as our Operating Partnership. Prior to the closing of our IPO on May 17, 2019, Andrew Spodek, our chief executive officer and a member of our board of directors (the “Board”), directly or indirectly controlled 190 properties owned by the Predecessor that were contributed as part of the Formation Transactions (as defined below). Of these 190 properties, 140 were held indirectly by our Predecessor through a series of holding companies, which we refer to collectively as “UPH.” The remaining 50 properties were owned by Mr. Spodek through 12 limited liability companies and one limited partnership, which we refer to collectively as the “Spodek LLCs.” References to our Predecessor consist of UPH, the Spodek LLCs and Nationwide Postal Management, Inc., a property management company whose management business we acquired in the Formation Transactions (as defined below), collectively. This management’s discussion and analysis of financial condition and results of operations contains forwardlooking statements that involve risks, uncertainties and assumptions. See “Cautionary Statement Regarding ForwardLooking Statements” for a discussion of the risks, uncertainties and assumptions associated with those statements. Our actual results may differ materially from those expressed or implied in the forwardlooking statements as a result of various factors, including, but not limited to, those in “Risk Factors” and included in other portions of this report. Overview Company We were formed as a Maryland corporation on November 19, 2018 and commenced operations upon completion of our IPO on May 17, 2019 and the related formation transactions (the “Formation Transactions”). We conduct our business through a traditional UPREIT structure in which our properties are owned by our Operating Partnership directly or through limited partnerships, limited liability companies or other subsidiaries. At the completion of our IPO and the Formation Transactions, we owned a portfolio of 271 postal properties located in 41 states comprising approximately of 872,000 net leasable interior square feet, all of which were leased to the USPS. From May 17, 2019 to December 31, 2019, we acquired 195 postal properties leased to the USPS for approximately $57.5 million. As of December 31, 2019, our portfolio consisted of 466 owned postal properties, located in 44 states and comprising approximately 1.4 million net leasable interior square feet. The following charts show certain statistics of our portfolio as of December 31, 2019: We are the sole general partner of our Operating Partnership through which our postal properties are directly or indirectly owned. As of March 25, 2020, we owned approximately 66.0% of the outstanding common units of limited partnership interest in the Operating Partnership (each , an “OP Unit,” and collectively, the “OP Units”) including long term incentive units of the Operating Partnership (each, an “LTIP Unit” and collectively, the “LTIP Units). Our Board oversees our business and affairs. Initial Public Offering On May 17, 2019, we completed our IPO, pursuant to which we sold 4,500,000 shares of our Class A common stock, par value $0.01 per share (our “Class A common stock”), at a public offering price of $17.00 per share. We raised $76.5 million in gross proceeds, resulting in net proceeds to us of approximately $71.1 million after deducting approximately $5.4 million in underwriting discounts and before giving effect to $6.4 million in other expenses relating to our IPO. Our Class A common stock began trading on the New York Stock Exchange (the “NYSE”) [/INST] Positive. </s>

Provident Bancorp, Inc. /MD/

2020-03-13

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This discussion and analysis reflects our consolidated financial statements and other relevant statistical data, and is intended to enhance your understanding of our financial condition and results of operations. You should read the information in this section in conjunction with the business and financial information regarding Provident Bancorp, Inc., including the financial statements, provided in this Annual Report. Overview Total assets were $1.1 billion at December 31, 2019, representing an increase of  $147.7 million, or 15.2%, from $974.1 million at December 31, 2018. The increase resulted primarily from increases in net loans of  $123.8 million and cash and cash equivalents of  $31.0 million. The increases were partially offset by a decrease in available-for-sale investment securities of  $9.6 million. Net income increased $1.5 million, or 15.9%, to $10.8 million for the year ended December 31, 2019 from $9.3 million for the year ended December 31, 2018. The increase was primarily due to an increase of $6.3 million, or 16.9%, in net interest and dividend income, offset by an increase in provision for loan losses of  $2.0 million, or 60.0%, and an increase in salaries and employee benefits expense of  $1.4 million, or 8.6%. Critical Accounting Policies A summary of our accounting policies is described in Note 2 to the Consolidated Financial Statements included in this annual report. Critical accounting estimates are necessary in the application of certain accounting policies and procedures and are particularly susceptible to significant change. Critical accounting policies are defined as those involving significant judgments and assumptions by management that could have a material impact on the carrying value of certain assets or on income under different assumptions or conditions. Management believes that the most critical accounting policies, which involve the most complex or subjective decisions or assessments, are as follows: Allowance for Loan Losses. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. 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, size and composition 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. A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial, commercial real estate and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, we do not separately identify individual consumer and residential loans for impairment disclosures. The allowance consists of a general component, a specific component for impaired loans, and in some cases an unallocated component. The general component of the allowance for loan losses is based on historical loss experience adjusted for qualitative factors stratified by the following loan segments: residential real estate, commercial real estate, construction and land development, commercial and consumer. Management uses a rolling average of historical losses based on a time frame appropriate to capture relevant loss data for each loan segment. This historical loss factor is adjusted for the following qualitative factors: levels/trends in delinquencies; trends in volume and terms of loans; effects of changes in risk selection and underwriting standards and other changes in lending policies, procedures and practices; experience/ ability/depth of lending management and staff; and national and local economic trends and conditions. There were no changes in our policies or methodology pertaining to the general component of the allowance for loan losses during 2019. To determine the general component of the allowance for loan losses, the Company’s loan portfolio is segregated into various risk categories. These risk categories and the relevant risk characteristics are as follows: Residential real estate: We generally do not originate loans with a loan-to-value ratio greater than 80% and do not originate subprime loans. Loans with loan to value ratios greater than 80% require the purchase of private mortgage insurance. All loans in this segment are collateralized by owner-occupied residential real estate and repayment is dependent on the credit quality of the individual borrower. The overall health of the economy, including unemployment rates and housing prices, will have an effect on the credit quality in this segment. Commercial real estate: Loans in this segment are primarily income-producing properties throughout Massachusetts and New Hampshire. The underlying cash flows generated by the properties are adversely impacted by a downturn in the economy as evidenced by increased vacancy rates, which in turn, will have an effect on the credit quality in this segment. Management periodically obtains rent rolls and continually monitors the cash flows of the assets securing these loans. Construction and land development: Loans in this segment primarily include speculative and pre-sold real estate development loans for which payment is derived from sale of the property and construction to permanent loans for which payment is derived from cash flows of the property. Credit risk is affected by cost overruns, time to sell at an adequate price, and market conditions. Commercial: Loans in this segment are made to businesses and are generally secured by assets of the business. Repayment is expected from the cash flows of the business. A weakened economy, and resultant decreased consumer spending, will have an effect on the credit quality in this segment. Consumer: Loans in this segment are generally unsecured and repayment is dependent on the credit quality of the individual borrower. The allocated component relates to loans that are classified as impaired. Impairment is measured on a loan by loan basis for commercial, commercial real estate and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral, less estimated selling costs, if the loan is collateral dependent. An allowance is established when the discounted cash flows (or collateral value) of the impaired loan is lower than the carrying value of that loan. We periodically may agree to modify the contractual terms of loans. When a loan is modified and a concession is made to a borrower experiencing financial difficulty, the modification is considered a troubled debt restructuring. All troubled debt restructurings are initially classified as impaired. An unallocated component may be maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating allocated and general reserves in the portfolio. Stock-based Compensation Plans. The Company measures and recognizes compensation cost relating to stock-based payment transactions based on the grant-date fair value of the equity instruments issued. Stock-based compensation is recognized over the period the employee is required to provide services for the award. The Company uses the Black-Scholes option-pricing model to determine the fair value of stock options granted. The fair value of restricted stock is recorded based on the grant date fair value of the equity instrument issued. Income Taxes. We recognize income taxes under the asset and liability method. Under this method, deferred tax assets and liabilities are established for the temporary differences between the accounting basis and the tax basis of our assets and liabilities at enacted tax rates expected to be in effect when the amounts related to such temporary differences are realized or settled. The Company reduces the deferred tax asset by a valuation allowance if, based on the weight of the available evidence, it is not “more likely than not” that some portion or all of the deferred tax assets will be realized. The Company assesses the realizability of its deferred tax assets by assessing the likelihood of the Company generating federal and state income tax, as applicable, in future periods in amounts sufficient to offset the deferred tax charges in the periods they are expected to reverse. Based on this assessment, management concluded that a valuation allowance was not required as of December 31, 2019 and 2018. We examine our significant income tax positions annually to determine whether a tax benefit is more likely than not to be sustained upon examination by tax authorities. Comparison of Financial Condition at December 31, 2019 and December 31, 2018 Assets. Our total assets increased $147.7 million, or 15.2%, to $1.1 billion at December 31, 2019 from $974.1 million at December 31, 2018. The primary reasons for the increase are increases in net loans and cash and cash equivalents, partially offset by a decrease in investments in available-for-sale securities Cash and Cash Equivalents. Cash and cash equivalents increased $31.0 million, or 108.5%, to $59.7 million at December 31, 2019 from $28.6 million at December 31, 2018. The increase was primarily related to an increase in short-term investments of  $30.0 million, or 169.7%, due to the completion of our second-step conversion and related stock offering in October 2019. Investments in Available-for-Sale Securities. Investments in available-for-sale securities decreased $9.6 million or 18.7% to $41.8 million at December 31, 2019 from $51.4 million at December 31, 2018. The decrease resulted primarily from principal pay downs partially offset by an increase in the fair value of the securities. Loan Portfolio Analysis. At December 31, 2019, net loans were $959.3 million, or 85.5% of total assets, compared to $835.5 million, or 85.8% of total assets at December 31, 2018. Increases in commercial loans of  $90.0 million, or 24.9%, commercial real estate loans of  $53.5 million, or 14.7%, and in construction and land development loans of  $2.2 million, or 4.8%, were partially offset by decreases in residential real estate loans of  $11.7 million, or 20.3%, and consumer loans of  $7.1 million, or 35.7%. Our commercial loan growth is attributed to a continued focus on our specialty lending of renewable energy loans and enterprise value loans. Renewable energy loans increased $15.7 million, or 31.2%, to $66.1 million at December 31, 2019 from $50.4 million at December 31, 2018. Enterprise value loans increased $39.2 million, or 28.3%, to $178.0 million at December 31, 2019 from $138.8 million at December 31, 2018. The following table sets forth the composition of our loan portfolio by type of loan at the dates indicated, excluding loans held for sale. (1) Includes home equity loans and lines of credit (2) Includes multi-family real estate loans Loan Maturity. The following table sets forth certain information at December 31, 2019 regarding the contractual maturity of our loan portfolio. Demand loans, loans having no stated repayment schedule or maturity, and overdraft loans are reported as being due in one year or less. The table does not include any estimate of prepayments that could significantly shorten the average life of all loans and may cause our actual repayment experience to differ from that shown below. The following table sets forth our fixed and adjustable-rate loans at December 31, 2019 that are contractually due after December 31, 2020. Asset Quality Credit Risk Management. Our strategy for credit risk management focuses on having well-defined credit policies and uniform underwriting criteria and providing prompt attention to potential problem loans. Management of asset quality is accomplished by internal controls, monitoring and reporting of key risk indicators, and both internal and independent third-party loan reviews. The primary objective of our loan review process is to measure borrower performance and assess risk for the purpose of identifying loan weakness in order to minimize loan loss exposure. From the time of loan origination through final repayment, commercial real estate, construction and land development and commercial business loans are assigned a risk rating based on pre-determined criteria and levels of risk. The risk rating is monitored annually for most loans; however, it may change during the life of the loan as appropriate. When entering a new lending line, we typically seek to manage risks and costs by limiting initial activity. We then decide whether it would be profitable and consistent with our risk tolerance levels to expand the activity, and continually calibrate and adjust our actions to maintain appropriate risk limitations. We typically enter a new lending line based upon the experience of our existing employees, or we may hire an experienced individual or group of individuals to manage new activities. Internal and independent third-party loan reviews vary by loan type. Depending on the size and complexity of the loan, some loans may warrant detailed individual review, while other loans may have less risk based upon size, or be of a homogeneous nature reducing the need for detailed individual analysis. Assets with these characteristics, such as consumer loans and loans secured by residential real estate, may be reviewed on the basis of risk indicators such as delinquency or credit rating. In cases of significant concern, a total re-evaluation of the loan and associated risks are documented by completing a loan risk assessment and action plan. Some loans may be re-evaluated in terms of their fair market value or net realizable value in order to determine the likelihood of potential loss exposure and, consequently, the adequacy of specific and general loan loss reserves. When a borrower fails to make a required loan payment, we take a number of steps to have the borrower cure the delinquency and restore the loan to current status, including contacting the borrower by letter and phone at regular intervals. When the borrower is in default, we may commence collection proceedings. If a foreclosure action is instituted and the loan is not brought current, paid in full, or refinanced before the foreclosure sale, the real property securing the loan generally is sold at foreclosure. Management informs the board of directors monthly of the amount of loans delinquent more than 30 days. Management provides detailed information to the board of directors quarterly on loans 60 or more days past due and all loans in foreclosure and repossessed property that we own. Delinquent Loans. The following tables set forth our loan delinquencies by type and amount at the dates indicated. Non-performing Assets. Non-performing assets include loans that are 90 or more days past due or on non-accrual status, including troubled debt restructurings on non-accrual status, and real estate and other loan collateral acquired through foreclosure and repossession. Troubled debt restructurings include loans for which either a portion of interest or principal has been forgiven, loans modified at interest rates materially less than current market rates, or the borrower is experiencing financial difficulty. Loans 90 days or greater past due may remain on an accrual basis if adequately collateralized and in the process of collection. At December 31, 2019, we did not have any accruing loans past due 90 days or greater. For non-accrual loans, interest previously accrued but not collected is reversed and charged against income at the time a loan is placed on non-accrual status. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. Real estate that we acquire as a result of foreclosure or by deed-in-lieu of foreclosure is classified as foreclosed real estate until it is sold. When property is acquired, it is initially recorded at the lower of cost or fair value less costs to sell at the date of foreclosure. Holding costs and declines in fair value after acquisition of the property result in charges against income. The following table sets forth information regarding our non-performing assets at the dates indicated. (1) Loans are presented before allowance for loan losses, but include deferred loan costs/fees. The decrease in non-accrual loans at December 31, 2019 as compared to the prior year was primarily due to workouts of loans in our portfolio. The largest non-performing loan outstanding as of December 31, 2019 is a $1.9 million commercial loan with a specific reserve of  $130,000. We have cooperative relationships with the vast majority of our nonperforming loan customers. Substantially all non-performing loans are collateralized by real estate and the repayment is largely dependent on the return of such loans to performing status or the liquidation of the underlying real estate collateral. We pursue the resolution of all non-performing loans through collections, restructures, voluntary liquidation of collateral by the borrower and, where necessary, legal action. When attempts to work with a customer to return a loan to performing status, including restructuring the loan, are unsuccessful, we will initiate appropriate legal action seeking to acquire property by deed in lieu of foreclosure or through foreclosure, or to liquidate business assets. Interest income that would have been recorded for the year ended December 31, 2019 had non-accruing loans been current according to their original terms amounted to $317,000. We recognized $42,000 of interest income for these loans for the year ended December 31, 2019. The following table sets forth the accruing and non-accruing status of troubled debt restructurings at the dates indicated. Total troubled debt restructurings increased in 2019 primarily due to two commercial business loans totaling $2.6 million being modified under trouble debt restructures. Impairment analyses were performed and a specific reserve of  $130,000 was allocated to one of the relationships. The loans modified during 2019 are paying in accordance with their modified terms. During 2018, there were no trouble debt restructures. Interest income that would have been recorded for the year ended December 31, 2019 had troubled debt restructurings been current according to their original terms amounted to $275,000. We recognized $100,000 of interest income for these loans for the year ended December 31, 2019. Potential Problem Loans. We classify certain commercial real estate, construction and land development, and commercial loans as “special mention”, “substandard”, or “doubtful”, based on criteria consistent with guidelines provided by our banking regulators. Certain potential problem loans represent loans that are currently performing, but for which known information about possible credit problems of the related borrowers causes management to have doubts as to the ability of such borrowers to comply with the present loan repayment terms and which may result in such loans becoming nonperforming at some time in the future. Potential problem loans also include non-accrual or restructured loans presented above. We expect the levels of non-performing assets and potential problem loans to fluctuate in response to changing economic and market conditions, and the relative sizes of the respective loan portfolios, along with our degree of success in resolving problem assets. Other potential problem loans are those loans that are currently performing, but where known information about possible credit problems of the borrowers causes us to have concerns as to the ability of 16 such borrowers to comply with contractual loan repayment terms. At December 31, 2019, other potential problem loans totaled $1.8 million, consisting of 12 troubled debt restructured loans that were accruing interest in accordance with their modified terms. Allowance for Loan Losses. The allowance for loan losses is maintained at levels considered adequate by management to provide for probable loan losses inherent in the loan portfolio as of the consolidated balance sheet reporting dates. The allowance for loan losses is based on management’s assessment of various factors affecting the loan portfolio, including portfolio composition, delinquent and non-accrual loans, national and local business conditions and loss experience and an overall evaluation of the quality of the underlying collateral. The following table sets forth activity in our allowance for loan losses for the years indicated. (1) Loans are presented before the allowance for loan losses but include deferred fees/costs Allocation of Allowance for Loan Losses. The following tables set forth the allowance for loan losses allocated by loan category. The allowance for loan losses allocated to each category is not necessarily indicative of future losses in any particular category and does not restrict the use of the allowance to absorb losses in other categories. The allowance consists of general, specific, and unallocated components. The general component relates to pools of non-impaired loans and is based on historical loss experience adjusted for qualitative factors. The allocated component relates to loans that are classified as impaired, whereby an allowance is established when the discounted cash flows, collateral value, less estimated selling costs, or observable market price of the impaired loan is lower than the carrying value of that loan. An unallocated component may be maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating allocated and general reserves in the portfolio. We had impaired loans totaling $24.7 million and $7.5 million as of December 31, 2019 and 2018, respectively. Impaired loans totaling $20.9 million and $1.8 million had a valuation allowance of  $1.7 million and $1.1 million at December 31, 2019 and 2018, respectively. Our average investment in impaired loans was $26.9 million and $13.1 million for the years ended December 31, 2019 and 2018, respectively. During the fourth quarter of 2019, a commercial real estate loan relationship with a total balance of  $18.6 million became impaired due to insufficient cash flows to pay the debt. We expect to formally restructure this loan relationship, and based on a discounted cash flow calculation using the anticipated restructure terms, we established a specific reserve of  $1.4 million for this relationship. A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial business, commercial real estate and construction and land development loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment based on payment status. Accordingly, we do not separately identify individual one- to four-family residential and consumer loans for impairment disclosures, unless such loans are subject to a troubled debt restructuring. We periodically agree to modify the contractual terms of loans. When a loan is modified and a concession is made to a borrower experiencing financial difficulty, the modification is considered a troubled debt restructuring. All troubled debt restructurings are initially classified as impaired. We review residential and commercial loans for impairment based on the fair value of collateral, if collateral-dependent, or the present value of expected cash flows. Management has reviewed the collateral value for all impaired and non-accrual loans that were collateral dependent as of December 31, 2019 and considered any probable loss in determining the allowance for loan losses. Loans that are partially charged off generally remain on non-accrual status until foreclosure or such time that they are performing in accordance with the terms of the loan and have a sustained payment history of at least six months. The accrual of interest is generally discontinued when the contractual payment of principal or interest has become 90 days past due or management has serious doubts about further collectability of principal or interest, even though the loan is currently performing. Loan losses are charged against the allowance when we believe the uncollectability of a loan balance is confirmed; for collateral-dependent loans, generally when appraised values (as adjusted values, if applicable) less estimated costs to sell, are less than our carrying values. Although we believe that we use the best information available to establish the allowance for loan losses, future adjustments to the allowance for loan losses may be necessary and our results of operations could be adversely affected if circumstances differ substantially from the assumptions used in making the determinations. Furthermore, while we believe we have established our allowance for loan losses in conformity with generally accepted accounting principles in the United States of America, our regulators, in reviewing our loan portfolio, may require us to increase our allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, the existing allowance for loan losses may not be adequate or increases may be necessary should the quality of any loans deteriorate as a result of the factors discussed above. Any material increase in the allowance for loan losses may adversely affect our financial condition and results of operations. Securities Portfolio The following table sets forth the composition of our securities portfolio at the dates indicated, At December 31, 2019, we had no investments in a single company or entity, other than government and government agency securities, that had an aggregate book value in excess of 10% of our equity. Portfolio Maturities and Yields. The composition and maturities of the investment securities portfolio at December 31, 2019, are summarized in the following table. Certain mortgage-backed securities have adjustable interest rates and will reprice annually within the various maturity ranges. These repricing schedules are not reflected in the table below. No tax-equivalent yield adjustments have been made, as the amount of tax-free interest-earning assets is immaterial. Each reporting period, we evaluate all securities with a decline in fair value below the amortized cost of the investment to determine whether or not the impairment is deemed to be other-than-temporary. Other-than-temporary impairment (“OTTI”) is required to be recognized if  (1) we intend to sell the security; (2) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis; or (3) for debt securities, the present value of expected cash flows is not sufficient to recover the entire amortized cost basis. For impaired debt securities that we intend to sell, or more likely than not will be required to sell, the full amount of the depreciation is recognized as OTTI, resulting in a realized loss that is a charged to earnings through a reduction in our non-interest income. For all other impaired debt securities, credit-related OTTI is recognized through earnings and non-credit related OTTI is recognized in other comprehensive income/loss, net of applicable taxes. We did not recognize any OTTI during the years ended December 31, 2019 or 2018. Deposits Total deposits increased $81.8 million, or 10.7%, to $849.9 million at December 31, 2019 from $768.1 million at December 31, 2018. Our continuing focus on the acquisition and expansion of core deposit relationships, which we define as all deposits except for certificates of deposit, resulted in net growth in these deposits of  $84.8 million, or 12.6%, to $755.5 million at December 31, 2019, or 88.9% of total deposits at that date. The following tables set forth the distribution of total deposits by account type at the dates indicated. As of December 31, 2019, our certificates of deposit included $48.6 million of brokered certificates of deposit and $8.7 million of QwickRate certificates of deposit, where we gather certificates of deposit nationwide by posting rates we will pay on these deposits. As of December 31, 2019, the aggregate amount of all our certificates of deposit in amounts greater than or equal to $100,000, which excludes all brokered certificates, was approximately $29.8 million. The following table sets forth the maturity of these certificates as of December 31, 2019. Borrowings Our borrowings at December 31, 2019 consisted of Federal Home Loan Bank advances. The following table sets forth information concerning balances and interest rates on Federal Home Loan Bank advances for the years indicated. We had no securities sold under agreements to repurchase during the years ended December 31, 2019, 2018 and 2017. Borrowings decreased $43.0 million, or 63.3%, to $25.0 million at December 31, 2019 from $68.0 million at December 31, 2018 primarily due to the liquidity provided from the completion of our stock offering. All of the borrowings at December 31, 2019 are long-term with an original maturity of more than one year. Shareholders’ Equity Total shareholders’ equity increased $105.3 million, or 83.9%, to $230.9 million at December 31, 2019, from $125.6 million at December 31, 2018. The increase was due primarily to raising $91.6 million in capital due to our second-step conversion and related stock offering and net income of  $10.8 million. Average Balance Sheets and Related Yields and Rates The following tables set forth average balance sheets, average yields and costs, and certain other information for the years indicated. No tax-equivalent yield adjustments have been made, as we consider the amount of tax free interest-earning assets is immaterial. All average balances are daily average balances. Non-accrual loans were included in the computation of average balances. The yields set forth below include the effect of deferred fees, discounts, and premiums that are amortized or accreted to interest income or interest expense. (1) Net interest rate spread represents the difference between the weighted average yield on interest-bearing assets and the weighted average rate of interest-bearing liabilities. (2) Net interest-earning assets represent total interest-earning assets less total interest-bearing liabilities. (3) Net interest margin represents net interest income divided by average total interest-earning assets Rate/Volume Analysis The following table sets forth the effects of changing rates and volumes on our net interest income. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate). The net column represents the sum of the prior columns. For purposes of this table, changes attributable to changes in both rate and volume that cannot be segregated have been allocated proportionally based on the changes due to rate and the changes due to volume. Results of Operations for the Years Ended December 31, 2019 and 2018 General. Net income increased $1.5 million, or 15.9%, to $10.8 million for the year ended December 31, 2019 from $9.3 million for the year ended December 31, 2018. The increase was primarily due to an increase of  $6.3 million, or 16.9%, in net interest and dividend income partially offset by an increase in provision for loan losses of  $2.0 million, or 13.7%, and an increase in salaries and employee benefits expense of $1.4 million, or 8.6%. Interest and Dividend Income. Interest and dividend income increased $9.2 million, or 21.7%, to $51.5 million for the year ended December 31, 2019 from $42.3 million for the year ended December 31, 2018. This was caused by an increase in interest and fees on loans, which increased $9.3 million, or 23.1%, partially offset by a decrease in interest and dividends on securities of  $120,000, or 7.2%. The increase in interest income on loans was due to an increase in average balance of  $123.3 million, or 15.7%, to $906.9 million for the year ended December 31, 2019 from $783.6 million for the year ended December 31, 2018, and an increase in yield on loans of 33 basis points, to 5.48% for the year ended December 31, 2019 from 5.15% for the year ended December 31, 2018, due to our continued shift to higher-yielding commercial loans and the higher market interest rate environment. The decrease in interest and dividends on securities was due to a decrease in the average balance of investment securities of  $7.9 million, or 14.2%, to $47.8 million for the year ended December 31, 2019 from $55.7 million for the year ended December 31, 2018. Interest Expense. Interest expense increased $2.9 million, or 56.3%, to $8.1 million for the year ended December 31, 2019 from $5.2 million for the year ended December 31, 2018, due to an increase in interest expense on deposits and an increase in interest expense on borrowings. Interest expense on deposits increased $1.8 million, or 40.1%, to $6.3 million for the year ended December 31, 2019 from $4.5 million for the year ended December 31, 2018, due to our cost of funds on interest-bearing deposits increasing 26 basis points to 1.06% for the year ended December 31, 2019 from 0.80% for the year ended December 31, 2018 and an increase in average balances. The increase in the cost of funds was primarily due to an increase in the average rate paid on certificates of deposit, which increased 76 basis points to 2.18%, and money market accounts, which increased 22 basis points to 1.20%. Interest expense on borrowings, which consists of advances from the Federal Home Loan Bank of Boston, increased $1.1 million, or 153.7%, to $1.9 million for the year ended December 31, 2019 from $745,000 for the year ended December 31, 2018. The average balance of borrowings increased $41.4 million, or 133.5%, to $72.4 million for the year ended December 31, 2019 from $31.0 million for the year ended December 31, 2018. Our cost of borrowings increased 21 basis points to 2.61% for the year ended December 31, 2019 compared to 2.40% for the year ended December 31, 2018 due to the rate environment. Net Interest and Dividend Income. Net interest and dividend income increased $6.3 million, or 16.9%, to $43.4 million for the year ended December 31, 2019 from $37.1 million for the year ended December 31, 2018. Our net interest rate spread remained the same as 4.05% for the years ended December 31, 2019 and, 2018, while our net interest margin increased 11 basis points to 4.44% for the year ended December 31, 2019 from 4.33% for the year ended December 31, 2018. The average yield we earned on interest-earning assets increased 33 basis points to 5.27% for the year ended December 31, 2019 from 4.94% for the year ended December 31, 2018. The average yield we paid on interest-bearing liabilities increased 33 basis points to 1.22% for the year ended December 31, 2019 from 0.89% for the year ended December 31, 2018. Provision for Loan Losses. Our provision for loan losses was $5.3 million for the year ended December 31, 2019 compared to $3.3 million for the year ended December 31, 2018. The provision recorded resulted in an allowance for loan losses of  $13.8 million, or 1.42% of total loans and 237.6% of non-performing loans at December 31, 2019, compared to $11.7 million, or 1.38% of total loans and 186.6% of non-performing loans at December 31, 2018. Our provision was higher in 2019 due to an increase in the specific allowance for impaired loans and continued growth in the total loan portfolio. The largest non-performing loan outstanding as of December 31, 2019 is a $1.9 million commercial loan with a specific reserve of  $130,000. During the fourth quarter of 2019, a commercial real estate loan relationship with a total balance of  $18.6 million became impaired due to insufficient cash flows to pay the debt. We expect to formally restructure this loan relationship, and based on a discounted cash flow calculation using the anticipated restructure terms, we established a specific reserve of  $1.4 million for this relationship. The increase in the allowance for loan losses was based on management’s assessment of loan portfolio growth and composition changes, historical charge-off trends, levels of problem loans and other asset quality trends. We apply historical loss ratios to newly originated loans, which, absent other factors, results in an increase in the allowance for loan losses as the loan portfolio increases. For further information related to changes in the provision and allowance for loan losses, refer to “- Asset Quality - Allowance for Loan Losses.” Noninterest Income. Noninterest income information is as follows. Gains on sales of securities, net, increased $113,000, or 100.0%, for the year ended December 31, 2019 compared to the year ended December 31, 2018 as we repositioned some of our securities by selling some municipal and mortgage-backed securities that were close to maturity and reinvested the proceeds into longer-term mortgage-backed securities. Customer service fees on deposit accounts increased $17,000, or 1.2%, primarily due to increased volume in transactional deposit accounts. Service charges and fees decreased $210,000, or 10.5%, primarily due to one-time loan fees collected in 2018. Bank owned life insurance income increased $13,000, or 1.9%, due to an increase in yields on cash surrender values on the purchased policies. Other income remained the same at $64,000. Noninterest Expense. Noninterest expense information is as follows. Salaries and employee benefits expense increased $1.4 million, or 8.6%, for the year ended December 31, 2019 from the year ended December 31, 2018 primarily due to a higher number of sales and operations positions compared to 2018, as well as increased ESOP expense of  $459,000 due to the added shares from the stock offering. Occupancy expense increased $235,000, or 13.6%, for the year ended December 31, 2019 from the year ended December 31, 2018 primarily due to the acceleration of our leasehold improvements amortization related to the closure of our Hampton, New Hampshire branch in May 2019. The increase of $140,000, or 57.1% in marketing expense is primarily due to increased marketing in our new products and review of our website. Directors’ compensation increased $121,000, or 19.5%, for the year ended December 31, 2019 from the year ended December 31, 2018 primarily due to the addition of a new director in 2019 and a full year of stocke-based compensation expense from the issuance of awards in the second half of 2018. Software amortization and implementation increased $89,000, or 13.8%, for the year ended December 31, 2019 from the year ended December 31, 2018 primarily due to new software purchased to assist with strategic deposit initiatives. Other noninterest expense increased $227,000, or 4.7%, for the year ended December 31, 2019 from the year ended December 31, 2018 primarily due to telecommunications expense from adding our new offices in Portsmouth and using a new system to connect our offices. Income Tax Provision. We recorded a provision for income taxes of  $3.8 million for the year ended December 31, 2019, reflecting an effective tax rate of 26.1%, compared to $3.2 million, or an effective tax rate of 25.8%, for the year ended December 31, 2018. Management of Market Risk General. The majority of our assets and liabilities are monetary in nature. Consequently, our most significant form of market risk is interest rate risk. Our assets, consisting primarily of loans, have longer maturities than our liabilities, consisting primarily of deposits. As a result, a principal part of our business strategy is to manage interest rate risk and reduce the exposure of our net interest income to changes in market interest rates. Accordingly, we have established a management-level Asset/Liability Management Committee, which takes initial responsibility for developing an asset/liability management process and related procedures, establishing and monitoring reporting systems and developing asset/liability strategies. On at least a quarterly basis, the Asset/Liability Management Committee reviews asset/liability management with the Investment Asset/Liability Committee that has been established by the board of directors. This committee also reviews any changes in strategies as well as the performance of any specific asset/liability management actions that have been implemented previously. On a quarterly basis, an outside consulting firm provides us with detailed information and analysis as to asset/liability management, including our interest rate risk profile. Ultimate responsibility for effective asset/liability management rests with our board of directors. We have sought to manage our interest rate risk in order to minimize the exposure of our earnings and capital to changes in interest rates. We have implemented the following strategies to manage our interest rate risk: originating loans with adjustable interest rates; promoting core deposit products; and adjusting the interest rates and maturities of funding sources, as necessary. In addition, we no longer originate single-family residential real estate loans, which often have longer terms and fixed rates. By following these strategies, we believe that we are better positioned to react to changes in market interest rates. Net Interest Income Simulation. We analyze our sensitivity to changes in interest rates through a net interest income simulation model. Net interest income is the difference between the interest income we earn on our interest-earning assets, such as loans and securities, and the interest we pay on our interest-bearing liabilities, such as deposits and borrowings. We estimate what our net interest income would be for a 12-month period in the current interest rate environment. We then calculate what the net interest income would be for the same period under the assumption that interest rates increase 200 basis points from current market rates and under the assumption that interest rates decrease 100 basis points from current market rates, with changes in interest rates representing immediate and permanent, parallel shifts in the yield curve. The following table presents the estimated changes in net interest income of The Provident Bank, calculated on a bank-only basis, that would result from changes in market interest rates over twelve-month periods beginning December 31, 2019 and 2018. Economic Value of Equity Simulation. We also analyze our sensitivity to changes in interest rates through an economic value of equity (“EVE”) model. EVE represents the present value of the expected cash flows from our assets less the present value of the expected cash flows arising from our liabilities adjusted for the value of off-balance sheet contracts. The EVE ratio represents the dollar amount of our EVE divided by the present value of our total assets for a given interest rate scenario. EVE attempts to quantify our economic value using a discounted cash flow methodology while the EVE ratio reflects that value as a form of capital ratio. We estimate what our EVE would be as of a specific date. We then calculate what EVE would be as of the same date throughout a series of interest rate scenarios representing immediate and permanent, parallel shifts in the yield curve. We currently calculate EVE under the assumptions that interest rates increase 100, 200, 300 and 400 basis points from current market rates, and under the assumption that interest rates decrease 100 basis points from current market rates. The following table presents the estimated changes in EVE of The Provident Bank, calculated on a bank-only basis, that would result from changes in market interest rates as of December 31, 2019 and 2018. Certain shortcomings are inherent in the methodologies used in the above interest rate risk measurements. Modeling changes require making certain assumptions that may or may not reflect the manner in which actual yields and costs respond to changes in market interest rates. In this regard, the tables presented above assume that the composition of our interest-sensitive assets and liabilities existing at the beginning of a period remains constant over the period being measured and assume that a particular change in interest rates is reflected uniformly across the yield curve regardless of the duration or repricing of specific assets and liabilities. Accordingly, although the tables provide an indication of our interest rate risk exposure at a particular point in time, such measurements are not intended to and do not provide a precise forecast of the effect of changes in market interest rates on our net interest income and will differ from actual results. Liquidity and Capital Resources Liquidity is the ability to meet current and future financial obligations of a short-term nature. Our primary sources of funds consist of deposit inflows, loan repayments and maturities and sales of securities. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition. We regularly review the need to adjust our investments in liquid assets based upon our assessment of: (1) expected loan demand, (2) expected deposit flows, (3) yields available on interest-earning deposits and securities, and (4) the objectives of our asset/liability management program. Excess liquid assets are invested generally in interest-earning deposits and short- and intermediate-term securities. Our most liquid assets are cash and cash equivalents. The levels of these assets are dependent on our operating, financing, lending and investing activities during any given period. At December 31, 2019, cash and cash equivalents totaled $59.7 million. Securities classified as available-for-sale, which provide additional sources of liquidity, totaled $41.8 million at December 31, 2019. At December 31, 2019, we had a borrowing capacity of  $205.6 million with the Federal Home Loan Bank of Boston, of which $25.0 million in advances were outstanding. At December 31, 2019, we also had an available line of credit with the Federal Reserve Bank of Boston’s borrower-in-custody program of $254.1 million, none of which was outstanding as of that date. We have no material commitments or demands that are likely to affect our liquidity other than as set forth below. In the event loan demand were to increase faster than expected, or any unforeseen demand or commitment were to occur, we could access our borrowing capacity with the Federal Home Loan Bank of Boston or obtain additional funds through brokered certificates of deposit. At December 31, 2019 and 2018, we had $29.4 million and $42.6 million in loan commitments outstanding, respectively. In addition to commitments to originate loans, at December 31, 2019 and 2018, we had $201.9 million and $196.1 million in unadvanced funds to borrowers, respectively. We also had $1.5 million in outstanding letters of credit at December 31, 2019 and 2018. Certificates of deposit due within one year of December 31, 2019 totaled $62.0 million, or 65.6% of total certificates of deposit. If these deposits do not remain with us, we will be required to seek other sources of funds, including other certificates of deposit and Federal Home Loan Bank of Boston advances. Depending on market conditions, we may be required to pay higher rates on such deposits or other borrowings than we currently pay on the certificates of deposit at December 31, 2019. We believe, however, based on past experience that a significant portion of our certificates of deposit will remain with us. We have the ability to attract and retain deposits by adjusting the interest rates offered. Our primary investing activities are the origination of loans and the purchase of securities. During the years ended December 31, 2019 and 2018, we had $302.9 million and $298.4 million of loan originations, respectively. The loan originations included $302.7 million and $286.6 million of loans to be held in our portfolio for the years ended December 31, 2019 and 2018, respectively. During the year ended December 31, 2019, we purchased $13.7 million of securities and received proceeds from the sales of securities totaling $13.6 million. During the year ended December 31, 2018, we did not purchase or sell any securities. Financing activities consist primarily of activity in deposit accounts and Federal Home Loan Bank advances. We experienced net increases in total deposits of  $81.8 million and $18.0 million for the years ended December 31, 2019 and 2018, respectively. Deposit flows are affected by the overall level of interest rates, the interest rates and products offered by us and our local competitors and other factors. We generally manage the pricing of our deposits to be competitive. Borrowings decreased $43.0 million and increased $41.2 million during the years ended December 31, 2019 and 2018, respectively. The Provident Bank is subject to various regulatory capital requirements administered by Massachusetts Commissioner of Banks, and the Federal Deposit Insurance Corporation. At December 31, 2019, The Provident Bank exceeded all applicable regulatory capital requirements, and was considered “well capitalized” under regulatory guidelines. See Note 11 of the Notes to the Consolidated Financial Statements for additional information. The net proceeds from our stock offering significantly increased our liquidity and capital resources. Over time, the initial level of liquidity will be reduced as net proceeds from the stock offering are used for general corporate purposes, including funding loans. Our financial condition and results of operations have been enhanced by the net proceeds from the stock offering. However, due to the increase in equity resulting from the net proceeds raised in the stock offering, as well as other factors associated with the stock offering, our return on equity has been adversely affected following the stock offering. Contractual Obligations and Off-Balance Sheet Arrangements Contractual Obligations. In the ordinary course of our operations, we enter into certain contractual obligations. Such obligations include operating leases for premises and equipment, agreements with respect to borrowed funds and deposit liabilities, agreements with respect to investments and employment agreements with certain of our executive officers. The following table presents our contractual obligations as of December 31, 2019. 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, which involve elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. Our exposure to credit loss is represented by the contractual amount of the instruments. We use the same credit policies in making commitments as we do for on-balance sheet instruments. For further information, see Note 14 of the Notes to the Consolidated Financial Statements. Recent Accounting Pronouncements For information with respect to recent accounting pronouncements that are applicable to Provident Bancorp, Inc., see Note 2 of the Notes to the Consolidated Financial Statements. Effect of Inflation and Changing Prices The consolidated financial statements and related financial data included in this annual report have been prepared in accordance with generally accepted accounting principles in the United States of America, which require the measurement of financial position and operating results in terms of historical dollars without considering the change in the relative purchasing power of money over time due to inflation. The primary impact of inflation on our operations is reflected in increased operating costs. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant impact on a financial institution’s performance than do general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.

<s>[INST] This discussion and analysis reflects our consolidated financial statements and other relevant statistical data, and is intended to enhance your understanding of our financial condition and results of operations. You should read the information in this section in conjunction with the business and financial information regarding Provident Bancorp, Inc., including the financial statements, provided in this Annual Report. Overview Total assets were $1.1 billion at December 31, 2019, representing an increase of  $147.7 million, or 15.2%, from $974.1 million at December 31, 2018. The increase resulted primarily from increases in net loans of  $123.8 million and cash and cash equivalents of  $31.0 million. The increases were partially offset by a decrease in availableforsale investment securities of  $9.6 million. Net income increased $1.5 million, or 15.9%, to $10.8 million for the year ended December 31, 2019 from $9.3 million for the year ended December 31, 2018. The increase was primarily due to an increase of $6.3 million, or 16.9%, in net interest and dividend income, offset by an increase in provision for loan losses of  $2.0 million, or 60.0%, and an increase in salaries and employee benefits expense of  $1.4 million, or 8.6%. Critical Accounting Policies A summary of our accounting policies is described in Note 2 to the Consolidated Financial Statements included in this annual report. Critical accounting estimates are necessary in the application of certain accounting policies and procedures and are particularly susceptible to significant change. Critical accounting policies are defined as those involving significant judgments and assumptions by management that could have a material impact on the carrying value of certain assets or on income under different assumptions or conditions. Management believes that the most critical accounting policies, which involve the most complex or subjective decisions or assessments, are as follows: Allowance for Loan Losses. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. 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, size and composition 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. A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a casebycase basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial, commercial real estate and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, we do not separately identify individual consumer and residential loans for impairment disclosures. The allowance consists of a general component, a specific component for impaired loans, and in some cases an unallocated component. The general component of the allowance for loan losses is based on historical loss experience adjusted for qualitative factors stratified by the following loan [/INST] Positive. </s>

Cortexyme, 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 our financial statements and related notes thereto included elsewhere in this Annual Report of Form 10-K. This discussion contains forward-looking statements that involve risk and uncertainties, such as statements of our plans, objectives, expectations, and intentions, that are based on the beliefs of our management. 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 the “Risk Factors” section of this Annual Report on Form 10-K Overview We are a clinical stage biopharmaceutical company pioneering a novel disease-modifying therapeutic approach to treat what we believe to be a key underlying cause of Alzheimer’s and other degenerative diseases. Our approach is based on the seminal discovery of the presence of Porphyromonas gingivalis, or P. gingivalis, and its secreted toxic virulence factor proteases, called gingipains, in the brains of greater than 90% of more than 100 Alzheimer’s patients observed across multiple studies to date. Additionally, we have observed that P. gingivalis infection causes Alzheimer’s pathology in animal models, and these effects have been successfully treated with a gingipain inhibitor in preclinical studies. Our proprietary lead drug candidate, COR388, is an orally administered, brain-penetrating small molecule gingipain inhibitor. COR388 was well-tolerated with no concerning safety signals in our Phase 1a and Phase 1b clinical trials conducted to date, which enrolled a total of 67 subjects, including nine patients with mild to moderate Alzheimer’s disease. We initiated a global Phase 2/3 clinical trial of COR388, called the GAIN trial, in mild to moderate Alzheimer’s patients in April 2019 in the United States and in September 2019 in Europe and expect top-line results by the end of 2021. Financial Overview Since commencing material operations in 2014, we have devoted substantially all of our efforts and financial resources to building our research and development capabilities, establishing our corporate infrastructure and most recently, executing our Phase 1a, Phase 1b and Phase 2/3 clinical trials of COR388. To date, we have not generated any revenue and we have never been profitable. We have incurred net losses since the commencement of our operations. As of December 31, 2019, we had an accumulated deficit of $69.8 million. We incurred a net loss of $37.0 million in the year ended December 31, 2019. We do not expect to generate product revenue unless and until we obtain marketing approval for and commercialize a drug candidate, and we cannot assure you that we will ever generate significant revenue or profits. To date, we have financed our operations primarily through the issuance and sale of convertible promissory notes and redeemable convertible preferred stock and common stock. From inception through December 31, 2019, we received net proceeds of approximately $177.3 million from the issuance of redeemable convertible preferred stock, convertible promissory notes and common stock. In February 2020, we also received net proceeds of approximately $117.6 million from the issuance and sale of common stock in a private placement to certain accredited investors As of December 31, 2019 and 2018, we had cash, cash equivalents and short-term investments of $99.9 million and $71.7 million, respectively. The balances exclude long-term investments of $16.8 million and $0 as of those same periods. Our cash equivalents, short-term and long-term investments are held in money market funds, certificate of deposits, repurchase agreements, investments in corporate debt securities and government agency obligations. We believe that our existing cash, cash equivalents and short-term investments will be sufficient to fund our planned operations through 2021, including through the completion and the announcement of the top-line results of our Phase 2/3 GAIN trial. 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. We expect to incur substantial expenditures in the foreseeable future as we expand our pipeline and advance our drug candidates through clinical development, the regulatory approval process and, if approved, commercial launch activities. Specifically, in the near term we expect to incur substantial expenses relating to our ongoing and planned clinical trials, the development and validation of our manufacturing processes, and other development activities. We will need substantial additional funding to support our continuing operations and pursue our development strategy. Until such time as we can generate significant revenue from sales of an approved drug, if ever, we expect to finance our operations through the sale of equity, debt financings or other capital sources. 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 our drug candidates or delay our efforts to expand our product pipeline. Components of Operating Results Operating Expenses Research and Development Expenses Our research and development expenses consist of expenses incurred in connection with the research and development of our research programs. These expenses include payroll and personnel expenses, including stock-based compensation, for our research and product development employees, laboratory supplies, product licenses, consulting costs, contract research, preclinical and clinical expenses, allocated rent, facilities costs and depreciation. We expense both internal and external research and development costs as they are incurred. Non-refundable advance payments and deposits 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. To date, substantially all of our research and development expenses have supported the advancement of COR388 and our other drug candidates are in early-stage preclinical development. As a result, we do not allocate our costs to individual drug candidates. We expect that at least for the foreseeable future, a substantial majority of our research and development expense will support the clinical and regulatory development of COR388. We expect our research and development expenses to increase substantially during the next few years as we seek to complete existing and initiate additional clinical trials, pursue regulatory approval of COR388 and advance other drug candidates into preclinical and clinical development. Over the next few years, we expect our preclinical, clinical and contract manufacturing expenses to increase significantly relative to what we have incurred to date. Predicting the timing or the final cost to complete our clinical program or validation of our manufacturing and supply processes is difficult and delays may occur because of many factors. General and Administrative Expenses General and administrative expenses consist principally of personnel-related costs, including payroll and stock-based compensation, for personnel in executive, finance, human resources, business and corporate development, and other administrative functions, professional fees for legal, consulting, insurance and accounting services, allocated rent and other facilities costs, depreciation, and other general operating expenses not otherwise classified as research and development expenses. We anticipate that our general and administrative expenses will increase as the size of our business operations grows to support additional research and development activities. Interest Income Interest and other income, net consists primarily of interest earned on our short-term and long-term investments portfolio, Change in fair value of derivative liability The change in the fair value of the derivative liability is the change in valuation of the bifurcated redemption premium related to the convertible promissory notes which fully settled upon completion of Series B financing. Critical Accounting Policies, Significant Judgments and Use of Estimates Our financial statements have been prepared in accordance with U.S. generally accepted accounting principles, or 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 and expenses incurred during the reporting periods. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe that the accounting policies 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. While our significant accounting policies are described in the notes to our financial statements, we believe that the following critical accounting policies are most important to understanding and evaluating our reported financial results. Research and Development Expenses Research and development costs are expensed as incurred. Research and development expenses consist primarily of personnel costs for our research and product development employees. Also included are non-personnel costs such as professional fees payable to third parties for preclinical and clinical studies and research services, laboratory supplies and equipment maintenance, product licenses, and other consulting costs. We estimate preclinical and clinical study and research expenses based on the services performed, pursuant to arrangements with contract research organizations, or CROs that conduct and manage preclinical and clinical studies and research services on our behalf. We estimate these expenses based on regular reviews 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. Based upon the combined inputs of internal and external resources, 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 associated with licensing agreements to acquire exclusive licenses to develop, use, manufacture and commercialize products that have not reached technological feasibility and do not have alternate commercial use are expensed as incurred. 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 Expense Stock-based compensation expense represents the cost of the grant date fair value of employee and non-employee awards over the requisite service period of the awards (usually the vesting period) on a straight-line basis. For stock awards for which vesting is subject to performance-based milestones, the expense is recorded over the remaining service period after the point when the achievement of the milestone becomes probable. We estimate the fair value of all stock option grants using the Black-Scholes option pricing model and recognize forfeitures as they occur. The fair value of a stock-based award is recognized over the period during which an optionee is required to provide services in exchange for the option award, known as the requisite service period (usually the vesting period) on a straight-line basis. Stock-based compensation expense is recognized based on the fair value determined on the date of grant and is reduced for forfeitures as they occur. Estimating the fair value of equity-settled 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. 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. We estimate the fair value of stock-based compensation utilizing the Black-Scholes option-pricing model, which is impacted by the following variables: Expected Term-We have opted to use the “simplified method” for estimating the expected term of options, whereby the expected term equals the arithmetic average of the vesting term and the original contractual term of the option (generally 10 years). Expected Volatility-Due to our limited operating history 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 data was computed using the daily closing prices for the selected companies’ shares during the equivalent period of the calculated expected term of the stock-based awards. Risk-Free Interest Rate-The risk-free rate assumption is based on the U.S. Treasury instruments with maturities similar to the expected term of our stock options. Expected Dividend-We have not issued any dividends in our history and do not expect to issue dividends over the life of the options and therefore have estimated the dividend yield to be zero. Common Stock Valuations The estimated fair value of the common stock underlying our stock options was determined at each grant date by our board of directors, with input from management. All options to purchase shares of our common stock are 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. Prior to our IPO in May 2019, on each grant date, our board of directors made a reasonable determination of the fair value of our common stock based on the information known to us on the date of grant, upon a review of any recent events and their potential impact on the estimated fair value per share of the common stock, and timely valuations from an independent third-party valuation in accordance with guidance provided by the American Institute of Certified Public Accountants Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation (the Practice Aid). The methodology to determine the fair value of our common stock included estimating the fair value of the enterprise using a market approach, which estimates the fair value of the company by including an estimation of the value of the business based on guideline public companies under a number of different scenarios. In determining the fair value of our common stock on each grant date, our board of directors considered numerous objective and subjective factors, including the results of independent third party valuations, external market conditions affecting the pharmaceutical and biotechnology industry and trends within the industry; our stage of development; the rights, preferences and privileges of our redeemable convertible preferred stock relative to those of our common stock; the prices at which we sold shares of our redeemable convertible preferred stock; our financial condition and operating results, including our levels of available capital resources; the progress of our research and development efforts, our stage of development and business strategy; equity market conditions affecting comparable public companies; general U.S. market conditions and the lack of marketability of our common stock. Following our IPO in May 2019, our board of directors determined the fair value of our common stock based on the closing price of our common stock on the date of grant. Income Taxes We account 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 account for uncertain tax positions in accordance with ASC 740-10, Accounting for Uncertainty in Income Taxes. 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. As of December 31, 2019, our total deferred tax assets were $16.5 million. A valuation allowance is established against the deferred tax assets to reduce their carrying value to an amount that is more likely than not to be realized. The deferred tax assets and liabilities are classified as noncurrent along with the related valuation allowance. Due to a lack of earnings history, the net deferred tax assets have been fully offset by a valuation allowance. The deferred tax assets were primarily comprised of federal and state tax net operating losses, or NOLs. Utilization of NOLs may be limited by the “ownership change” rules, as defined in Section 382 of the Code. Similar rules may apply under state tax laws. Our ability to use our remaining NOLs may be further limited if we experience an ownership change in connection with this offering, future offerings or as a result of future changes in our stock ownership. Results of Operations Comparison of the Years Ended December 31, 2019 and 2018 The following table summarizes our results of operations for the periods indicated (dollars in thousands): Research and Development Expenses The following table summarizes our research and development expenses: Research and development expenses increased $20.1 million or 199.6% for the year ended December 31, 2019, primarily due to an increase of $17.4 million in expenses for our lead product candidate, COR388, which entered into our Phase 2/3 GAIN clinical trials. Personnel-related expenses, including stock-based compensation, increased by $1.6 million due to an increase in headcount as we launched and scaled the GAIN clinical trial during 2019. In addition, we had an increase of $1.1 million in research and development expenses related to other preclinical programs currently in development. We expect the clinical trial expenses to continue to increase as the study progresses to full enrollment in 2020. General and Administrative Expenses General and administrative expenses increased $6.9 million, or 340.2 %, primarily due to an increase of $2.6 million in personnel costs, including stock-based compensation, as a result of an increase in our employee headcount and an increase of $4.3 million in insurance, legal, accounting, investor relations and other compliance cost associated with becoming a public company. We anticipate these costs will increase as the full year effect of being a public company is realized in 2020. Interest Income Interest income increased $1.4 million or 171.5% due to increased average cash balances and on our investment portfolio as a result of the receipt of proceeds from our IPO in May 2019. Interest Expense Interest expense decreased $1.0 million due to the retirement of all interest-bearing obligations in 2018. Change in fair value of derivative liability The change in fair value of derivative liability decreased $0.2 million due to the extinguishment of the liability upon the conversion of the convertible promissory note to redeemable convertible preferred stock in May 2018. Liquidity and Capital Resources 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 $69.8 million. As of December 31, 2019, we had cash, cash equivalents and investments of $116.6 million. Based on our existing business plan, we believe that our existing cash, cash equivalents and investments will be sufficient to fund our anticipated level of operations through at least the next 12 months. We will continue to require additional capital to develop our drug candidates and fund operations for the foreseeable future. We may seek to raise capital through private or public equity or debt financings, collaborative or other arrangements with other companies, or through other sources of financing. 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. We anticipate that we will need to raise substantial additional capital, the requirements of which will depend on many factors, including: • the progress, costs, trial design, results of and timing of our Phase 2/3 GAIN trial and other clinical trials of COR388, including for potential additional indications that we may pursue beyond Alzheimer’s disease; • the willingness of the FDA or EMA to accept our Phase 2/3 GAIN trial, as well as data from our completed and planned clinical and preclinical studies and other work, as the basis for review and approval of COR388 for Alzheimer’s disease; • the outcome, costs and timing of seeking and obtaining FDA, EMA and any other regulatory approvals; • the number and characteristics of drug candidates that we pursue; • our ability to manufacture sufficient quantities of our drug candidates; • our need to expand our research and development activities; • the costs associated with securing and establishing commercialization and manufacturing capabilities; • the costs of acquiring, licensing or investing in businesses, drug candidates and technologies; • our ability to maintain, expand and defend the scope of our intellectual property portfolio, including the amount and timing of any payments we may be required to make, or that we may receive, in connection with the licensing, filing, prosecution, defense and enforcement of any patents or other intellectual property rights; • our need and ability to retain management and hire scientific and clinical personnel; • the effect of competing drugs and drug candidates and other market developments; • our need to implement additional internal systems and infrastructure, including financial and reporting systems; and • the economic and other terms, timing of and success of any collaboration, licensing or other arrangements into which we may enter in the future. If we raise additional funds by issuing equity securities, our stockholders will 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 to others rights to our drug candidates in certain territories or indications that we would prefer to develop and commercialize ourselves. 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 (in thousands): Cash Used in Operating Activities Net cash used in operating activities was $33.3 million for the year ended December 31, 2019 and $11.7 million for the year ended December 31, 2018. Cash used in operating activities in the year ended December 31, 2019 was primarily due to our net loss for the period of $37.0 million, which included non-cash expenses of $2.6 million and changes to operating assets and liabilities of $1.9 million offset by non-cash interest income of $0.8 million. Cash used in operating activities in the year ended December 31, 2018 was primarily due to our net loss for the period of $12.5 million, and was also affected by changes to accrued interest, debt discount on conversion features, operating assets and liabilities, other current assets and long-term assets that totaled $1.5 million. Cash used in operating activities was also affected by changes in operating assets and liabilities, a decrease in prepaids of $0.7 million and increase in accrued liabilities of $0.3 million, and non-cash charges relating to depreciation and amortization and stock-based compensation expense of $0.1 million. Cash Used in Investing Activities Cash used in investing activities was $17.7 million in the year ended December 31, 2019, primarily related to the purchase of investments of $135.4 million and maturities of debt investments of $117.7 million. Cash used in investing activities was $46.8 million in the year ended December 31, 2018, primarily related to the purchase of investments of $55.2 million, and maturities of short-term investments of $8.7 million. Cash Provided by Financing Activities Cash provided by financing activities was $77.4 million in the year ended December 31, 2019, which consisted of net proceeds of $77.8 million from our IPO, $0.1 million from the exercise of stock options, less payment on our finance leases of $0.5 million. Cash provided by financing activities was $75.9 million in the year ended December 31, 2018, which consisted primarily of net proceeds of $75.7 million from the issuance and sale of shares of our Series B redeemable convertible preferred stock. Contractual Obligations and Commitments We enter into contracts in the normal course of business with third party contract organizations for clinical trials, non-clinical studies and testing, manufacturing, and other services and products for operating purposes. The amount and timing of the payments under these contracts varies based upon the timing of the services performed. We have not included in this disclosure any such contingent payment obligations as the amount, timing and likelihood of such payments are not known. 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 Securities and Exchange Commission. Indemnification As permitted under Delaware law and in accordance with our bylaws, we indemnify our officers and directors for certain events or occurrences while the officer or director is or was serving in such capacity. We are also party to indemnification agreements with our officers and directors. We believe the fair value of the indemnification rights and agreements is minimal. Accordingly, we have not recorded any liabilities for these indemnification rights and agreements as of December 31, 2019 and December 31, 2018. JOBS Act Accounting Election The Jumpstart Our Business Startups Act of 2012 (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. We have chosen to irrevocably opt out of the extended transition period for complying with certain new or revised accounting standards pursuant to Section 107(b) of the JOBS Act. We will remain an emerging growth company until the earlier of (1) December 31, 2024, (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, which means the market value of our common stock that is held by non-affiliates exceeds $700.0 million of the prior June 30th and (4) 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 In August 2018, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework-Changes to the Disclosure Requirements for Fair Value Measurement. The new guidance changes disclosure requirements related to fair value measurements as part of the disclosure framework project. The disclosure framework project aims to improve the effectiveness of disclosures in the notes to the financial statements by focusing on requirements that clearly communicate the most important information to users of the financial statements. This guidance is effective for fiscal years beginning after December 15, 2019, with early adoption permitted. The Company does not believe this pronouncement will have a material impact on its financial statements or disclosures. In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”). ASU 2016-13 requires companies to measure credit losses utilizing a methodology that reflects expected credit losses and requires a consideration of a broader range of reasonable and supportable information to inform credit loss estimates. ASU 2016-13 is effective for public business entities that are SEC filers, excluding smaller reporting companies for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. All other entities, including smaller reporting companies the effective date is for fiscal years beginning after December 15, 2022. Accordingly, as a smaller reporting company, we will adopt the standard effective January 1, 2023. We are currently evaluating the impact that the adoption of this standard will have on our financial statements. In August 2018, the FASB issued ASU No. 2018-15, Intangibles-Goodwill and Other-Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract (“ASU 2018-15”), which clarifies the accounting for implementation costs in cloud computing arrangements. ASU 2018-15 is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. We will adopt the standard prospectively on January 1, 2020. We do not expect the adoption of ASU 2018-15 to result in a material change to our financial statements. Recently Adopted Accounting Pronouncements In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). This ASU requires that substantially all leases be recognized by lessees on their balance sheet as a right-of-use asset and corresponding lease liability, including leases currently accounted for as operating leases. The ASU is effective for interim and annual periods beginning after December 15, 2018. Additionally, the FASB issued ASU No. 2018-11, Leases (Topic 842): Targeted Improvements, which offers an additional transition method whereby entities may apply the new leases standard at the adoption date and recognize a cumulative-effect adjustment to the opening balance of retained earnings rather than application of the new leases standard at the beginning of the earliest period presented in the financial statements. The Company elected this transition method and adopted ASC 842 on January 1, 2019 and as a result, recorded a right-of-use asset of $0.9 million, a short-term lease liability of $0.3 million, and a long-term lease liability of $0.6 million and no cumulative effect adjustment was made to the retained earnings as of the adoption date. The Company also elected the package of practical expedients under the transition guidance that will retain the historical lease classification and initial direct costs for any leases that exist prior to adoption of the new guidance and the practical expedient to not separate lease and nonlease components. See Note 6 to our audited financial statements for further information. In July 2017, the FASB issued ASU No. 2017-11, Earnings Per Share (Topic 260), Distinguishing Liabilities from Equity (Topic 480), Derivatives and Hedging (Topic 815) I. Accounting for Certain Financial Instruments with Down Round Features II. Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception (“ASU 2017-11”). Part I applies to entities that issue financial instruments such as warrants, convertible debt or redeemable convertible preferred stock that contain down-round features. Part II replaces the indefinite deferral for certain mandatorily redeemable noncontrolling interests and mandatorily redeemable financial instruments of nonpublic entities contained within ASC Topic 480 with a scope exception and does not impact the accounting for these mandatorily redeemable instruments. For public entities, ASU 2017-11 is required to be adopted for annual periods beginning after December 15, 2018, including interim periods within those fiscal years. The adoption of ASU 2017-11 did not have any impact on the Company’s financial statements since we did not have any instruments subject to the scope of ASU 2017-11. On December 18, 2019, the FASB issued ASU No. 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes (“ASU 2019-12”), which removes certain exceptions to the general principles in Topic 740 and also clarifies and amends existing guidance to improve consistent application. Most amendments within the standard are required to be applied on a prospective basis, while certain amendments must be applied on a retrospective or modified retrospective basis. The pronouncement is effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2020, with early adoption permitted. We early adopted ASU 2019-12 effective January 1, 2019. The adoption did not have a material impact on the financial statements. All other newly issued accounting pronouncements not yet effective have been deemed either immaterial or not applicable.

<s>[INST] Overview We are a clinical stage biopharmaceutical company pioneering a novel diseasemodifying therapeutic approach to treat what we believe to be a key underlying cause of Alzheimer’s and other degenerative diseases. Our approach is based on the seminal discovery of the presence of Porphyromonas gingivalis, or P. gingivalis, and its secreted toxic virulence factor proteases, called gingipains, in the brains of greater than 90% of more than 100 Alzheimer’s patients observed across multiple studies to date. Additionally, we have observed that P. gingivalis infection causes Alzheimer’s pathology in animal models, and these effects have been successfully treated with a gingipain inhibitor in preclinical studies. Our proprietary lead drug candidate, COR388, is an orally administered, brainpenetrating small molecule gingipain inhibitor. COR388 was welltolerated with no concerning safety signals in our Phase 1a and Phase 1b clinical trials conducted to date, which enrolled a total of 67 subjects, including nine patients with mild to moderate Alzheimer’s disease. We initiated a global Phase 2/3 clinical trial of COR388, called the GAIN trial, in mild to moderate Alzheimer’s patients in April 2019 in the United States and in September 2019 in Europe and expect topline results by the end of 2021. Financial Overview Since commencing material operations in 2014, we have devoted substantially all of our efforts and financial resources to building our research and development capabilities, establishing our corporate infrastructure and most recently, executing our Phase 1a, Phase 1b and Phase 2/3 clinical trials of COR388. To date, we have not generated any revenue and we have never been profitable. We have incurred net losses since the commencement of our operations. As of December 31, 2019, we had an accumulated deficit of $69.8 million. We incurred a net loss of $37.0 million in the year ended December 31, 2019. We do not expect to generate product revenue unless and until we obtain marketing approval for and commercialize a drug candidate, and we cannot assure you that we will ever generate significant revenue or profits. To date, we have financed our operations primarily through the issuance and sale of convertible promissory notes and redeemable convertible preferred stock and common stock. From inception through December 31, 2019, we received net proceeds of approximately $177.3 million from the issuance of redeemable convertible preferred stock, convertible promissory notes and common stock. In February 2020, we also received net proceeds of approximately $117.6 million from the issuance and sale of common stock in a private placement to certain accredited investors As of December 31, 2019 and 2018, we had cash, cash equivalents and shortterm investments of $99.9 million and $71.7 million, respectively. The balances exclude longterm investments of $16.8 million and $0 as of those same periods. Our cash equivalents, shortterm and longterm investments are held in money market funds, certificate of deposits, repurchase agreements, investments in corporate debt securities and government agency obligations. We believe that our existing cash, cash equivalents and shortterm investments will be sufficient to fund our planned operations through 2021, including through the completion and the announcement of the topline results of our Phase 2/3 GAIN trial. 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. We expect to incur substantial expenditures in the foreseeable future as we expand our pipeline and advance our drug candidates through clinical development, the regulatory approval process and, if approved, commercial launch activities. Specifically, in the near term we expect to incur substantial expenses relating to our ongoing and planned clinical trials, the development and validation of our manufacturing processes, and other development [/INST] Positive. </s>

Aprea Therapeutics, Inc.

2020-03-27

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of financial condition and results of operations is provided to enhance the understanding of, and should be read in conjunction with Part I, Item I, “Business” and Item 8, ‘Financial Statements and Supplementary Data.” For information on risks and uncertainties related to our business that may make past performance not indicative of future results or cause actual results to differ materially from any forward looking statements, see “Special Note Regarding Forward-Looking Statements,” and Part I, Item 1A, ‘Risk Factors.” Overview We are a clinical-stage biopharmaceutical company focused on developing and commercializing novel cancer therapeutics that reactivate mutant p53 tumor suppressor protein. p53 is the protein expressed from the TP53 gene, the most commonly mutated gene in cancer. We believe that mutant p53 is an attractive therapeutic target due to the high incidence of p53 mutations across a range of cancer types and its involvement in key cellular activities such as apoptosis. Cancer patients with mutant p53 face a significantly inferior prognosis even when treated with the current standard of care, and a large unmet need for these patients remains. Our lead product candidate, APR-246, is a small molecule p53 reactivator that is in late-stage clinical development for hematologic malignancies, including myelodysplastic syndromes, or MDS, and acute myeloid leukemia, or AML. APR-246 has received Orphan Drug, Fast Track and Breakthrough designations from the FDA for MDS, and Orphan Drug designation from the European Commission for MDS, AML and ovarian cancer, and we believe APR-246 will be a first-in-class therapy if approved by applicable regulators. We have commenced a pivotal Phase 3 trial of APR-246 with azacitidine for frontline treatment of TP53 mutant MDS and expect initial data from this trial in the second half of 2020. Our pivotal Phase 3 trial is supported by data from two ongoing Phase 1b/2 investigator initiated trials, one in the U.S. and one in France, testing APR-246 with azacitidine as frontline treatment in TP53 mutant MDS and AML patients. Aprea Therapeutics AB, or Aprea AB, was originally incorporated in 2002 and commenced principal operations in 2006. We incorporated Aprea Therapeutics, Inc. (the “Company”) in May 2019. In September 2019 we completed a corporate reorganization and, as a result, all of the issued and outstanding stock of Aprea AB was exchanged for common stock, preferred stock or options, as applicable, of the Company. As a result of such transactions, Aprea AB became a wholly-owned subsidiary of the Company. We have devoted substantially all of our resources to developing our product candidates, including APR-246, 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 through private placements of preferred stock and the net proceeds received from the initial public offering (IPO) of our common stock. Through December 31, 2019, we had received net proceeds of approximately $223.8 million from our sales of preferred and common stock. Since our inception, we have incurred significant losses on an aggregate basis. Our ability to generate product revenue sufficient to achieve profitability will depend on the successful development and eventual commercialization of one or more of our product candidates. Our net losses were $28.1 million, $15.5 million and $15.2 million for the years ended December 31, 2019, 2018 and 2017, respectively. As of December 31, 2019, we had an accumulated deficit of $90.5 million. These losses have resulted primarily from costs incurred in connection with research and development activities, patent investment, and general and administrative costs associated with our operations. 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 if and as we: · conduct our current and future clinical trials and additional preclinical research of APR-246; · initiate and continue research and preclinical and clinical development of our other product candidates; · seek to identify and develop additional product candidates; · seek marketing approvals for any of our product candidates that successfully complete clinical trials, if any; · establish a sales, marketing, manufacturing and distribution infrastructure to commercialize any products for which we may obtain marketing approval; · require the manufacture of larger quantities of our product candidates for clinical development and potentially commercialization; · maintain, expand, protect and enforce our intellectual property portfolio; · acquire or in-license other drugs and technologies; · defend against any claims of infringement, misappropriation or other violation of third-party intellectual property; · hire and retain additional clinical, quality control and scientific personnel; · add operational, financial and management information systems and personnel, including personnel to support our drug development, any future commercialization efforts and our transition to a public company; and · continue to operate as a public company. Furthermore, 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. 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. As of December 31, 2019, we had cash and cash equivalents of $130.1 million. We believe that our existing cash and cash equivalents, will enable us to fund our operating expenses and capital expenditure requirements into 2023. 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.” Components of our 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 our development efforts for APR-246 or other product candidates that we may develop in the future are successful and result in marketing approval or collaboration or license agreements with third parties, we may generate revenue in the future from a combination of product sales or payments from collaboration or license agreements that we may enter into with third parties. Operating expenses Our 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: · expenses incurred under agreements with third parties, including contract research organizations, or CROs, that conduct research, preclinical activities and clinical trials on our behalf as well as contract manufacturing organizations, or CMOs, that manufacture our product candidates for use in our preclinical and clinical trials; · salaries, benefits and other related costs, including stock-based compensation expense, for personnel engaged in research and development functions; · costs of outside consultants, including their fees, stock-based compensation and related travel expenses; · costs of laboratory supplies and acquiring, developing and manufacturing preclinical study and clinical trial materials; · expenses related to compliance with regulatory requirements; and · facility-related expenses, which include direct depreciation costs and allocated expenses for rent and maintenance of facilities and other operating costs. We expense research and development costs as incurred. We recognize costs for certain development activities, such as clinical trials, based on an evaluation of the progress to completion of specific tasks using data such as patient enrollment, clinical site activations, or information provided to us by our vendors and our clinical investigative sites. Payments for these activities are based on the terms of the individual agreements, which may differ from the pattern of costs incurred, and are reflected in our financial statements as prepaid or accrued research and development expenses. We typically use our employee and infrastructure resources across our development programs. We track outsourced development costs and payments made to our research partners by product candidate or development program, but we do not allocate personnel costs or other internal costs to specific development programs or product candidates. 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 that our research and development expenses will continue to increase for the foreseeable future as we initiate additional clinical trials of APR-246, pursue later stages of clinical development of APR-246, initiate clinical trials for product candidates other than APR-246 and continue to discover and develop additional product candidates. We cannot determine with certainty the duration and costs of the current or future clinical trials of our product candidates or if, when, or to what extent we will generate revenue from the commercialization and sale of any our product candidates for which we obtain marketing approval. We may never succeed in obtaining marketing approval for any of our product candidates. The duration, costs and timing of clinical trials and development of our product candidates will depend on a variety of factors, including: · the scope, rate of progress, expense and results of our ongoing clinical trials of APR-246, as well as of any future clinical trials of APR-246 or other product candidates and other research and development activities that we may conduct; · uncertainties in clinical trial design and patient enrollment rates; · significant and changing government regulation and regulatory guidance; · the timing and receipt of any marketing approvals; and · the expense of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights. 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 U.S. Food and Drug Administration, or 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 trial delays 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. We are currently conducting multiple clinical trials of APR-246: our Phase 3 trial in the United States for the treatment of TP53 mutant MDS with azacitidine, our Phase 1b/2 trials in the United States and France for the treatment of MDS and AML with azacitidine, and our Phase 2 trial of post-transplant maintenance therapy with azacitidine in MDS and AML. At this time, we cannot reasonably estimate the cost for initiating and completing other clinical trials of APR-246 and preclinical studies of APR-246, as it will be highly dependent on the clinical data from ongoing clinical trials as well as any target disease subpopulations chosen for further evaluation. 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, corporate and business development and administrative functions. General and administrative expenses also include legal fees relating to patent 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 general and administrative personnel headcount to support personnel in research and development and to support our operations generally as we increase our research and development activities and activities related to the potential commercialization of 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 exchange listing and SEC requirements; director and officer insurance costs; and investor and public relations costs. Other income and expense Interest income and expense Interest income consists of income earned on our cash and cash equivalents. Interest expense consists of bank charges and fees incurred on our cash and cash equivalents. Our interest income will initially increase as our investment balances will be higher due to the cash proceeds received from our IPO. Such interest income will then decrease as our cash balance decreases as we continue to fund our operations. Foreign currency gain Our consolidated financial statements are presented in U.S. dollars, which is our reporting currency. The financial position and results of operations of our subsidiaries Aprea AB and Aprea Personal AB are measured using the foreign subsidiaries’ local currency as the functional currency. Aprea AB cash accounts holding U.S. dollars are remeasured based upon the exchange rate at the date of remeasurement with the resulting gain or loss included in the consolidated statement of operations and comprehensive loss. Expenses of such subsidiaries have been translated into U.S. dollars at average exchange rates prevailing during the period. Assets and liabilities have been translated at the rates of exchange on the consolidated balance sheet date. The resulting translation gain and loss adjustments are recorded directly as a separate component of stockholders’ equity and as other comprehensive loss on the consolidated statement of operations and comprehensive loss. Income taxes Since Aprea AB’s inception in 2002, we have not recorded any U.S. federal, state or foreign income tax expense or benefits for the net losses we have incurred in any year, due to our uncertainty of realizing a benefit from those items. We have provided a valuation allowance for the full amount of the net deferred tax assets as, based on all available evidence, it is considered more likely than not that all the recorded deferred tax assets will not be realized in a future period. At December 31, 2019, we had $89.9 million, $7.4 million and $5.8 million of foreign, federal and state net operating loss carryforwards, respectively, that expire at various dates through 2037. Certain of these foreign, federal and state net operating loss carryforwards may be subject to Internal Revenue Code Section 382 or similar provisions, which impose limitations on their utilization amounts. Critical accounting policies and use of estimates Our management’s discussion and analysis of 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. The preparation of our 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 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 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 financial statements, we are required to estimate our accrued research and development expenses at each balance sheet. This process involves reviewing open contract 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 costs incurred for the services when we have not yet been invoiced or otherwise notified of the 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 our financial statements based on facts and circumstances known to us at that time. Examples of estimated accrued research and development expenses include fees paid to: · CROs in connection with performing research activities on our behalf and conducting preclinical studies and clinical trials on our behalf; · investigative sites or other service providers in connection with clinical trials; · vendors in connection with preclinical and clinical development activities; and · vendors related to product manufacturing and development and distribution of preclinical and clinical supplies. 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 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 fees, we estimate the time period over which services will be performed, enrollment of patients, number of sites activated 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 amount of 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 us reporting amounts that are too high or too low in any particular period. To date, we have not made 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 directors based on their fair value on the date of the grant and recognize compensation expense of those awards, net of estimated forfeitures, over the requisite service period, which is generally the vesting period of the respective award. We apply the straight-line method of expense recognition to all awards with only service-based vesting conditions and apply the graded-vesting method to all awards with performance-based vesting conditions or to awards with both service-based and performance-based vesting conditions. For stock-based awards granted to non-employees, compensation expense is recognized over the period during which services are rendered by such non-employees until completed in accordance with the FASB issued ASU No. 2018-07, Compensation-Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting. The new standard largely aligns the accounting for share-based payment awards issued to employees and nonemployees by expanding the scope of ASC 718 to apply to nonemployee share-based transactions, as long as the transaction is not effectively a form of financing. We estimate the fair value of each stock option grant on the date of grant using the Black-Scholes option-pricing model, which 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 stock options, the risk-free interest rate for a period that approximates the expected term of our stock options and our expected dividend yield. Determination of fair value of common stock As a privately held company (through October 2, 2019), there had been no public market for our common stock, the estimated fair value of our common stock had been determined by our board of directors as of the date of each option grant, 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 and which may have changed from the date of the most recent 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 common stock valuations were prepared using a hybrid method, which used market approaches to estimate our enterprise value. The hybrid method is a probability-weighed expected return method, or PWERM, where the equity value in one or more scenarios is calculated using an option-pricing method, or OPM. The OPM treats common stock and preferred stock 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 stock has value only if the funds available for distribution to stockholders exceeded the value of the preferred stock liquidation preference at the time of the liquidity event, such as a strategic sale or a merger. The PWERM is a scenario-based methodology that estimates the fair value of common stock based upon an analysis of future values for the company, assuming various outcomes. The common stock value is based on the probability-weighted present value of expected future investment returns considering each of the possible outcomes available as well as the rights of each class of stock. The future value of the common stock under each outcome is discounted back to the valuation date at an appropriate risk-adjusted discount rate and probability weighted to arrive at an indication of value for the common stock. These third-party valuations were performed at various dates, which resulted in valuations of our common stock of $0.92 per share as of May 31, 2016, $1.01 per share as of October 2, 2017, $3.18 per share as of December 31, 2018 and $10.95 per share as of July 15, 2019. In addition to considering the results of these third-party valuations, 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 prices at which we sold shares of preferred stock and the superior rights and preferences of the preferred stock relative to our common stock at the time of each grant; · the progress of our research and development programs, including the status and results of preclinical studies and clinical trials for our product candidates; · our stage of development and commercialization and our business strategy; · external market conditions affecting the biopharmaceutical industry and trends within the biopharmaceutical 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 and our preferred stock; · the likelihood of achieving a liquidity event, such as an initial public offering, or IPO, or sale of our company in light of prevailing market conditions; and · the analysis of IPOs and the market performance of similar companies in the biopharmaceutical industry. The assumptions underlying these valuations represented management’s best estimate, which involved inherent uncertainties and the application of management’s judgment. As a result, if we had used significantly different assumptions or estimates, the fair value of our common stock and our stock-based compensation expense could have been materially different. 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 consolidated financial statements or in our tax returns. Under this method, deferred tax assets and liabilities are determined based on differences between the financial statement carrying amounts and the tax bases of the assets and liabilities using the enacted tax rates in effect in the years in which the differences are expected to reverse. A valuation allowance against deferred tax assets is recorded if, based on the weight of the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. Potential for recovery of deferred tax assets is evaluated by considering several factors, including estimating the future taxable profits expected, estimating future reversals of existing taxable temporary differences, considering taxable profits in carryback periods, and considering prudent and feasible tax planning strategies. We account for uncertain tax positions using a more-likely-than-not threshold for recognizing and resolving uncertain tax positions. The evaluation of uncertain tax positions is based on factors including, but not limited to, changes in the law, the measurement of tax positions taken or expected to be taken in tax returns, the effective settlement of matters subject to audit, new audit activity, and changes in facts or circumstances related to a tax position. As of each balance sheet date, we did not have any uncertain tax positions. Emerging growth company and smaller reporting company status We are an emerging growth company, as defined in the JOBS Act. Under this act, emerging growth companies are permitted to delay adopting new or revised accounting standards applicable to public companies 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. We may remain classified as an EGC until the end of the fiscal year in which the fifth anniversary of our IPO occurs, although if the market value of our common stock that is held by non-affiliates exceeds $700 million as of any June 30 before that time or if we have annual gross revenues of $1.07 billion or more in any fiscal year, we would cease to be an EGC as of December 31 of the applicable year. We also would cease to be an EGC if we issue more than $1 billion of non-convertible debt over a three-year period. We are also a “smaller reporting company,” as such term is defined in Rule 12b-2 of the Exchange Act, meaning that the market value of our common stock held by non-affiliates is less than $700 million and our annual revenue is less than $100 million during the most recently completed fiscal year. We may continue to be a smaller reporting company if either (i) the market value of our common stock held by non-affiliates is less than $250 million or (ii) our annual revenue is less than $100 million during the most recently completed fiscal year and the market value of our common stock held by non-affiliates is less than $700 million. If we are a smaller reporting company at the time we cease to be an emerging growth company, we may continue to rely on exemptions from certain disclosure requirements that are available to smaller reporting companies. Specifically, as a smaller reporting company we may choose to present only the two most recent fiscal years of audited financial statements in our Annual Report on Form 10-K and, similar to emerging growth companies, smaller reporting companies have reduced disclosure obligations regarding executive compensation. Results of operations Comparison of the years ended December 31, 2019 and 2018 Research and development expenses Research and development expenses for the year ended December 31, 2019 were $21.0 million, compared to $14.2 million for the year ended December 31, 2018. The increase of $6.8 million was primarily related to the advancement of our clinical product candidate APR-246. In the first quarter of 2019 we commenced a pivotal Phase 3 clinical trial of APR-246 with azacitidine for frontline treatment of TP53 mutant MDS which is supported by two ongoing Phase 1b/2 investigator initiated trials, one in the U.S. and one in France, testing APR-246 with azacitidine as frontline treatment in TP53 mutant MDS and AML patients. General and administrative expenses General and administrative expenses for the year ended December 31, 2019 were $8.6 million, compared to $2.3 million for the year ended December 31, 2018. The increase of $6.3 million was primarily related to increases of $3.4 million in legal and accounting fees, $0.3 million in consulting fees and $1.9 million in personnel related costs including $1.0 million of non-cash stock-based compensation. The increase in legal, accounting and consulting fees was primarily related to costs associated with the corporate reorganization that was completed in September 2019 as well as the preparation of our financial statements and overall readiness to become a public company. The increase in personnel costs was primarily related to increased non-cash stock-based compensation expense as a result of the addition of a member of senior management in August 2019. Other income and expense Foreign currency gain for the year ended December 31, 2019 was $1.3 million compared to $0.9 million for the year ended December 31, 2018. The increase of $0.4 million was primarily due to a strengthening of the U.S. dollar against the Swedish Krona during the year ended December 31, 2019. Interest income (expense) for the year ended December 31, 2019 consisted primarily of interest expense associated with our facility leases and interest income on our cash and cash equivalents. Interest expense for the year ended December 31, 2018 consisted of an insignificant amount of banking charges or fees. Comparison of the years ended December 31, 2018 and 2017 Research and development expenses Research and development expenses for the year ended December 31, 2018 were $14.2 million, compared to $13.4 million for the year ended December 31, 2017. The increase of $0.8 million was primarily related to the advancement of our clinical product candidate APR-246. General and administrative expenses General and administrative expenses for the year ended December 31, 2018 were $2.3 million, compared to $2.5 million for the year ended December 31, 2018. Other income and expense Other income and expense for the year ended December 31, 2018 consisted of an insignificant amount of banking fees on our cash balances and a foreign currency gain of $1.0 million. Other income and expense for the year ended December 31, 2017 consisted of an insignificant amount of banking charges or fees and a foreign currency gain of $0.7 million. Liquidity and capital resources Since our inception, we have incurred significant losses on an aggregate basis. We have not yet commercialized any of our product candidates, which are in various phases of preclinical and clinical development, 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 through private placements of our preferred and common stock and the net proceeds received from the initial public offering (IPO) of our common stock. Through December 31, 2019, we had received net proceeds of $223.8 million from our sales of preferred and common stock. As of December 31, 2019, we had cash and cash equivalents of $130.1 million. Cash flows The following table summarizes our sources and uses of cash for each of the periods presented: Operating activities Cash used in operating activities 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 $26.7 million for the year ended December 31, 2019 compared to $15.3 million for the year ended December 31, 2018. The increase in cash used in operating activities of $11.5 million was primarily attributable to an increase in our net loss of $12.5 million, resulting from both increased research and development expenses and increased general and administrative expenses discussed previously. Net cash used in operating activities was $15.3 million for the year ended December 31, 2018 compared to $14.0 million for the year ended December 31, 2017. The increase in cash used in operating activities of $1.3 million was primarily attributable to an increase in our net loss of $0.3 million, an increase in non-cash expenses of $0.4 million, resulting primarily from an increase in foreign currency gains of $0.3 million and a decreases in stock-based compensation of $0.1 million, and a decrease in the components of working capital of $0.5 million. Investing activities Cash used in investing activities for the years ended December 31, 2019, 2018 and 2017 was $30,901, $3,702 and $0, respectively. Cash used in investing activities for these years represented the acquisition and property and equipment We expect that investing activities will increase over the next several years. Financing activities Net cash provided by financing activities was $92.6 million for the year ended December 31, 2019 compared to $56.4 million for the year ended December 31, 2018. The increase in cash provided by financing activities of $36.2 million was primarily attributable to net proceeds of $86.9 million received from our IPO which was completed in October 2019 and net proceeds of $5.6 million from the issuance of Series C convertible preferred stock in February 2019. Net cash provided by financing activities was $56.4 million for the year ended December 31, 2018 compared to $23.3 million for the year ended December 31, 2017. The increase in cash provided by financing activities of $33.1 million was attributable to the issuance of Series C convertible preferred stock in November 2018 for net proceeds of $56.4 million. In October 2017, we issued Series B convertible preferred stock for net proceeds of $23.3 million. Funding requirements We expect our expenses to increase substantially in connection with our ongoing development activities related to APR-246 and other product candidates and programs which are still in the early stages of clinical development. In addition, we have incurred and continue to incur additional costs associated with operating as a public company. We expect that our expenses will increase substantially if and as we: · conduct our current and future clinical trials and additional preclinical research of APR-246; · initiate and continue research and preclinical and clinical development of our other product candidates; · seek to identify and develop additional product candidates; · seek marketing approvals for any of our product candidates that successfully complete clinical trials, if any; · establish a sales, marketing, manufacturing and distribution infrastructure to commercialize any products for which we may obtain marketing approval; · require the manufacture of larger quantities of our product candidates for clinical development and potentially commercialization; · maintain, expand, protect and enforce our intellectual property portfolio; · acquire or in-license other drugs and technologies; · defend against any claims of infringement, misappropriation or other violation of third-party intellectual property; · hire and retain additional clinical, quality control and scientific personnel; · build out new facilities or expand existing facilities to support our ongoing development activity; · add operational, financial and management information systems and personnel, including personnel to support our drug development, any future commercialization efforts and our transition to a public company; and · continue to operate as a public company. As of December 31, 2019, we had cash and cash equivalents of $130.1 million. We believe that our existing cash and cash equivalents, will enable us to fund our operating expenses and capital expenditure requirements into 2023. 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. Because of the numerous risks and uncertainties associated with the development of APR-246 and other product candidates and programs and because the extent to which we may enter into collaborations with third parties for development of our product candidates is unknown, we are unable to estimate the timing and amounts of increased capital outlays and operating expenses associated with completing the research and development of our product candidates. Our future capital requirements will depend on many factors, including: · the scope, progress, results and costs of our current and future clinical trials of APR-246 for our current targeted indications; · the scope, progress, results and costs of drug discovery, preclinical research and clinical trials for APR-246 and our other product candidates; · the number of future product candidates that we pursue and their development requirements; · the costs, timing and outcome of regulatory review of our product candidates; · the extent to which we acquire or invest in businesses, products and technologies, including entering into or maintaining licensing or collaboration arrangements for product candidates on favorable terms, although we currently have no commitments or agreements to complete any such transactions; · the costs and timing of future commercialization activities, including drug sales, marketing, manufacturing and distribution, for any of our product candidates for which we receive marketing approval, to the extent that such sales, marketing, manufacturing and distribution are not the responsibility of any collaborator that we may have at such time; · the amount of revenue, if any, received from commercial sales of our product candidates, should any of our product candidates receive marketing approval; · the costs of preparing, filing and prosecuting patent applications, maintaining, protecting and enforcing our intellectual property rights and defending intellectual property-related claims; · our headcount growth and associated costs as we expand our business operations and our research and development activities; and · the costs of operating as a public company. Developing drug products, including conducting preclinical studies 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 for any product candidates or generate revenue from the sale of any products for which we may obtain marketing approval. In addition, our product candidates, if approved, may not achieve commercial success. Our commercial revenues, if any, will be derived from sales of drugs that we do not expect to be commercially available for many years, if ever. Accordingly, we will need to obtain substantial additional funds to achieve our business objectives. Adequate additional funds may not be available to us on acceptable terms, or at all. We do not currently have any committed external source of funds. To the extent that we raise additional capital through the sale of equity or convertible debt securities, ownership interests in our securities may be diluted, and the terms of these securities may include liquidation or other preferences and anti-dilution protections that could adversely affect the rights of our common stockholders. Additional debt or preferred equity financing, if available, may involve agreements that include restrictive covenants that may limit our ability to take specific actions, such as incurring debt, making capital expenditures or declaring dividends, which could adversely impact our ability to conduct our business, and may require the issuance of warrants, which could potentially dilute existing ownership interest. If we raise additional funds through collaborations, strategic alliances or licensing arrangements with third parties, we may have to relinquish valuable rights to our technology, 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 or collaborations, strategic alliances or licensing arrangements with third parties when needed, we may be required to delay, limit, reduce and/or terminate our 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. Contractual obligations and commitments The following table summarizes our contractual obligations at December 31, 2019: (1) Represents minimum payments due for our lease of office space in Boston, Massachusetts under an operating lease agreement that, as amended, expires in 2021 and our lease of office and laboratory space in Solna, Sweden under an operating lease agreement that expires in June 2022. We enter into contracts in the normal course of business with CROs and CMOs for clinical trials, preclinical research studies and testing, manufacturing and other services and products for operating purposes. These contracts do not contain any minimum purchase commitments and are cancelable by us upon prior notice of 30 days and, as a result, are not included in the table of contractual obligations above. Payments due upon cancelation consist only of payments for services provided and expenses incurred up to the date of cancelation. 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. Recent accounting pronouncements See Note 2 to our consolidated financial statements that discusses new accounting pronouncements

<s>[INST] Overview We are a clinicalstage biopharmaceutical company focused on developing and commercializing novel cancer therapeutics that reactivate mutant p53 tumor suppressor protein. p53 is the protein expressed from the TP53 gene, the most commonly mutated gene in cancer. We believe that mutant p53 is an attractive therapeutic target due to the high incidence of p53 mutations across a range of cancer types and its involvement in key cellular activities such as apoptosis. Cancer patients with mutant p53 face a significantly inferior prognosis even when treated with the current standard of care, and a large unmet need for these patients remains. Our lead product candidate, APR246, is a small molecule p53 reactivator that is in latestage clinical development for hematologic malignancies, including myelodysplastic syndromes, or MDS, and acute myeloid leukemia, or AML. APR246 has received Orphan Drug, Fast Track and Breakthrough designations from the FDA for MDS, and Orphan Drug designation from the European Commission for MDS, AML and ovarian cancer, and we believe APR246 will be a firstinclass therapy if approved by applicable regulators. We have commenced a pivotal Phase 3 trial of APR246 with azacitidine for frontline treatment of TP53 mutant MDS and expect initial data from this trial in the second half of 2020. Our pivotal Phase 3 trial is supported by data from two ongoing Phase 1b/2 investigator initiated trials, one in the U.S. and one in France, testing APR246 with azacitidine as frontline treatment in TP53 mutant MDS and AML patients. Aprea Therapeutics AB, or Aprea AB, was originally incorporated in 2002 and commenced principal operations in 2006. We incorporated Aprea Therapeutics, Inc. (the “Company”) in May 2019. In September 2019 we completed a corporate reorganization and, as a result, all of the issued and outstanding stock of Aprea AB was exchanged for common stock, preferred stock or options, as applicable, of the Company. As a result of such transactions, Aprea AB became a whollyowned subsidiary of the Company. We have devoted substantially all of our resources to developing our product candidates, including APR246, 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 through private placements of preferred stock and the net proceeds received from the initial public offering (IPO) of our common stock. Through December 31, 2019, we had received net proceeds of approximately $223.8 million from our sales of preferred and common stock. Since our inception, we have incurred significant losses on an aggregate basis. Our ability to generate product revenue sufficient to achieve profitability will depend on the successful development and eventual commercialization of one or more of our product candidates. Our net losses were $28.1 million, $15.5 million and $15.2 million for the years ended December 31, 2019, 2018 and 2017, respectively. As of December 31, 2019, we had an accumulated deficit of $90.5 million. These losses have resulted primarily from costs incurred in connection with research and development activities, patent investment, and general and administrative costs associated with our operations. 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 if and as we: · conduct our current and future clinical trials and additional preclinical research of APR246; · initiate and continue research and preclinical and clinical development of our other product candidates; · seek to identify and develop additional product candidates; · seek marketing approvals for any of our product candidates that successfully complete clinical trials, if any; · establish a sales, marketing, manufacturing and distribution infrastructure to commercialize any products for which we [/INST] Positive. </s>

Frequency Therapeutics, Inc.

2020-03-26

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 and other financial information included elsewhere in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis contains forward-looking statements that involve risks and uncertainties. You should review the section titled “Risk factors” in this Annual Report on Form 10-K for a discussion of important factors that could cause actual results to differ materially from the results described below. Overview We are a clinical-stage biotechnology company focused on harnessing the body’s innate biology to repair or reverse damage caused by a broad range of degenerative diseases and an industry leader in the science and development of medicines for inner-ear cellular regeneration and hearing restoration. Our initial focus is on advancing our lead product candidate, FX-322, through clinical studies with the goal of developing and commercializing a medicine to help millions of patients with the most common form of hearing loss and build upon the potential of regenerative therapeutics for hearing. Our initial therapeutic focus is sensorineural hearing loss, or SNHL, which is the most prevalent type of hearing loss. We are developing FX-322 to treat the underlying cause of SNHL, which is the loss of hair cells. FX-322 is designed to regenerate hair cells through the activation of progenitor cells already present in the ear. In our Phase 1/2 clinical trial evaluating FX-322 in 23 patients with stable SNHL, we observed a statistically significant and clinically meaningful improvement in key measures of hearing loss, including word recognition, and clarity of sounds, and FX-322 was observed to be well-tolerated. We commenced dosing of a Phase 2a clinical trial of FX-322 in patients with SNHL in October 2019. As of March 26, 2020, the Phase 2a clinical trial was approximately at the halfway point of enrollment based on the original trial design and we are continuing to enroll and dose patients in the trial. However, we have observed an impact on the Phase 2a clinical trial from the COVID-19 pandemic as several clinical trial sites have informed us that they have temporarily halted enrollment in the trial. We expect that the effects of the pandemic may result in other clinical trial sites being similarly affected for an unknown period of time, slowing or temporarily halting patient enrollment and potentially impacting patient retention. As a result, we will provide updated guidance on the timing of completion and reporting of top-line data of the Phase 2a clinical trial once we better understand the extent of the impact of the COVID-19 pandemic on the trial. Nevertheless, we believe that, if necessary, we could achieve the key objectives of the Phase 2a clinical trial with fewer study subjects than originally designed. We are also working to identify a product candidate for the treatment of multiple sclerosis, or MS. This program focuses on activating progenitor cells in the central nervous system to repair the myelin sheath that protects nerves and may have the potential to reverse damage done by the disease. We intend to submit an investigational new drug application or, IND, to the U.S. Federal Drug Administration, or the FDA, for our MS product candidate in the second half of 2021. In October 2019, we completed the initial public offering of our common stock, or the IPO. In the IPO, we issued and sold 6,325,000 shares of our common stock at a price to the public of $14.00 per share, inclusive of the underwriters’ exercise in part of their over-allotment option. We received approximately $79.7 million in net proceeds, after deducting underwriting discounts and commissions and other offering expenses. In July 2019, we closed our Series C convertible preferred stock financing in which we issued and sold 39,492,960 shares of our Series C convertible preferred stock for aggregate gross proceeds of approximately $61.7 million. In July 2019, we also entered into a License and Collaboration Agreement, or the Astellas Agreement, with Astellas Pharma Inc., or Astellas, pursuant to which Astellas paid us an upfront payment of $80.0 million. Since our formation in 2014, we have devoted substantially all our resources to developing our PCA platform, conducting research and development activities, including product candidate development, recruiting skilled personnel, establishing our intellectual property portfolio, and providing general and administrative support for these operations. We have financed our operations primarily through proceeds from the sale of convertible notes and of our convertible preferred stock, the IPO and the Astellas Agreement. To date, we have raised approximately $316.5 million through a combination of convertible notes, convertible preferred stock financings, the upfront payment under the Astellas Agreement, grants and the IPO. Since our formation, we have incurred significant operating losses and have not generated any revenue from the sale of products. 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. Our net losses were $18.7 million, $19.2 million and $20.2 million for the years ended December 31, 2019, 2018 and 2017, respectively. As of December 31, 2019, we had an accumulated deficit of $68.9 million. We expect our operating expenses to increase substantially in connection with the expansion of our product development programs and capabilities. In addition, we expect to continue to incur significant additional costs associated with operating as a public company. We will not generate revenue from product sales unless and until we successfully complete clinical development, obtain regulatory approval for, and successfully commercialize our product candidates, or until our collaborators do so, which could result in milestone payments or royalties to us. 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. As a result of these anticipated expenditures, 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 cash needs through a combination of public or private equity or debt financings and other sources, which may include current and new collaborations with third parties. Adequate additional financing may not be available to us on acceptable terms, or at all. Our inability to raise capital as and when needed would have a negative impact on our financial condition and our ability to pursue our business strategy. We cannot be sure that we will ever generate sufficient revenue to achieve profitability. Because of the numerous risks and uncertainties associated with the development of therapeutics, 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 can 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 required to raise additional capital on terms that are unfavorable to us or we may be unable to continue our operations at planned levels and be forced to reduce or terminate our operations. License and collaboration agreements Astellas Pharma Inc. In July 2019, we entered into the Astellas Agreement with Astellas, under which we granted Astellas an exclusive, royalty-bearing, sub-licensable, nontransferable license to certain patent rights to research, develop, manufacture, have manufactured, use, seek, and secure regulatory approval for, commercialize, offer for sale, sell, have sold and import, and otherwise exploit licensed products containing both a GSK-3 inhibitor and an HDAC inhibitor, or the Astellas licensed products, including our product candidate FX-322, outside of the United States. We and Astellas have agreed to jointly develop the Astellas licensed products, including carrying out joint studies. Each party has agreed to use commercially reasonable efforts to carry out development activities assigned to it under an agreed-upon development plan. Astellas has agreed to use commercially reasonable efforts to obtain regulatory approval for at least one Astellas licensed product in SNHL and in age-related hearing loss, in each case in one major Asian country and one major European country. We have agreed to use commercially reasonable efforts to obtain regulatory approval for at least one Astellas licensed product in the United States. Astellas has the sole right to commercialize the Astellas licensed products outside of the United States and we have the sole right to commercialize the Astellas licensed products in the United States. Astellas has agreed to use commercially reasonable efforts to commercialize Astellas licensed products in a major Asian country and a major European country following receipt of regulatory approval in such countries. As a consideration for the licensed rights under the Astellas Agreement, Astellas paid us an upfront payment of $80.0 million in July 2019 and has agreed to pay potential development milestones up to $230.0 million. Specifically, we would receive development milestone payments of $65.0 million and $25.0 million upon the first dosing of a patient in Phase 2b clinical trial for SNHL in Europe and Asia, respectively and $100.0 million and $40.0 million upon the first dosing of a patient in a Phase 3 clinical for SNHL in Europe and Asia, respectively. If the Astellas Licensed Products are successfully commercialized, we would be eligible for up to $315.0 million in potential commercial milestone payments and tiered royalties at rates ranging from low to mid-teen percentages. The parties shall share equally, on a 50/50 basis, all out-of-pocket costs and joint study costs for all the joint activities conducted pursuant to the development plans or the joint manufacturing plan. Pursuant to our Exclusive Patent License Agreement, or the MIT License, with the Massachusetts Institute of Technology, or MIT, we are required to pay MIT a royalty on sublicense revenues. A royalty of $16.0 million related to the $80.0 million upfront payment received from Astellas was expensed in the quarter ended September 30, 2019 and paid in November 2019.The $80.0 million upfront payment received from Astellas in July 2019 has been recorded as deferred revenue and is being recognized as revenue, using the input method, over the period in which we will be conducting Phase 2a clinical trials for FX-322. We have recognized $28.9 million of the $80.0 million as revenue as of December 31, 2019. Massachusetts Institute of Technology In December 2016, we entered into the MIT License, with MIT under which we received an exclusive, worldwide, royalty-bearing license to certain patent rights to develop, make, have made, use, sell, offer to sell, lease, and import products, or the MIT licensed products, and to develop and perform processes, or the MIT licensed processes, which incorporate the licensed technology for the treatment of disease, including but not limited to the prevention and remediation of hearing loss. We are required to use diligent efforts to develop and commercialize the MIT licensed products or processes, and to make such products or processes reasonably available to the public. We are also subject to certain development obligations with regards to a first MIT licensed product. We have satisfied certain obligations related to preclinical studies and the filing of an IND for a first MIT licensed product with our development activities related to FX-322. Our future development obligations are: (i) to commence a Phase II clinical trial for such product within two years of the IND filing for such product, (ii) to commence a Phase III clinical trial for such product within five years of the IND filing for such product, (iii) to file a New Drug Application, or NDA, or equivalent with the FDA or comparable European regulatory agency for such product within nine years of the IND filing for such product, and (iv) to make a first commercial sale of such product within 11 years of the IND filing for such product. We also have certain development obligations with regards to a second MIT licensed product. Upon entering into the MIT License, we paid a $50 thousand license fee payment and issued shares of our common stock equal to 5% of our then-outstanding capital stock to MIT. We are required to pay certain annual license maintenance fees ranging from $30 thousand to $0.1 million per year prior to first commercial sale of a MIT licensed product and an annual license maintenance fee of $0.2 million every year afterwards, which may be credited to running royalties during the same calendar year, if any. We are also required to make potential milestone payments in an aggregate amount of up to $2.9 million on each MIT licensed product or process. In addition, we agreed to pay a low single-digit royalty on the MIT licensed products and processes and a low-twenties royalty on sub-license revenues. In the year ended December 31, 2019, we paid MIT a $16.0 million royalty on the upfront license fee received from Astellas. See “Business-License and collaboration agreements-Massachusetts Institute of Technology.” Massachusetts Eye and Ear Infirmary In February 2019, we entered into an Non-Exclusive Patent License Agreement, or the MEEI License, with the Massachusetts Eye and Ear Infirmary, or MEEI, under which we received a non-exclusive, non-sub-licensable, worldwide, royalty-bearing license to certain patent rights to develop, make, have made, use, sell, offer to sell, lease, and import products, and to develop and perform processes that incorporate the licensed technology for the treatment or prevention of hearing loss, or the MEEI licensed products. We are obligated to use diligent efforts to develop and commercialize the MEEI licensed products. We are also subject to milestone timeline obligations to dose a first patient in a Phase II trial by December 31, 2020 and to dose a first patient in a Phase III trial by December 31, 2024. Upon entering into the MEEI License, we made a $20 thousand license fee payment. We are obligated to pay certain annual license maintenance fees between $5 thousand and $7.5 thousand per each MEEI patent family case number included in the licensed MEEI patent rights prior to first commercial sale of an MEEI licensed product. We are also obligated to pay a minimum annual royalty payment of $15 thousand per each MEEI patent family case number included in the licensed MEEI patent rights after first commercial sale of an MEEI licensed product. We are also obligated to make milestone payments up to $350 thousand on each product or process that incorporates the licensed patent rights. In addition, we have agreed to pay a low single-digit royalty on products and processes that incorporate the licensed patent rights. See “Business-License and collaboration agreements-Massachusetts Eye and Ear Infirmary.” The Scripps Research Institute (California Institute for Biomedical Research) In September 2018, we entered into a license agreement, or the CALIBR License, with the California Institute for Biomedical Research, or CALIBR, a division of Scripps, under which we received an exclusive, worldwide, royalty-bearing license to certain patent rights to make, have made, use, sell, offer to sell, and import products, or the CALIBR licensed products, which incorporate licensed technology for the treatment of MS. We have agreed to use commercially reasonable efforts to develop, manufacture, and sell at least one CALIBR licensed product. We are also subject to certain milestone timeline obligations to: (i) submit an IND (or equivalent) for a CALIBR licensed product by the 30th month after the effective date of the CALIBR License, (ii) initiate a Phase II clinical trial (or equivalent) for a CALIBR licensed product by the fourth anniversary of the effective date of the CALIBR License, and (iii) initiate a Phase III clinical trial (or equivalent) for a CALIBR licensed product by the sixth anniversary of the effective date of the CALIBR License. Upon entering into the CALIBR License, we made a $1.0 million license fee payment, and are required to make milestone payments in an aggregate amount of up to $26.0 million for each category of CALIBR licensed products. Category 1 is any CALIBR licensed products containing a compound that modulates any muscarinic receptor, and Category 2 is any CALIBR licensed products not included in Category 1 that could differentiate oligodendrocyte precursor cells from in vitro studies and/or are active in animal models relevant to MS. We are also required to pay a mid-single-digit royalty on CALIBR licensed products and a royalty on sub-license revenues ranging from a low-teen percentage to 50%. See “Business-License and collaboration agreements-The Scripps Research Institute (California Institute for Biomedical Research).” The Scripps Research Institute In September 2018, we entered into a Research Funding and Option Agreement, or the Scripps option agreement, with Scripps, under which we were granted an exclusive option to acquire an exclusive, sublicensable, worldwide license under certain intellectual property related to the treatment of MS. As consideration for the Scripps option agreement, we are required to make funding payments totaling $0.7 million to Scripps to support its research activities. Scripps has agreed to use reasonable efforts to perform the research program pursuant to the Scripps option agreement. The Scripps option agreement had a one-year term and was renewed for a second year by mutual written agreement. We have the right to terminate by giving 90 days’ advance notice. Scripps has the right to terminate in the event of nonpayment by us that remains uncured for 10 days. Each party has the right to terminate in the event of the other party’s material breach that remains uncured for 60 days or if the other party becomes bankrupt. See “Business-License and collaboration agreements-The Scripps Research Institute (California Institute for Biomedical Research).” Cambridge Enterprise Limited In December 2019, we entered into an Exclusive Patent License Agreement, or the Cambridge License, with Cambridge, under which we received an exclusive, worldwide, royalty-bearing license to certain patent rights to make, have made, use, sell, offer to sell, and import products, or the Cambridge licensed products, which incorporate licensed technology for the treatment of demyelinating diseases. We also have the right to grant sublicenses under the Cambridge License. Cambridge reserves the right to use for itself (as well as the investors and the funder) and the right to grant nonexclusive licenses to other academic institutions for any academic publication, research and teaching and clinical patient care. We have agreed to use diligent and good faith efforts to develop and commercially exploit at least one Cambridge licensed product. Upon entering into the Cambridge License, we made a $50 thousand license fee payment. We are obligated to pay an annual license fee of $50 thousand. We are also obligated to make milestone payments up to $10.5 million on each Cambridge licensed product. In addition, we have agreed to pay a low single-digit royalty on products that incorporate the licensed patent rights, subject to offset in certain circumstances. The Cambridge License continues in effect on a country-by-country basis until the expiration or revocation, without right of further appeal, of all licensed issued patents and filed patent applications, unless terminated earlier. We have the right to terminate for any reason upon 90 days’ prior written notice. Each party has the right to terminate immediately if the other party ceases to carry on its business. Either party may also terminate the Cambridge License for material breach if such breach remains uncured for 30 days. Cambridge may also terminate the Cambridge License if we fail to diligently develop and commercially exploit at least one Cambridge licensed product or we or our affiliates or sub-licensees commence any action against Cambridge to declare or render any claim of the licensed patent rights invalid, unpatentable, unenforceable, or not infringed. 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 product sales in the foreseeable future. In July 2019, we entered into the Astellas Agreement and received an upfront license fee payment of $80.0 million. In accordance with ASC 606, we are recognizing the $80.0 million as revenue over the period that research and development services and the Phase 2a clinical study for FX-322 are being provided using the input method. For the purpose of revenue recognition, this is the period from execution of the Astellas Agreement to, based on management’s best estimate, the estimated completion date of the Phase 2a clinical study. In the year ended December 31, 2019, we recognized $28.9 million of the $80.0 million upfront fee as revenue. This reflects revenue of $16.0 million equal to the royalty expense under the MIT License as well as $12.9 million from applying the input method to the remaining $64.0 million of the upfront payment. Royalty We are required to pay royalties under the MIT License on the receipt of fees for the sublicense of the MIT intellectual property. We expensed the $16.0 million royalty due MIT on the $80.0 million license fee pursuant to the Astellas Agreement in the third quarter of 2019. Research and development expenses Research and development expenses consist primarily of costs incurred for our research activities, including our discovery efforts and for the development of our product candidate, FX-322. These include the following: • 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, or CROs, and other third parties that conduct preclinical research and development activities and clinical trials on our behalf; • costs to manufacture our clinical trial material for use in our preclinical studies and clinical trials; • costs of outside consultants, including their fees and related travel expenses; • costs of laboratory supplies and acquiring, developing and manufacturing preclinical study and clinical trial materials; • option and license payments made to third parties, including MIT, Scripps, MEEI and Cambridge, for intellectual property used in research and development activities; and • facility-related expenses, which include direct depreciation costs and expenses for rent and maintenance of facilities and other operating costs if specifically, identifiable to research activities. We expense research and development costs as incurred. We track external research and development costs, including the cost of services, outsourced research and development, clinical trials, contract manufacturing, laboratory equipment and maintenance, and certain other development costs, by product candidate when the costs are specifically identifiable to a product candidate. Internal and external costs associated with infrastructure resources, other research and development costs, facility-related costs, and depreciation and amortization that are not identifiable to a specific product candidate are included in the platform development, early-stage research, and unallocated expenses category in the table below. The following table summarizes our research and development expenses by product candidate or development program for the years ended December 31, 2019, 2018 and 2017: We expect that our research and development expenses will continue to increase substantially for the foreseeable future as we initiate and complete our Phase 2a clinical trial and additional clinical trials for FX-322 and continue to discover and develop additional product candidates. Product candidates in later stages of clinical development generally have higher development costs than those in earlier stages of clinical development, primarily due to increased scale, duration and the higher costs associated with later stage clinical trials. We cannot determine with certainty the duration and costs of future clinical trials of FX-322 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. The duration, costs, and timing of clinical trials and development of FX-322 and any other product candidate we may develop will depend on a variety of factors, including: • the scope, rate of progress, expense and results of clinical trials of FX-322, as well as of any future clinical trials of other product candidates and other research and development activities that we may conduct; • the actual probability of success for our product candidates, including their safety and efficacy, early clinical data, competition, manufacturing capability, and commercial viability; • significant and changing government regulation and regulatory guidance; • the timing and receipt of any marketing approvals; • the progress of the development efforts of parties with whom we may enter into collaboration agreements; • our ability to secure manufacturing supply through relationships with third parties; • the commercialization of our product candidates, if and when approved; and • the expense of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights. 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. 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 expenses for rent and maintenance of facilities, and other operating costs that are not specifically attributable to research and development activities. We expect that our general and administrative expenses will increase in the future as we increase our personnel headcount to support our continued research activities and development of product candidates. In addition, due to our IPO in October 2019, we 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 the requirements of The Nasdaq Stock Market LLC and the SEC; director and officer insurance costs; and investor and public relations costs. Interest income Interest income consists of interest earned on cash equivalents and short-term investments. Interest expense Interest expense consists of interest paid on convertible notes payable which were converted in our Series A convertible preferred stock financing in 2017 and our Series B convertible preferred stock financing in 2018. Realized gain on investments Realized gain on investments represents the gain realized on our marketable securities in the year ended December 31, 2019. Loss on extinguishment of debt In 2015 and 2016, we issued notes payable, which were convertible at a 20% discount to the price of shares issued in a qualified financing. In March 2017, the notes payable converted into Series A convertible preferred stock at a 20% discount to the price of the Series A convertible preferred stock, which we recorded as a $3.7 million loss on extinguishment of debt. In 2018, we issued notes payable, which were convertible at a 5% discount to the price of shares issued in a qualified financing. In October 2018, the notes payable converted into Series B convertible preferred stock at a 5% discount to the price of the Series B convertible preferred stock, which we recorded as a $0.3 million loss on extinguishment of debt. Foreign exchange gain (loss) Foreign exchange gain (loss) represents the gain or loss recorded as a result of remeasuring the financial statements of our foreign subsidiaries. Income taxes Since our inception in 2014, we have generated cumulative federal and state net operating loss and research and development credit carryforwards for which we have not recorded any net tax benefit due to uncertainty around utilizing these tax attributes within their respective carryforward periods. As of December 31, 2019, we had federal net operating loss carryforwards, or NOLs, of approximately $50.2 million and Massachusetts state NOLs of approximately $41.2 million which may be available to offset future taxable income. Our federal NOLs include $22.4 million available to reduce future taxable income through 2037 and approximately $27.8 million of NOLs that do not expire and are available to reduce future taxable income indefinitely. The state NOLs are available to offset future taxable income through 2039. As of December 31, 2019, we also had federal and Massachusetts research and development tax credit carryforwards of $0.7 million and $0.5 million, respectively, which are available to offset federal and state tax liabilities through 2039 and 2034, respectively. Realization of future tax benefits is dependent on many factors, including our ability to generate taxable income within the NOL period. NOL and tax credit carryforwards 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 provided under Sections 382 and 383 of the Internal Revenue Code of 1986, as amended, or the Code, as well as under similar state provisions. These ownership changes may limit the amount of NOLs that can be utilized annually to offset future taxable income. In general, an ownership change, as defined under Section 382 of the Code, or Section 382, results from transactions increasing the ownership of certain shareholders or public groups in the stock of a corporation by more than 50% over a three-year period. We have completed several financings and have conducted a study to assess whether a change of control has occurred or whether there have been multiple changes of control since inception and have determined that an ownership change did occur in March 2017. Accordingly, utilization of $12.4 million of the federal NOLs that were incurred prior to March 2017 (pre-ownership change) is limited under Section 382. After the Section 382 limitations, we may utilize approximately $10.8 million of our pre-ownership change NOLs based upon an annual usage of approximately $1.6 million for each of the next five years after the ownership change and approximately $0.2 million for each of the 15 years thereafter. The remaining pre-ownership change NOLs of approximately $1.6 million were written off due to expiration under limitation. The limitation has been determined by first multiplying the value of our stock at the time of the ownership change by the applicable long-term tax-exempt rate. These NOLs may be subject to further annual limitations under Section 382 in the event of future changes in ownership. Additionally, we determined that a second ownership change occurred in October of 2019 as a result of the IPO. Accordingly, utilization of approximately $46.1 million of the federal NOL carryforwards incurred prior to October 2019 is also limited under Section 382. We have determined that we will be able to utilize the entire $46.1 million of pre-ownership change NOL’s based upon the limitations calculated from the October 2019 ownership change. These NOL’s may be subject to further annual limitations under Section 382 in the event of future changes in ownership. In December 2017, the Tax Cuts and Jobs Act was signed into U.S. law. The Tax Cuts and Jobs Act included a number of changes to the 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%, which went into effect on January 1, 2018, as well as a limitation of the deduction for NOLs 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 NOLs 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 Tax Cuts and Jobs Act. Results of operations Comparison of 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 Revenue was $28.9 million for the year ended December 31, 2019. We had no revenue for the year ended December 31, 2018. In July 2019, we entered into the Astellas Agreement and received an upfront license fee payment of $80.0 million. In accordance with ASC 606, we are recognizing the $80.0 million as revenue over the period that research and development services and the Phase 2a clinical study for FX-322 are being provided using the input method. In the year ended December 31, 2019, we recognized revenue of $16.0 million equal to the royalty payment under the MIT License as well as $12.9 million applying the input method to the remaining $64.0 million of the upfront payment. Research and development expenses Research and development expenses for the year ended December 31, 2019 were $18.8 million, compared to $11.9 million for the year ended December 31, 2018. The increase of $6.9 million was primarily due to an increase of $1.6 million in FX-322 external research and development expenses and an increase of $5.3 million in platform development, early-stage research and unallocated expenses. The $4.3 million of FX-322 external development costs incurred for the year ended December 31, 2019 consisted primarily of $2.1 million of clinical development costs including manufacturing costs for FX-322 to be used in clinical trials, $0.7 million of outside consulting costs, $1.1 million in clinical trial costs and $0.3 in milestone payments under the MIT License. The $2.7 million of FX-322 external development costs incurred in the year ended December 31, 2018 consisted primarily of approximately $1.6 million of preclinical costs for safety testing and consulting, and approximately $1.1 million related to conducting the Phase 1 clinical trial. FX-322 external development costs for the year ended December 31, 2018 are presented net of approximately $0.7 million in research and development tax credits received from the Australian government related to our Phase 1 clinical trial conducted in Australia. Platform development, early-stage research and unallocated expenses were $14.5 million for the year ended December 31, 2019, compared to $9.2 million for the year ended December 31, 2018. The increase of $5.3 million was primarily due to a $0.8 million increase in outsourced research and development spending on our development programs, excluding our FX-322 program, a $3.8 million increase in employee-related costs associated with increased headcount to support preclinical and clinical development of FX-322 and research on our PCA platform development and a $0.7 million increase in facility-related and other costs associated with the increase in research and development headcount. General and administrative expenses General and administrative expenses were $14.8 million for the year ended December 31, 2019, compared to $7.1 million for the year ended December 31, 2018. General and administrative expenses increased by $7.8 million due to an increase of $1.3 million in the infrastructure necessary to manage research and development and fundraising activities, increases of $0.7 million in directors and officers insurance, $0.3 million in audit, tax and consulting fees, $1.5 million in legal and patent filing fees incurred to file and defend intellectual property, $0.7 million in corporate legal fees and $3.1 million in employee-related costs as we increased our general and administrative headcount to manage our growth and the impact of becoming a public company. Interest income Interest income was $1.8 million for the year ended December 31, 2019 compared to $0.0 million for the year ended December 31, 2018, due to an increase in cash equivalents and short-term investments in 2019. Interest expense Interest expense was $0.1 million for the year ended December 31, 2018. This represents interest on convertible notes payable issued in 2018 and converted into Series B convertible preferred stock in 2018. We did not incur interest expense in the year ended December 31, 2019. Realized gain on investments Realized gain on investments was $138 thousand for the year ended December 31, 2019 due to our purchasing short-term marketable securities in 2019. We held no investments in the year ended December 31, 2018. Foreign exchange gain Foreign exchange gain was $7 thousand for the year ended December 31, 2019 as compared to $151 thousand for the year ended December 31, 2018. The decrease of $144 thousand was due to differences in foreign exchange remeasurement of the financial statements of our foreign subsidiaries. Comparison of years ended December 31, 2018 and 2017 The following table summarizes our results of operations for the years ended December 31, 2019 and 2018: Revenue We had no revenue for the years ended December 31, 2018 and 2017. Research and development expenses Research and development expenses for the year ended December 31, 2018 were $11.9 million, compared to $12.0 million for the year ended December 31, 2017. The decrease of $0.1 million in 2018 was primarily due to a decrease of $4.3 million in FX-322 external research and development expenses and a comparable increase of $4.2 million in platform development, early-stage research, and unallocated expenses. The $2.7 million of FX-322 external development costs incurred in 2018 consisted primarily of approximately $1.6 million of preclinical costs for safety testing and consulting and approximately $1.1 million of costs of conducting the Phase 1 clinical trial and the Phase 1/2 clinical trial. FX-322 external development costs for the year ended December 31, 2018 are presented net of approximately $0.7 million in research and development tax credits received from the Australian government related to our Phase 1 clinical trial conducted in Australia. The $6.9 million of FX-322 external development costs incurred in 2017 consisted primarily of approximately $4.5 million of preclinical costs, including $3.2 million for toxicology and the manufacture of FX-322 for toxicity testing, and approximately $2.4 million of clinical development costs for conducting the Phase 1 clinical trial and manufacturing FX-322 to be used in the Phase 1 clinical trial and in the Phase 1/2 clinical trial conducted in 2018. Platform development, early-stage research, and unallocated expenses were $9.2 million for the year ended December 31, 2018, compared to $5.0 million for the year ended December 31, 2017. The increase of $4.2 million in 2018 is primarily due to a $2.8 million increase in outsourced research and development spending on our development programs, excluding our FX-322 program. This includes approximately $1.7 million of outsourced research to Scripps for our MS program, including an upfront $1.0 million license fee. We also incurred $1.3 million of increased employee-related cost associated with increased headcount to support our preclinical and clinical development of FX-322 and research on our PCA platform development. General and administrative expenses General and administrative expenses were $7.1 million for the year ended December 31, 2018, compared to $4.3 million for the year ended December 31, 2017. General and administrative expenses increased by $2.7 million in 2018 due to increased business development activities, increase in the infrastructure necessary to manage research and development, and fund-raising activities. Contributing to the increase were increases of $0.8 million in audit, tax, and consulting fees, $0.5 million in legal and patent filing fees incurred to file and defend intellectual property, $0.4 million in corporate legal fees, and $0.5 million in employee-related costs as we increased our general and administrative headcount to manage our growth. Loss on extinguishment of debt Loss on extinguishment of debt was $0.3 million for the year ended December 31, 2018, compared to $3.7 million for the year ended December 31, 2017. The decrease of $3.4 million in loss on extinguishment of debt was due to the lower discount rate of 5% upon conversion of the notes payable that converted in 2018 compared to the discount rate of 20% for notes payable that converted in 2017 and the lower amount of notes that converted in 2018 compared to 2017. Interest expense Interest expense was $0.1 million for the year ended December 31, 2018 compared to $0.2 million for the year ended December 31, 2017. The decrease of $0.1 million was due to lower amounts outstanding under convertible notes payable. Foreign exchange gain (loss) Foreign exchange gain (loss) was a gain of $0.2 million for the year ended December 31, 2018, compared to a foreign exchange loss of $8 thousand for the year ended December 31, 2017. The increase of $0.2 million was due to differences in foreign exchange remeasurement of the financial statements of our foreign subsidiaries. Liquidity and capital resources Since our inception, we have incurred significant operating losses. We expect to continue to incur significant expenses and operating losses for the foreseeable future as we advance the preclinical and clinical development of our product candidates. We expect that our research and development and general and administrative costs will continue to increase, including in connection with conducting preclinical studies and clinical trials for our product candidates, contracting with contract manufacturing organizations, or CMOs, to support preclinical studies and clinical trials, expanding our intellectual property portfolio, and providing general and administrative support for our operations particularly as a public company. As a result, we will need additional capital to fund our operations, which we may obtain from additional equity or debt financings, collaborations, licensing arrangements or other sources. We do not currently have any approved products and have never generated any revenue from product sales. We have financed our operations primarily through proceeds from the sale of our convertible notes, convertible preferred stock, our IPO and the upfront payment under the Astellas Agreement. To date, we have raised approximately $316.5 million through a combination of convertible notes, convertible preferred stock, the upfront payment under the Astellas Agreement, grants and our IPO. Our cash, cash equivalents and short-term investments totaled $217.4 million as of December 31, 2019. In October 2019, we completed an IPO of our common stock and issued and sold 6,325,000 shares of common stock at a public offering of $14.00 per share, inclusive of the exercise in part by the underwriters of their option to purchase additional shares, resulting in net proceeds of $79.7 million after deducting underwriting discounts and commissions and offering expenses. We had no indebtedness as of December 31, 2019. In July 2019, we closed our Series C convertible preferred stock financing, in which we issued 39,492,960 shares of our Series C convertible preferred stock, for aggregate gross proceeds of approximately $62.0 million. Cash flows The following table summarizes our sources and uses of cash for the periods presented: Cash flows for the year ended December 31, 2019 Operating activities Net cash provided by operating activities for the year ended December 31, 2019 was $34.2 million, primarily consisting of a net loss of $18.7 million as we incurred expenses associated with our FX-322 program, platform development and early-stage research, and general and administrative expenses. In addition, we had non-cash charges of $4.3 million primarily for depreciation, stock-based compensation expense and deferred lease incentives. Net cash used in operating activities was also impacted by a net $48.0 million change in operating assets and liabilities, including an increase of $51.5 million in deferred revenues from the upfront payment under the Astellas Agreement and a $1.5 million increase accrued expenses, which were partially offset by an increase of $3.3 million in prepaid expenses and other current assets and a $.6 million decrease in accounts payable.. Investing activities Net cash used in investing activities for the year ended December 31, 2019 was $18.3 million, which was attributable to $1.1 million of purchases of property and equipment and $17.2 million of net purchases of marketable securities. Financing activities Net cash provided by financing activities for the year ended December 31, 2019 was $142.0 million, consisting of proceeds from our IPO of $79.7 million, the issuance of our Series C convertible preferred stock of $61.7 million, the issuance of additional shares of our Series B convertible preferred stock of $0.3 million, and $0.3 million of proceeds from the exercise of stock options. Cash flows for the year ended December 31, 2018 Operating activities Net cash used in operating activities for the year ended December 31, 2018 was $17.0 million, primarily consisting of a net loss of $19.2 million as we incurred expenses associated with our FX-322 program, platform development and early-stage research, and general and administrative expenses. In addition, we had non-cash charges of $1.3 million for depreciation, stock-based compensation expense, non-cash interest expense, loss on extinguishment of debt, and deferred lease incentives. Net cash used in operating activities was also impacted by $0.8 million in changes in operating assets and liabilities, including $0.8 million in accounts payable, and $0.7 million in accrued expenses, which were partially offset by an increase of $0.7 million in grants receivable, prepaid expenses, and other current assets. Investing activities Net cash used in investing activities for the year ended December 31, 2018 was $0.4 million, which was attributable to purchases of property and equipment. Financing activities Net cash provided by financing activities for the year ended December 31, 2018 was $41.7 million, consisting primarily of the net proceeds from the issuance of our Series B convertible preferred stock financing of $37.8 million, including the issuance and subsequent conversion of $5.0 million notes payable into Series B convertible preferred stock and net of offering costs. We also issued shares of preferred stock in Frequency Therapeutics Japan KK, our majority-owned subsidiary, in 2018 for proceeds of $3.8 million, which has been recorded as a liability. Cash flows for the year ended December 31, 2017 Operating activities Net cash used in operating activities for the year ended December 31, 2017 was $14.6 million, primarily consisting of our net loss of $20.2 million as we incurred expenses associated with preclinical and clinical activities on our FX-322 program, research activities on other applications for our PCA platform, and incurred general and administrative expenses. In addition, we had non-cash charges of $5.3 million for depreciation, stock-based compensation expense, non-cash interest expense, loss on extinguishment of debt, deferred lease incentives, and the issuance of common stock for a license agreement. Net cash used in operating activities was also impacted by $0.3 million in changes in operating assets and liabilities, including $0.4 million in accrued expenses, which was partially offset by a decrease in accounts payable of $0.2 million and an increase of $0.1 million in grants receivable, prepaid expenses, and other current assets. Investing activities Net cash used in investing activities for the year ended December 31, 2017 was $1.9 million, which was attributable to purchases of property and equipment. Financing activities Net cash provided by financing activities for the year ended December 31, 2017 was $28.0 million, primarily consisting of the net proceeds from the issuance of our Series A convertible preferred stock, net of expenses. Funding requirements Our operating expenses increased substantially in the years ended December 31, 2019 and 2018 and are expected to increase substantially in the future in connection with our ongoing activities, particularly as we advance FX-322 through clinical trials and as we research and develop additional product candidates including preclinical activities, studies for INDs, and initiation of human clinical trials. In addition, we expect to incur additional general and administrative costs to build the infrastructure necessary to manage the growth of our research and development efforts and the increased costs associated with operating as a public company. Specifically, our costs and expenses will increase as we: • advance the clinical development of FX-322; • pursue the preclinical and clinical development of other product candidates using our PCA platform, including our program for the treatment of MS; • in-license or acquire the rights to other products, product candidates or technologies; • maintain, expand, and protect our intellectual property portfolio; • hire additional personnel in research, manufacturing, and regulatory and clinical development, as well as management personnel; and • expand our operational, financial, investor relations, and management systems and increase personnel, including personnel to support our operations as a public company. 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 2022. We have based this estimate on assumptions that may prove to be incorrect, and we could utilize our available capital resources sooner than we expect. Because of the numerous risks and uncertainties associated with the research, development, and commercialization of therapeutics, it is difficult to estimate with certainty the amount of our working capital requirements. Our future funding requirements will depend on many factors, including: • the progress, costs, and results of our clinical development and clinical trials for FX-322; • the progress, costs, and results of our additional research and preclinical development programs, including our program for the treatment of MS; • the outcome, timing and cost of meeting regulatory requirements established by the FDA and comparable foreign regulatory authorities, if applicable, for our product candidates; • the costs and timing of internal process development, manufacturing activities, and clinical trial management associated with FX-322 and other product candidates we advance through preclinical and clinical development; • our ability to establish and maintain strategic collaborations, licensing or other agreements and the financial terms of such agreements; • the scope, progress, results, and costs of any product candidates that we may derive from our PCA platform or any other product candidates we may develop alone or with collaborators; • the extent to which we in-license or acquire rights to other products, product candidates, or technologies; • additions or departures of key scientific or management personnel; • the costs and timing of preparing, filing, and prosecuting patent applications, maintaining and protecting our intellectual property rights, and defending against any intellectual property-related claims; and • the costs and timing of future commercialization activities, including product manufacturing, marketing, sales, and distribution for any product candidates for which we or our collaborators obtain marketing approval. Until such time as we can generate significant revenue from product sales, if ever, we expect to finance our cash needs through a combination of public or private equity or debt financings and other sources, which may include current and new collaborations with third parties. 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 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 capital expenditures or declaring dividends. If we raise additional funds through other sources, such as collaboration agreements, strategic alliances, licensing arrangements or marketing and distribution arrangements, we may have to relinquish valuable rights to our technologies, future revenue streams, product development, and 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 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 is a summary of our contractual obligations and commitments as of December 31, 2019: Payments due by period Total Less than 1 year 1 - 3 years 4 - 6 years More than 6 years (in thousands) Operating lease obligations (1) $ 54,371 $ $ 13,237 $ 14,386 $ 26,244 (1) Represents future minimum lease payments under our operating leases for office and laboratory space at our Woburn, Massachusetts, Lexington, Massachusetts and Farmington, Connecticut facilities (see Note 16 of notes to our consolidated financial statements included elsewhere in this Annual Report on Form 10K for additional information on these lease agreements). We have not included future milestone payments under our collaboration and license agreements in the table above since the payment obligations under these agreements are contingent upon future events, such as the achievement of specified product development milestones or generating product sales, and we are unable to estimate the timing or likelihood of achieving these milestones or generating future product sales. We are also required to spend certain minimum amounts on research and development of licensed products or processes under the MIT License, and may have certain funding obligations under the Scripps option agreement, which are not included in the table above. See “-License and collaboration agreements” for more information regarding our payment obligations under these agreements. We also enter into contracts in the normal course of business with CROs, CMOs, universities, and other third parties for preclinical research studies, clinical trials and testing and manufacturing services. These contracts generally do not contain minimum purchase commitments and are cancelable by us upon prior written notice although, purchase orders for clinical materials are generally non-cancelable. 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 or upon completion of a manufacturing run. These payments are not included in the table above as the amount and timing of such payments are not known or are not material Critical accounting policies and use of estimates Our management’s discussion and analysis of financial condition and results of operations is based on our audited 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 and related disclosures requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenue, 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 included elsewhere in this Annual Report on Form 10K, 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 account for contracts with customers in accordance with Accounting Standards Codification (“ASC”), Topic 606, Revenue from Contracts with Customers (“Topic 606”), including all amendments thereto. This standard applies to all contracts with customers, except for contracts that are within the scope of other standards, such as collaborative arrangements and leases. Our disclosure in the accompanying consolidated financial statements reflects the Company’s accounting policies in compliance with this standard. Under Topic 606, an entity recognizes revenue when or as 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 recognize revenue for arrangements that an entity determines are within the scope of Topic 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, including variable consideration, if any; (iv) allocate the transaction price to the performance obligations in the contract; and (v) recognize revenue when (or as) the entity satisfies its performance obligations. We only apply the five-step model to contracts when it is probable that the entity will collect substantially all of the consideration to which it will be entitled in exchange for the goods or services it transfers to the customer. Once a contract is determined to be within the scope of Topic 606, we assess the goods or services promised within each contract and identifies as a performance obligation each promise to transfer to the customer either (a) a good or service (or bundle of goods and services) that is distinct, or (b) a series of distinct goods and services that are substantially the same and have been the same pattern of transfer to the customer. We assess whether each promised good or service is distinct for the purpose of identifying the performance obligations in the contract. This assessment involves subjective determinations and requires management to make judgments about the individual promised goods or services and whether such are separable from the other aspects of the contractual relationship. Promised goods and services are considered distinct provided that: (i) the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct) and (ii) the entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the promise to transfer the good or service is distinct within the context of the contract). In assessing whether a promised good or service is distinct, we consider factors such as the research, manufacturing and commercialization capabilities of the collaboration partner (the “customer” in this type of arrangement) and the availability of the associated expertise in the general marketplace. We also consider the intended benefit of the contract in assessing whether a promised good or service is separately identifiable from other promises in the contract. If a promised good or service is not distinct, an entity is required to combine that good or service with other promised goods or services until it identifies a bundle of goods or services that is distinct. For each arrangement that results in revenues, we identify all performance obligations, which may include, for example, a license to IP and know-how, research and development activities, and/or manufacturing services. In addition to any upfront payment, if the consideration promised in a contract includes a variable amount, we estimate the amount of consideration to which it will be entitled in exchange for transferring the promised goods or services to a customer. We determine the amount of variable consideration by using the expected value method or the most likely amount method. We include the estimated variable consideration in the transaction price to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur. At the end of each subsequent reporting period, we re-evaluate the estimated variable consideration included in the transaction price and any related constraint, and if necessary, adjusts its estimate of the overall transaction price. Any such adjustments are recorded on a cumulative catch-up basis in the period of adjustment. If an arrangement includes development and regulatory milestone payments, we evaluate whether the milestones are considered probable of being reached and estimates the amount to be included in the transaction price using the most likely amount method. There is considerable judgment involved in determining whether it is probable that a significant revenue reversal would not occur. If it is probable that a significant revenue reversal will not occur, the associated milestone value is included in the transaction price. Milestone payments that are not within our control or of the licensee such as regulatory approvals, are generally not considered probable of being achieved until those approvals are received. At the end of each subsequent reporting period, we re-evaluate 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 revenues and earnings in the period of adjustment. For contracts that include sales-based royalties (including milestone payments based on the level of sales) promised in the exchange for licenses of intellectual property, and the license is deemed to be the predominant item to which the royalties relate, we recognize royalty revenue and sales-based milestone payments 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. In determining the transaction price, we adjust the promised amount of consideration for the effects of the time value of money if the timing of payments provides the Company or the Company’s customer with a significant benefit of financing the transfer of goods and services. We do not assess whether a contract has a significant financing component if the expectation at contract inception is such that the period between payment by the licensees and the transfer of the promised goods or services to the licensees will be one year or less. We assess each of its revenue generating arrangements in order to determine whether a significant financing component exists. We recognize as revenue the amount of the transaction price that is allocated to the respective performance obligation when (or as) each performance obligation is satisfied, either at a point in time or over time. For performance obligations satisfied over time, we measure progress toward completion of its performance obligations using an input method based on our efforts and inputs to satisfy its performance obligations relative to total expected inputs to the satisfaction of that performance obligation. Amounts received from a customer prior to revenue recognition are recorded as deferred revenue. Amounts received from a customer that are expected to be recognized as revenue within the 12 months following the balance sheet date are classified as a current liability in the accompanying consolidated balance sheets. 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 costs incurred for the services when we have not yet been invoiced or otherwise notified of the actual costs. Most 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 our consolidated financial statements based on facts and circumstances known to us at that time. Examples of estimated accrued research and development expenses include fees paid to the following: • CROs and other third parties in connection with performing research and development activities and conducting preclinical studies and clinical trials on our behalf; • Vendors in connection with preclinical development activities; and • CMOs and other vendors in connection with product manufacturing and development and distribution of preclinical supplies. We base our expenses related to preclinical studies on our estimates of the services received and efforts expended pursuant to quotes and contracts with CROs that conduct and manage preclinical studies and clinical trials and CMOs that manufacture product for our research and development activities 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. In accruing 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 amount of 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 cause us to report amounts that are too high or too low in any particular period. To date, we have not made 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 our employees, directors, consultants, advisors based on the fair value on the date of the grant, awards, net of actual forfeitures, over the requisite service period, which is generally the vesting period of the respective award. For stock-based awards granted to non-employees, compensation expense is recognized over the period during which services are rendered by such non-employees until completed. We estimate the fair value of each stock option grant on the date of grant using the Black-Scholes option-pricing model, which 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 stock options, the risk-free interest rate for a period that approximates the expected term of our stock options, and our expected dividend yield. Determination of fair value of common stock Prior to the IPO, there had been no public market for our common stock and as such, the estimated fair value of our common stock had been determined by our board of directors as of the date of each option grant, with input from management, taking into consideration our most recently available third-party valuations of common stock at the time of the grants, 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 valuation through the date of the grant. Third-party valuations, or valuation reports, 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 stock valuation reports were prepared using a market approach, utilizing either the guideline M&A or guideline public company methodologies. Under the guideline M&A methodology, a set of mergers and acquisitions within the biotechnology and pharmaceutical industries for similar stage companies were reviewed and an applicable equity value was selected to apply to our company. Under the guideline public company methodology, the market capitalizations of similar public companies were analyzed, and an applicable capitalization for our company was selected based on qualitative and quantitative factors. For each valuation report, an option pricing allocation method, or OPM, was selected to allocate the total equity value across the various securities outstanding at the time of the valuation. The OPM treats common stock and preferred stock 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. In addition to considering the results of the valuation reports, 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 prices at which we sold shares of convertible preferred stock and the superior rights and preferences of the convertible preferred stock relative to our common stock at the time of each grant; • the progress of our research and development programs, including the status and results of preclinical studies and clinical trials for our product candidates; • our stage of development and commercialization and our business strategy; • external market conditions affecting the biotechnology industry and trends within that 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 and our convertible preferred stock; • the likelihood of achieving a liquidity event, such as an initial public offering, or IPO, or sale of our company considering prevailing market conditions; and • the analysis of IPOs and the market performance of similar companies in the biotechnology industry. The assumptions underlying these valuations represented management’s best estimate, which involved inherent uncertainties and the application of management’s judgment. As a result, if we had used different assumptions or estimates, the fair value of our common stock and our stock-based compensation expense could have been materially different. Recent accounting pronouncements A description of recent accounting pronouncements that may potentially impact our financial position, results of operations, or cash flows is disclosed below: In February 2016, the FASB issued ASU No. 2016-02, Leases, which is intended to increase transparency and comparability among companies that enter into leasing arrangements. The new standard establishes a right-of-use model that requires a lessee to record a right-of-use asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either financing or operating, with classification affecting the pattern of expense recognition. The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, with early adoption permitted. In July 2018, the FASB issued ASU No. 2018-11, with targeted improvements to the guidance including an additional transition method, which allows us to apply the provisions of the new leasing standard as of January 1, 2021, without adjusting the comparative periods presented by recognizing a cumulative-effect adjustment to the opening balance of retained earnings. We plan to elect early adoption of this standard effective January 1, 2020 and elect the new transition method approved by the FASB. We also plan to elect the package of practical expedients intended to ease transition whereby the Company need not assess (1) whether any expired or existing contracts are or contain leases, (2) the lease classification for any expired or existing leases and (3) initial direct costs for any existing leases. Furthermore, we will elect the practical expedient to combine non-lease components and lease components. As we finalize our adoption processes, we estimate the adoption of the ASU in the first quarter of 2020 will result in the recognition of a right-of-use asset and related lease liability related to the lease for our Woburn Massachusetts facility in the range of approximately $1 million to $2 million with an estimated immaterial effect to our retained earnings and our consolidated statement of operations. As disclosed in Note 16, we have entered into a lease for a facility in Lexington Massachusetts which has an estimated commencement date of December 1, 2020. In accordance with ASU No. 2016-02, we will recognize a right-of-use asset and related lease liability at such time. There are no other recent accounting pronouncements that we believe will have a material impact on our consolidated financial statements. 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 SEC rules.

<s>[INST] Overview We are a clinicalstage biotechnology company focused on harnessing the body’s innate biology to repair or reverse damage caused by a broad range of degenerative diseases and an industry leader in the science and development of medicines for innerear cellular regeneration and hearing restoration. Our initial focus is on advancing our lead product candidate, FX322, through clinical studies with the goal of developing and commercializing a medicine to help millions of patients with the most common form of hearing loss and build upon the potential of regenerative therapeutics for hearing. Our initial therapeutic focus is sensorineural hearing loss, or SNHL, which is the most prevalent type of hearing loss. We are developing FX322 to treat the underlying cause of SNHL, which is the loss of hair cells. FX322 is designed to regenerate hair cells through the activation of progenitor cells already present in the ear. In our Phase 1/2 clinical trial evaluating FX322 in 23 patients with stable SNHL, we observed a statistically significant and clinically meaningful improvement in key measures of hearing loss, including word recognition, and clarity of sounds, and FX322 was observed to be welltolerated. We commenced dosing of a Phase 2a clinical trial of FX322 in patients with SNHL in October 2019. As of March 26, 2020, the Phase 2a clinical trial was approximately at the halfway point of enrollment based on the original trial design and we are continuing to enroll and dose patients in the trial. However, we have observed an impact on the Phase 2a clinical trial from the COVID19 pandemic as several clinical trial sites have informed us that they have temporarily halted enrollment in the trial. We expect that the effects of the pandemic may result in other clinical trial sites being similarly affected for an unknown period of time, slowing or temporarily halting patient enrollment and potentially impacting patient retention. As a result, we will provide updated guidance on the timing of completion and reporting of topline data of the Phase 2a clinical trial once we better understand the extent of the impact of the COVID19 pandemic on the trial. Nevertheless, we believe that, if necessary, we could achieve the key objectives of the Phase 2a clinical trial with fewer study subjects than originally designed. We are also working to identify a product candidate for the treatment of multiple sclerosis, or MS. This program focuses on activating progenitor cells in the central nervous system to repair the myelin sheath that protects nerves and may have the potential to reverse damage done by the disease. We intend to submit an investigational new drug application or, IND, to the U.S. Federal Drug Administration, or the FDA, for our MS product candidate in the second half of 2021. In October 2019, we completed the initial public offering of our common stock, or the IPO. In the IPO, we issued and sold 6,325,000 shares of our common stock at a price to the public of $14.00 per share, inclusive of the underwriters’ exercise in part of their overallotment option. We received approximately $79.7 million in net proceeds, after deducting underwriting discounts and commissions and other offering expenses. In July 2019, we closed our Series C convertible preferred stock financing in which we issued and sold 39,492,960 shares of our Series C convertible preferred stock for aggregate gross proceeds of approximately $61.7 million. In July 2019, we also entered into a License and Collaboration Agreement, or the Astellas Agreement, with Astellas Pharma Inc., or Astellas, pursuant to which Astellas paid us an upfront payment of $80.0 million. Since our formation in 2014, we have devoted substantially all our resources to developing our PCA platform, conducting research and development activities, including product candidate development, recruiting skilled personnel, establishing our intellectual property portfolio, and providing general and administrative support for these operations. We have financed our operations primarily through proceeds from the sale of convertible notes and of our convertible preferred stock, the IPO and the Astellas Agreement. To date, [/INST] Negative. </s>

Arcutis Biotherapeutics, Inc.

2020-03-19

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 together with our “Selected Financial Data” and our audited financial statements and related notes appearing 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, objectives, expectations, projections and strategy for our business, includes forward-looking statements that involve risks and uncertainties. As a result of many factors, including those factors identified below and those set forth in the “Risk Factors” section of this Annual Report on Form 10-K, our actual results and the timing of selected events could differ materially from the forward-looking statements contained in the following discussion and analysis. Please also see the section entitled “Special Note Regarding Forward-Looking Statements.” Overview We are a late-stage biopharmaceutical company focused on developing and commercializing treatments for dermatological diseases with high unmet medical needs. Our current portfolio is comprised of topical treatments with significant potential to address immune-mediated dermatological diseases and conditions, or immuno-dermatology. Our strategy is to identify and develop treatments against validated biological targets in dermatology that deliver a differentiated clinical profile that addresses major shortcomings of existing therapies in our targeted indications. We believe this strategy uniquely positions us to rapidly progress towards our goal of bridging the treatment innovation gap in dermatology, while maximizing our probability of technical success and financial resources. Our lead product candidate, ARQ-151, is in Phase 3 clinical trials in plaque psoriasis. ARQ-151 is a topical cream formulation of roflumilast, a highly potent and selective phosphodiesterase type 4, or PDE4, inhibitor, which we are developing for the treatment of plaque psoriasis, including psoriasis in intertriginous regions such as the groin, axillae, and inframammary areas, as well as atopic dermatitis. In July 2018, we executed a licensing agreement with AstraZeneca AB, or AstraZeneca, for exclusive worldwide rights to all topical dermatological uses of roflumilast. We have successfully completed a Phase 2b study of ARQ-151 in plaque psoriasis, and, in August 2019, paid AstraZeneca the first milestone payment of $2.0 million that was earned upon the achievement of positive Phase 2 data for any AZ-Licensed Product (as defined in “-License Agreements-AstraZeneca License Agreement”). We have initiated three Phase 3 studies in plaque psoriasis, with topline data expected in the first half of 2021. We have also completed enrollment in a long-term safety study of ARQ-151 in plaque psoriasis patients, and expect to report topline data in the first half of 2021. We also completed a Phase 2 proof of concept study of ARQ-151 in atopic dermatitis and plan to initiate a Phase 2b study in the second half of 2020, with topline results expected in the second half of 2021. In addition, we are developing ARQ-154, a topical foam formulation of ARQ-151, and have initiated a Phase 2 proof of concept study in seborrheic dermatitis and a Phase 2b study in scalp psoriasis. We expect to report topline data in the second half of 2020 with respect to seborrheic dermatitis and in Q4 2020/Q1 2021 with respect to scalp psoriasis. Beyond this, in 2020, we also plan to initiate clinical studies of ARQ-252, a potent and highly selective topical janus kinase type 1, or JAK1, inhibitor for the treatment of hand eczema and vitiligo. Additionally, we have formulation and preclinical efforts underway for ARQ-255, an alternative topical formulation of ARQ-252 designed to reach deeper into the skin in order to potentially treat alopecia areata. In January 2018, we executed an exclusive option and license agreement with Jiangsu Hengrui Medicine Co., Ltd. of China, or Hengrui, to the active pharmaceutical ingredient in ARQ-252 and ARQ-255 for all topical formulations for dermatological uses in the United States, Europe and Japan. In December 2019, we exercised our exclusive option associated with this agreement, for which we made a $1.5 million cash payment, and also contemporaneously amended the agreement to expand the territory to additionally include Canada. Since our inception in 2016, we have invested a significant portion of our efforts and financial resources in research and development activities. We have not generated any revenue from product sales and, to date, have funded our operations primarily with $162.5 million in net cash proceeds from private placements of our convertible preferred stock as of December 31, 2019. In February 2020, we received $183.3 million in gross cash proceeds related to our initial public offering. We have incurred net losses in each year since inception, including net losses of $42.0 million, $19.3 million and $5.0 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 $66.3 million and $24.3 million, respectively, and cash, cash equivalents and marketable securities of $101.3 million and $50.9 million, respectively. We expect to continue to incur losses for the foreseeable future and expect to incur increased expenses as we advance our product candidates through clinical trials and regulatory submissions. We do not expect to generate revenue from product sales unless, and until, we obtain regulatory approval or clearance from the FDA or other foreign regulatory authorities for our product candidates. If we obtain regulatory approval or clearance for our product candidates, we expect to incur significant commercialization expenses related to product sales, marketing, manufacturing and distribution. In addition, we expect that our expenses will increase substantially as we continue preclinical studies and clinical trials for, and research and development of, our product candidates and maintain, expand and protect our intellectual property portfolio. As a result, we will need substantial additional funding to support our operating activities. Adequate funding may not be available to us on acceptable terms, or at all. We currently anticipate that we will seek to fund our operations through equity or debt financings or other sources, such as future potential collaboration agreements. Our failure to obtain sufficient funds on acceptable terms as and when needed could have a material adverse effect on our business, results of operations and financial condition. See “-Liquidity, Capital Resources and Requirements” below and Note 1 to the financial statements for additional information. Based on our current planned operations, we expect our current cash, cash equivalent, and marketable securities will be sufficient to fund our operations through 2021. We rely on third parties in the conduct of our preclinical studies and clinical trials and for manufacturing and supply of our product candidates. We have no internal manufacturing capabilities, and we will continue to rely on third parties, many of whom are single-source suppliers, for our preclinical and clinical trial materials, as well as the commercial supply of our products. 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 product sales. We cannot, at this time, predict the specific extent, duration, or full impact that the COVID-19 outbreak will have on our ongoing and planned clinical trials and other business operations. We do, however, believe that there will be an impact on the clinical development of our product candidates, which may include potential delays, halts or modifications to our ongoing and planned trials. License Agreements AstraZeneca License Agreement In July 2018, we entered into an exclusive license agreement, or the AstraZeneca License Agreement, with AstraZeneca, granting us a worldwide exclusive license, with the right to sublicense through multiple tiers, under certain AstraZeneca-controlled patent rights, know-how and regulatory documentation, to research, develop, manufacture, commercialize and otherwise exploit products containing roflumilast in topical forms, as well as delivery systems sold with or for the administration of roflumilast, or collectively, the AZ-Licensed Products, for all diagnostic, prophylactic and therapeutic uses for human dermatological indications, or the Dermatology Field. Under this agreement, we have sole responsibility for development, regulatory, and commercialization activities for the AZ-Licensed Products in the Dermatology Field, at our expense, and we shall use commercially reasonable efforts to develop, obtain and maintain regulatory approvals for, and commercialize the AZ-Licensed Products in the Dermatology Field in each of the United States, Italy, Spain, Germany, the United Kingdom, France, China, and Japan. We paid AstraZeneca an upfront non-refundable cash payment of $1.0 million and issued 484,388 shares of our Series B Preferred stock, valued at $3.0 million on the date of the AstraZeneca License Agreement. We subsequently paid AstraZeneca the first milestone cash payment of $2.0 million upon the completion of a Phase 2b study of ARQ-151 in plaque psoriasis in August 2019 for the achievement of positive Phase 2 data for an AZ-Licensed Product. We have agreed to make additional cash payments to AstraZeneca of up to an aggregate of $12.5 million upon the achievement of specific regulatory approval milestones with respect to the AZ-Licensed Products and payments up to an additional aggregate amount of $15.0 million upon the achievement of certain aggregate worldwide net sales milestones. With respect to any AZ-Licensed Products we commercialize under the AstraZeneca License Agreement, we will pay AstraZeneca a low to high single-digit percentage royalty rate on our, our affiliates’ and our sublicensees’ net sales of such AZ-Licensed Products, until, as determined on an AZ-Licensed Product-by-AZ-Licensed Product and country-by-country basis, the later of the date of the expiration of the last-to-expire AstraZeneca-licensed patent right containing a valid claim in such country and ten years from the first commercial sale of such AZ-Licensed Product in such country. For more information, please see “Business-Exclusive License and Option Agreements.” Hengrui Exclusive Option and License Agreement In January 2018, we entered into an exclusive option and license agreement, or Hengrui License Agreement, with Hengrui, whereby Hengrui granted us an exclusive option to obtain certain exclusive rights to research, develop and commercialize products containing the compound designated by Hengrui as SHR0302, a JAK inhibitor, in topical formulations for the treatment of skin diseases, disorders, and conditions in the United States, Japan, and the European Union (including for clarity the United Kingdom). We made a $0.4 million upfront non-refundable cash payment to Hengrui upon execution of the Hengrui License Agreement. In December 2019, we exercised our exclusive option under the agreement, for which we made a $1.5 million cash payment, and also contemporaneously amended the agreement to expand the territory to additionally include Canada. In addition, we have agreed to make cash payments of up to an aggregate of $20.5 million upon our achievement of specified clinical development and regulatory approval milestones with respect to the licensed products and cash payments of up to an additional aggregate of $200.0 million in sales-based milestones based on achieving certain aggregate annual net sales volumes with respect to a licensed product. With respect to any products we commercialize under the Hengrui License Agreement, we will pay tiered royalties to Hengrui on net sales of each licensed product by us, or our affiliates, or our sublicensees, ranging from mid single-digit to sub-teen percentage rates based on tiered annual net sales bands subject to specified reductions. We are obligated to pay royalties until the later of (1) expiration of the last valid claim of the licensed patent rights covering such licensed product in such country and (2) the expiration of regulatory exclusivity for the relevant licensed product in the relevant country, on a licensed product-by-licensed product and country-by-country basis. Additionally, we are obligated to pay Hengrui a specified percentage, ranging from the low-thirties to the sub-teens, of certain non-royalty sublicensing income we receive from sublicensees of our rights to the licensed products, such percentage decreasing as the development stage of the licensed products advance. For more information, please see “Business-Exclusive License and Option Agreements.” Hawkeye Collaboration Agreement In June 2019, we entered into a collaboration agreement, or the Hawkeye Agreement, with Hawkeye Therapeutics, Inc., or Hawkeye, a related party with common ownership, to collaborate on the research and development of one or more new applications of roflumilast. The Hawkeye Agreement grants Hawkeye an exclusive license to certain intellectual property developed under the agreement as it relates to the applications. Contemporaneously with the execution of the Hawkeye Agreement, we entered into a stock purchase agreement, purchasing 995,000 shares of Hawkeye’s common stock at $0.0001 per share, representing 19.9% of the outstanding common stock of Hawkeye. See Note 6 to the financial statements for additional information. Components of Our Results of Operations Revenue We have not generated any revenue from the sale of our products, and we do not expect to generate any revenue unless and until we obtain regulatory clearance or approval of, and commercialize, our product candidates. Operating Expenses Research and Development Expenses Since our inception, we have focused significant resources on our research and development activities, including conducting preclinical studies and clinical trials, manufacturing development efforts and activities related to regulatory filings for our product candidates. Research and development costs are expensed as incurred. These costs include direct program expenses, which are payments made to third parties that specifically relate to our research and development, such as payments to clinical research organizations, clinical investigators, manufacturing of clinical material, preclinical testing and consultants. In addition, employee costs, including salaries, payroll taxes, benefits, stock-based compensation and travel, for employees contributing to research and development activities are classified as research and development costs. We allocate direct external costs to our product candidates; internal costs are not allocated to specific product candidates. We expect to continue to incur substantial research and development expenses in the future as we develop our product candidates. In particular, we expect to incur substantial research and development expenses for the Phase 3 trials of ARQ-151 for plaque psoriasis, the preclinical studies and clinical trials for the continued development of ARQ-151 for atopic dermatitis, ARQ-154 for seborrheic dermatitis and scalp psoriasis, ARQ-252 for hand eczema and vitiligo, and ARQ-255 for alopecia areata. We have entered, and may continue to enter, into license agreements to access and utilize certain molecules for the treatment of dermatological diseases and disorders. We evaluate if the license agreement is an acquisition of an asset or a business. To date, none of our license agreements have been considered to be an acquisition of a business. For asset acquisitions, the upfront payments to acquire such licenses, as well as any future milestone payments made before product approval, are immediately recognized as research and development expense when due, provided there is no alternative future use of the rights in other research and development projects. The successful development of our product candidates is highly uncertain. At this time, we cannot reasonably estimate the nature, timing or costs required to complete the remaining development of ARQ-151, ARQ-154, ARQ-252 and ARQ-255 or any future product candidates. This is due to the numerous risks and uncertainties associated with the development of product candidates. See “Risk Factors” for a discussion of the risks and uncertainties associated with the development of our product candidates. General and Administrative Expenses Our general and administrative expenses consist primarily of salaries and related costs, including payroll taxes, benefits, stock-based compensation and travel. Other general and administrative expenses include legal costs of pursuing patent protection of our intellectual property, insurance, and professional services fees for auditing, tax and general legal services. We expect our general and administrative expenses to continue to increase in the future as we expand our operating activities and prepare for potential commercialization of our product candidates, increase our headcount and support our operations as a public company, including increased expenses related to legal, accounting, insurance, regulatory and tax-related services associated with maintaining compliance with exchange listing and Securities and Exchange Commission requirements, directors and officers liability insurance premiums and investor relations activities. Other Income (Expense), Net Other income (expense), net primarily consists of changes in the fair value of our convertible preferred stock liability and interest income earned on our marketable securities. Results of Operations Comparison of the Years Ended December 31, 2019 and 2018 The following table sets forth our results of operations for the periods indicated: Research and Development Expenses Research and development expenses increased by $18.6 million, or 104%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was primarily due to an increase in clinical trial costs of $14.6 million, an increase in compensation and personnel-related expenses of $3.0 million, and an increase in manufacturing costs of $1.0 million. The increases in clinical trial costs and manufacturing costs relate to the initiation of the Phase 2b and open label extension studies in ARQ-151 for plaque psoriasis in the second half of 2018 and the initiation of the Phase 2 study in ARQ-151 in atopic dermatitis in early 2019. The increase in compensation and personnel-related expenses, which includes stock compensation, was primarily due to an increase in headcount. General and administrative expenses increased by $4.8 million, or 268%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was primarily due to an increase in professional services associated with the general growth of the business of $2.3 million, which includes legal, tax, audit, market research studies and various other administrative functions, as well as an increase of $2.1 million in compensation and personnel-related expenses, which includes stock compensation, due to an increase in headcount. Other Income, Net Other income, net increased by $0.7 million, or 137%, for the year ended December 31, 2019 compared to the year ended December 31, 2018 . The increase was primarily due to interest earned on marketable securities, in which we had larger balances in 2019 than in 2018 due to the timing of issuances of our Series B and C convertible preferred stock. Comparison of the Years Ended December 31, 2018 and 2017 The following table sets forth our results of operations for the periods indicated: Research and Development Expenses Research and development expenses increased by $14.5 million, or 426%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase was due to increases in clinical trial costs of $6.3 million, product milestones of $4.4 million, manufacturing costs of $2.2 million, compensation and personnel-related expenses of $1.1 million, and regulatory and clinical consulting costs of $0.5 million. The increase in clinical trial and manufacturing costs were related to our Phase 2 proof of concept and Phase 2b clinical trials of ARQ-151 for the treatment of plaque psoriasis, which were initiated in 2018. Product milestones consisted of a $4.0 million upfront payment to AstraZeneca, comprised of $1.0 million paid in cash and the issuance of $3.0 million in shares of our Series B convertible preferred stock during 2018, as well as a $0.4 million cash payment made to Hengrui for the option to obtain a license. The increase in compensation and personnel-related expenses, which includes stock compensation, was due to an increase in headcount. General and Administrative Expenses General and administrative expenses increased by $1.1 million, or 158%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase was primarily due to an increase of $0.6 million in compensation and personnel-related expenses, which includes stock compensation, due to an increase in headcount. The increase was also driven by increases in professional services of $0.5 million for legal, market research studies and other administrative services. Other Income (Expense), Net Other income (expense), net changed by $1.4 million, or 155%, for the year ended December 31, 2018 compared to the year ended December 31, 2017. The change was due to an increase in interest income of $0.4 million from interest earned on the funds received from the issuance of convertible preferred stock in 2018, and a decrease in expense of $0.8 million primarily from the fair value remeasurement of the Series A convertible preferred stock liability and $0.2 million from the fair value remeasurement of the derivative liability related to our promissory notes payable that converted into Series A convertible preferred stock in 2017. Liquidity, Capital Resources and Requirements Sources of Liquidity We have incurred operating losses since our inception and have an accumulated deficit as a result of ongoing efforts to develop our product candidates, including conducting preclinical and clinical trials and providing general and administrative support for these operations. As of December 31, 2019 and 2018, we had cash, cash equivalents and marketable securities of $101.3 million and $50.9 million, respectively, and an accumulated deficit of $66.3 million and $24.3 million, respectively. Additionally, we received gross cash proceeds of $183.3 million in connection with our initial public offering in February 2020. We anticipate that operating losses and net cash used in operating activities will increase over the next several years as we further develop ARQ-151, ARQ-154, ARQ-252 and ARQ-255, move into later and more costly stages of product development, develop new product candidates, hire personnel and prepare for regulatory submissions and the commercialization of our product candidates. We have historically financed our operations primarily through private placements of preferred stock as well as our initial public offering completed in January 2020, and will continue to be dependent upon equity, debt financing or collaborations or other forms of capital at least until we are able to generate positive cash flows from our operations. Cash Flows The following table sets forth our cash flows for the periods indicated: Net Cash Used in Operating Activities During the year ended December 31, 2019, net cash used in operating activities was $42.8 million, which consisted of a net loss of $42.0 million, a change in net operating assets and liabilities of $1.5 million, partially offset by net non-cash charges of $0.7 million. The change in net operating assets and liabilities was due to an increase of $3.3 million in prepaid expenses and other current assets for advances made for clinical trial costs, partially offset by an increase of $1.9 million in accounts payable and accrued liabilities due to our overall growth, increased research and development spending and timing of payments. The net non-cash charges were primarily related to stock-based compensation expense of $0.8 million, and depreciation and right-of-use asset amortization of $0.2 million, partially offset by net amortization/accretion on marketable securities of $0.4 million. During the year ended December 31, 2018, net cash used in operating activities was $14.1 million and consisted primarily of a net loss of $19.3 million adjusted by non-cash charges of $3.1 million and a change of $2.1 million in our net operating assets and liabilities. The non-cash charges were primarily related to the issuance of convertible preferred stock in connection with the AstraZeneca License Agreement, which was expensed to research and development. The change in net operating assets and liabilities was primarily due to a net increase of $1.9 million in accounts payable and accrued liabilities due to our overall growth, increased research and development spending and timing of payments. During the year ended December 31, 2017, net cash used in operating activities was $3.8 million and consisted primarily of a net loss of $5.0 million, adjusted by non-cash charges of $0.9 million and a change of $0.3 million in our net operating assets and liabilities. The non-cash charges consisted of a loss from fair value remeasurement of our convertible preferred stock liability of $0.7 million and a loss from fair value measurement of the derivative liability of $0.2 million due to the conversion of our promissory notes payable into Series A convertible preferred stock. The change in our net operating assets and liabilities was primarily due to a net increase of $0.7 million in accounts payable and accrued liabilities due to our overall growth, increased research and development spending and timing of payments. These changes were partially offset by an increase of $0.4 million in prepaid expenses and other current assets for advances made for clinical trial costs. Net Cash Used in Investing Activities During the year ended December 31, 2019, net cash used in investing activities was $26.3 million, which was comprised of purchases of marketable securities of $60.8 million and property and equipment of $0.3 million, partially offset by proceeds from the maturities of marketable securities of $34.8 million. During the year ended December 31, 2018, net cash used in investing activities was $11.5 million, which represented the purchase of marketable securities. Net Cash Provided by Financing Activities During the year ended December 31, 2019, net cash provided by financing activities was $93.1 million, which was comprised of the net proceeds received from the issuance of Series C convertible preferred stock of $94.2 million as well as the proceeds from the exercise of stock options of $0.3 million, offset by deferred financing costs of $1.4 million paid in connection with the IPO. During the year ended December 31, 2018, net cash provided by financing activities was $61.6 million, which was comprised of $61.2 million in proceeds from the issuance of our Series A and Series B convertible preferred stock and $0.4 million from proceeds received from the exercise of stock options. During the year ended December 31, 2017, net cash provided by financing activities was $7.1 million, primarily comprised of proceeds from the issuance of our Series A convertible preferred stock. Funding Requirements We have historically incurred significant losses and negative cash flows from operations since our inception and had an accumulated deficit of $66.3 million and $24.3 million as of December 31, 2019 and 2018, respectively. We had cash, cash equivalents and marketable securities of $101.3 million and $50.9 million as of December 31, 2019 and 2018, respectively. In February 2020, we received $183.3 million gross cash proceeds from our initial public offering. Based on our current planned operations, we expect that our current cash, cash equivalents and marketable securities will be sufficient to fund our operations through 2021. Our ability to continue as a going concern is dependent upon our ability to successfully secure sources of financing and ultimately achieve profitable operations. We will need to raise substantial additional capital to fund our operations through the sale of our equity securities, incurring debt, entering into licensing or collaboration agreements with partners, grants or other sources of financing. There can be no assurance that sufficient funds will be available to us at all or on attractive terms when needed from these sources. If we are unable to obtain additional funding from these or other sources when needed it may be necessary to significantly reduce our current rate of spending through reductions in staff and delaying, scaling back, or stopping certain research and development programs. Insufficient liquidity may also require us to relinquish rights to product candidates at an earlier stage of development or on less favorable terms than we would otherwise choose. We have based our projections of operating capital requirements on assumptions that may prove to be incorrect and we may use all 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, progress, results and costs of researching and developing our lead product candidates or any future product candidates, and conducting preclinical studies and clinical trials, in particular our currently ongoing Phase 3 studies of ARQ-151 in plaque psoriasis, our planned Phase 2b study of ARQ-151 in atopic dermatitis, our ongoing Phase 2 proof of concept study of ARQ-154 in seborrheic dermatitis, our currently ongoing Phase 2b study of ARQ-154 in scalp psoriasis, our planned Phase 2b study of ARQ-252 in hand eczema, our planned Phase 2a study of ARQ-252 in vitiligo and our formulation and preclinical efforts for ARQ-255 for alopecia areata. •the timing of, and the costs involved in, obtaining regulatory approvals for our lead product candidate or our other product candidates; •the number and characteristics of any additional product candidates we develop or acquire; •the cost of manufacturing our lead product candidates or any future product candidates and any products we successfully commercialize, including costs associated with building out our supply chain; •the cost of commercialization activities if our lead product candidates or any future product candidates are approved for sale, including marketing, sales and distribution costs; •the cost of building a sales force in anticipation of product commercialization; •our ability to establish and maintain strategic collaborations, licensing or other arrangements and the financial terms of any such agreements that we may enter into; •the costs related to milestone payments to AstraZeneca or Hengrui, upon the achievement of predetermined milestones; •any product liability or other lawsuits related to our products; •the expenses needed to attract and retain skilled personnel; •the costs associated with being a public company; •the costs involved in preparing, filing, prosecuting, maintaining, defending and enforcing patent claims, and the outcome of this and any other future patent litigation we may be involved in; and •the timing, receipt and amount of sales of any future approved products, if any. Contractual Obligations and Contingent Liabilities The following summarizes our significant contractual obligations as of December 31, 2019: We entered into a lease agreement in January 2019 for our headquarters in Westlake Village, California. The term of the lease commenced in March 2019 and terminates in July 2021. The total estimated lease payments for this facility over the term of the lease is approximately $0.5 million. We are party to license agreements pursuant to which we have in-licensed various intellectual property rights. The license agreements obligate us to make certain milestone payments related to achievement of specified events, as well as royalties in the low single-digits based on sales of licensed products. The table above does not include any milestone or royalty payments to the counterparties to these agreements as the amounts, timing and likelihood of such payments are not known. See Note 6 to our audited financial statements. We enter into contracts in the normal course of business with clinical research organizations for clinical trials and clinical supply manufacturing and with vendors for preclinical research studies, research supplies and other services and products for operating purposes. These contracts generally provide for termination on notice, and therefore we believe that our non-cancelable obligations under these agreements are not material. Indemnification In the normal course of business, we enter into contracts and agreements that contain a variety of representations and warranties and provide for general indemnifications. Our exposure under these agreements is unknown because it involves claims that may be made against us in the future, but have not yet been made. To date, we have not paid any claims or been required to defend any action related to our indemnification obligations. However, we may record charges in the future as a result of these indemnification obligations. In accordance with our certificate of incorporation and bylaws, we have indemnification obligations to our officers and directors for specified events or occurrences, subject to some limits, while they are serving at our request in such capacities. There have been no claims to date, and we have director and officer insurance that may enable us to recover a portion of any amounts paid for future potential claims. 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 SEC rules. Critical Accounting Policies and Use of Estimates Our management’s discussion and analysis of financial condition and results of operations is based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, 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 during the reporting periods. These items are monitored and analyzed by us for changes in facts and circumstances, and material changes in these estimates could occur in the future. 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. Changes in estimates are reflected in reported results for the period in which they become known. Actual results may differ materially from these estimates under different assumptions or conditions. While our significant accounting policies are more fully described in the notes to our financial statements included elsewhere in this Annual Report on Form 10-K, we believe that the following accounting policies are critical to the process of making significant judgments and estimates in the preparation of our financial statements and understanding and evaluating our reported financial results. Preclinical and Clinical Accruals and Costs We record accrued liabilities for estimated costs of research and development activities conducted by third-party service providers, which include the conduct of preclinical studies, clinical studies, clinical trials and contract manufacturing activities. These costs are a significant component of our research and development expenses. Research and development costs are expensed as incurred unless there is an alternative future use in other research and development projects. We accrue for these costs based on factors such as estimates of the work completed and in accordance with agreements established with third-party service providers under the service agreements. As it relates to clinical trials, 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. 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. Such payments are evaluated for current or long-term classification based on when they will be realized. Additionally, if expectations change such that the Company does not expect goods to be delivered or services to be rendered, such prepayments are charged to expense. Our objective is to reflect the appropriate expense in our financial statements by matching those expenses with the period in which the services and efforts are expended. We account for these expenses according to the progress of the trial as measured by patient progression and the timing of various aspects of the trial utilizing financial models taking into consideration discussions with applicable personnel and outside service providers. In this manner, our clinical trial accrual is dependent in part upon the timely and accurate reporting of progress and efforts incurred from contract research organizations, contract manufacturers and other third-party vendors. Although we expect our estimates to be materially consistent with actual amounts 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 our reporting changes in estimates in any particular period. We make significant judgments and estimates in determining the accrued liabilities balance in each reporting period. As actual costs become known, we adjust our accrued liabilities. We have not experienced any material differences between accrued costs as of December 31, 2019 and 2018 and actual costs incurred. Stock-Based Compensation We account for share-based payments at fair value. For share-based awards that vest subject to the satisfaction of a service requirement, the fair value measurement date for such awards is the date of grant and the expense is recognized on a straight-line basis, over the expected vesting period. For share-based awards that vest subject to a performance condition, we recognize compensation cost for awards if and when we conclude that it is probable that the awards with a performance condition will be achieved on an accelerated attribution method. We account for forfeitures as they occur. We calculate the fair value measurement of stock options using the Black-Scholes option pricing model and assumptions discussed below. Each of these inputs is subjective and generally requires significant judgement. Fair value of common stock-see the subsection titled “Common Stock Valuations” below. Expected Term-The expected term represents the period that we expect our stock-based awards to be outstanding. We used the simplified method (based on the mid-point between the vesting date and the end of the contractual term) to determine the expected term. Expected Volatility-Since we do not have sufficient trading history for our common stock, the expected volatility was estimated based on the average historical volatilities for comparable publicly traded pharmaceutical 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 and area of specialty. We will continue to apply this process until a sufficient amount of historical information regarding the volatility of our stock price becomes available. 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. Dividend Yield-We have never paid dividends on common stock and have no plans to pay dividends on our common stock. Therefore, we used an expected dividend yield of zero. See Note 9 to our audited financial statements included elsewhere in this Annual Report on Form 10-K for more information concerning certain of the specific assumptions we used in applying the Black-Scholes option pricing model to determine the estimated fair value of our stock options. Certain of such assumptions 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 could be materially different. We recorded stock-based compensation expense of $824,000, $151,000, and $27,000 for the years ended December 31, 2019, 2018 and 2017, respectively. As of December 31, 2019, there was $5.6 million of unrecognized compensation expense related to unvested options, which are expected to be recognized over a weighted-average period of approximately 3.64 years. We expect to continue to grant stock options and other equity-based awards in the future, and to the extent that we do, our stock-based compensation expense recognized in future periods will likely increase. Common Stock Valuation Prior to the completion of our public offering, there are significant assumptions and estimates required in determining the fair value of our common stock. Due to the absence of an active market for our common stock prior to our initial public offering and during the time period of our grants, the fair value of our common stock was determined in good faith by our board of directors, with the assistance and upon the recommendation of management and valuations of our common stock prepared by an unrelated third-party valuation firm, based on a number of objective and subjective factors consistent with the methodologies outlined in the American Institute of Certified Public Accountants Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, referred to as the AICPA Practice Aid, including: •contemporaneous valuations of our shares of common stock; •the prices of each of our series of preferred stock sold by us to outside investors in arm’s length transactions, and the rights, preferences and privileges of each of these series of preferred stock relative to our common stock; •our results of operations, financial position and the status of our research and development efforts; •the composition of our management team and board of directors; •the material risks related to our business; •the market performance of publicly traded companies in the life sciences and biotechnology sectors; •the likelihood of achieving a liquidity event for the holders of our shares of common stock, such as a sale of the company or an initial public offering, given prevailing market conditions; •the lack of marketability of our common stock; and •external market conditions affecting the life sciences and biotechnology industry sectors. If we had made different assumptions than those described below, the fair value of the underlying common stock and amount of our stock-based compensation expense, net loss and net loss per share amounts would have differed. Following the closing of our initial public offering, the fair value per share of our common stock for purposes of determining stock-based compensation will be the closing price of our common stock as reported on the applicable grant date. Historically, prior to our initial public offering, fair values of the shares of common stock underlying our share-based awards were estimated on each grant date by our board of directors. Our board of directors considered, among other things, valuations of our common stock which were prepared by an unrelated third-party valuation firm in accordance with the guidance provided by the American Institute of Certified Public Accountants 2013 Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. In 2019, we reassessed the determination of the fair value of the common shares underlying the grants made prior to August 2018 in connection with a valuation of the convertible preferred stock liability. This analysis revised our implied equity value, which was then allocated to each equity class using an option pricing method and the implied value of common stock was then reduced by a discount for lack of marketability. As a result of this reassessment, we determined that fair value of common stock increased to $0.46, $1.12 and $1.18 per share as of April 2017, December 2017 and March 2018, respectively. The increase to both recognized and unrecognized share-based compensation expense due to these higher share prices was approximately $86,000 and $0.4 million, respectively, as of December 31, 2018. Income Taxes As of December 31, 2019, we had net deferred tax assets of $14.9 million. The deferred tax assets have been offset by a valuation allowance due to uncertainties surrounding our ability to realize these tax benefits. The deferred tax assets are primarily composed of net operating loss, or NOL, tax carryforwards. As of December 31, 2019, we had federal and state NOL carryforwards of $54.6 million and $55.1 million, respectively, available to potentially offset future taxable income. As of December 31, 2019, we also had federal and California research and development tax credit carryforwards of approximately $2.0 million and $0.7 million, respectively, available to potentially offset future federal income taxes. The federal research and development tax carryforwards, if not utilized, will expire beginning in 2037. The California research and development tax credit carryforwards are available indefinitely. Federal and California tax law impose significant restrictions on the utilization of net operating loss carryforwards in the event of a change in ownership, as defined by Internal Revenue Code Section 382 and 383. We have not completed a formal study to determine any limitations on our tax attributes due to changes in ownership and may have limitations on the utilization of net operating loss carryforwards, credit carryforwards, or other tax attributes due to ownership changes. Recent Accounting Pronouncements We adopted Accounting Standards Update, or ASU, No. 2016-02, Leases (Topic 842), on January 1, 2019. See Note 2 to our audited financial statements for more information. 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. 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 that we are (i) 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, these financial statements may not be comparable to companies that comply with the new or revised accounting pronouncements as of public company effective dates. We early adopted ASU 2016-01, Financial Instruments-Overall (Topic 825)-Recognition and Measurement of Financial Assets and Financial Liabilities, ASU 2016-09, Compensation-Stock Compensation (Topic 718)-Improvements to Employee Share Based Payment Accounting, ASU No. 2018-07, Compensation-Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting, and ASU No. 2016-02, Leases as the JOBS Act does not preclude an emerging growth company from early adopting a new or revised accounting standard earlier than the time such standard applies to private companies. We expect to use the extended transition period for any other new or revised accounting standards during the period in which we remain an emerging growth company. We will remain an emerging growth company until the last day of our fiscal year following the fifth anniversary of the completion of our initial public offering. However, if certain events occur prior to the end of such five-year period, including if we become a “large accelerated filer,” our annual gross revenues exceed $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 the end of such five-year period.

<s>[INST] Overview We are a latestage biopharmaceutical company focused on developing and commercializing treatments for dermatological diseases with high unmet medical needs. Our current portfolio is comprised of topical treatments with significant potential to address immunemediated dermatological diseases and conditions, or immunodermatology. Our strategy is to identify and develop treatments against validated biological targets in dermatology that deliver a differentiated clinical profile that addresses major shortcomings of existing therapies in our targeted indications. We believe this strategy uniquely positions us to rapidly progress towards our goal of bridging the treatment innovation gap in dermatology, while maximizing our probability of technical success and financial resources. Our lead product candidate, ARQ151, is in Phase 3 clinical trials in plaque psoriasis. ARQ151 is a topical cream formulation of roflumilast, a highly potent and selective phosphodiesterase type 4, or PDE4, inhibitor, which we are developing for the treatment of plaque psoriasis, including psoriasis in intertriginous regions such as the groin, axillae, and inframammary areas, as well as atopic dermatitis. In July 2018, we executed a licensing agreement with AstraZeneca AB, or AstraZeneca, for exclusive worldwide rights to all topical dermatological uses of roflumilast. We have successfully completed a Phase 2b study of ARQ151 in plaque psoriasis, and, in August 2019, paid AstraZeneca the first milestone payment of $2.0 million that was earned upon the achievement of positive Phase 2 data for any AZLicensed Product (as defined in “License AgreementsAstraZeneca License Agreement”). We have initiated three Phase 3 studies in plaque psoriasis, with topline data expected in the first half of 2021. We have also completed enrollment in a longterm safety study of ARQ151 in plaque psoriasis patients, and expect to report topline data in the first half of 2021. We also completed a Phase 2 proof of concept study of ARQ151 in atopic dermatitis and plan to initiate a Phase 2b study in the second half of 2020, with topline results expected in the second half of 2021. In addition, we are developing ARQ154, a topical foam formulation of ARQ151, and have initiated a Phase 2 proof of concept study in seborrheic dermatitis and a Phase 2b study in scalp psoriasis. We expect to report topline data in the second half of 2020 with respect to seborrheic dermatitis and in Q4 2020/Q1 2021 with respect to scalp psoriasis. Beyond this, in 2020, we also plan to initiate clinical studies of ARQ252, a potent and highly selective topical janus kinase type 1, or JAK1, inhibitor for the treatment of hand eczema and vitiligo. Additionally, we have formulation and preclinical efforts underway for ARQ255, an alternative topical formulation of ARQ252 designed to reach deeper into the skin in order to potentially treat alopecia areata. In January 2018, we executed an exclusive option and license agreement with Jiangsu Hengrui Medicine Co., Ltd. of China, or Hengrui, to the active pharmaceutical ingredient in ARQ252 and ARQ255 for all topical formulations for dermatological uses in the United States, Europe and Japan. In December 2019, we exercised our exclusive option associated with this agreement, for which we made a $1.5 million cash payment, and also contemporaneously amended the agreement to expand the territory to additionally include Canada. Since our inception in 2016, we have invested a significant portion of our efforts and financial resources in research and development activities. We have not generated any revenue from product sales and, to date, have funded our operations primarily with $162.5 million [/INST] Positive. </s>

Merus N.V.

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 accounting principles generally accepted in the United States (U.S. 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 important 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 clinical-stage oncology company developing innovative antibody therapeutics. Our pipeline of full-length human multispecific antibody candidates are generated from our proprietary technology platforms, which are able to generate a diverse array of antibody binding domains, or Fabs, against virtually any target. Each antibody binding domain consists of a target-specific heavy chain paired with a common light chain. Multiple binding domains can be combined to produce novel bispecific and trispecific antibodies that bind to a wide range of targets and display novel and innovative biology. These platforms referred to as Biclonics® and TriclonicsTM allows us to generate large numbers of diverse panels of bispecific and trispecific antibodies, respectively, which can then be functionally screened in large-scale cell-based assays to identify those unique molecules that possess novel biology, which we believe are best suited for a given therapeutic application. Further, by binding to multiple targets, Biclonics® and TriclonicsTM may be designed to provide a variety of mechanisms of action, including simultaneously blocking receptors that drive tumor cell growth and survival and mobilizing the patient’s immune response by engaging T cells, and/or activating various killer cells to eradicate tumors. Our technology platforms employ an assortment of patented technologies and techniques to generate human antibodies. We utilize our patented MeMo® mouse to produce a host of antibodies with diverse heavy chains and a common light chain that are capable of binding to virtually any antigen target. We use our patented heavy chain dimerization technology to generate substantially pure bispecific and trispecific antibodies. We also employ our patented Spleen to Screen® technology to efficiently screen panels of diverse heavy chains, designed to allow us to rapidly identify Biclonics® and TriclonicsTM therapeutic candidates with differentiated modes of action for pre-clinical and clinical testing. Using our Biclonics® platform we have produced, and are currently developing, the following candidates: MCLA-128, or zenocutuzumab, for the potential treatment of solid tumors that harbor Neuregulin 1(NRG1) gene fusions; MCLA-117 for the potential treatment of acute myeloid leukemia; MCLA-158 for the potential treatment of solid tumors; and MCLA-145, developed in collaboration with Incyte Corporation, for the potential treatment of solid tumors and a hematological malignancy, B-cell lymphoma. We are also developing a late-stage pre-clinical candidate, MCLA-129 in collaboration with Betta Pharmaceuticals, for the potential treatment of solid tumors. Furthermore, we have a pipeline of proprietary antibody candidates in pre-clinical development and intend to further leverage our Biclonics® technology platform to identify multiple additional antibody candidates and advance them to clinical development. Further, Merus is developing its next generation TriclonicsTM technology, and has pre-clinical trispecific antibody candidates capable of simultaneously binding three targets at once. Funding Our Operations We are a clinical-stage company and have not generated any revenue from product sales. We expect to incur significant expenses and operating losses for the foreseeable future as we advance our antibody candidates from discovery through pre-clinical development and into clinical trials, and seek regulatory approval and pursue commercialization of any approved antibody candidate. In addition, if we obtain regulatory approval for any of our antibody candidates, we expect to incur significant commercialization expenses related to product manufacturing, marketing, sales and distribution. We expect to incur expenses in connection with the in-license or acquisition of additional antibody candidates. We anticipate that we will require 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 and business development opportunities with third parties. Adequate additional financing may not be available to us on acceptable terms, or at all. Our inability to raise capital as and when needed would have a negative impact on our financial condition and our ability to pursue our business strategy. We will need to generate significant revenue to achieve profitability, and we may never do so. Based on our current operating plan, we expect that our existing cash, cash equivalents and marketable securities of $241.8 million as of December 31, 2019 will be sufficient to fund our operations into 2022. Collaborations and Other Revenue Generating Agreements Refer to Item 1, “Business-Our Collaborations” and Note 12, “Collaborations,” of the notes to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for a description of the key terms of our arrangements. Results of Operations for the Years Ended December 31, 2019 and 2018 In prior periods, we prepared our financial information in accordance with IFRS. As a consequence of becoming a domestic issuer as of January 1, 2020, we are required to present our financial information in accordance with U.S. GAAP and expressed in U.S. dollars from that date. The below financial information has been prepared in accordance with U.S. GAAP. The financial information should not be expected to correspond to figures we have previously presented under IFRS. Revenue The following is a comparison of collaboration revenue for the years ended December 31, 2019 and 2018: Our revenue from each collaboration partner consists of revenue recognized from the amortization of deferred revenue related to upfront payments for licenses or options to obtain licenses in the future, research and development services reimbursement revenue earned and milestone payments earned under collaboration and license agreements with our collaboration partners. Collaboration revenue for the year ended December 31, 2019 decreased $6.8 million as compared to the year ended December 31, 2018, primarily as a result of a decrease in Incyte reimbursement revenue of $3.2 million, $1.0 million upfront payment from Betta recognized in 2018 that is non-recurring in 2019, decrease in Ono reimbursement revenue of $0.9 million, and $0.6 million lower Ono milestone revenue. The decrease in exchange rates through 2019 negatively impacted collaboration revenue by $1.3 million. As of December 31, 2019, we have total deferred revenue of $110.3 million, which primarily relates to the upfront payment received under our Incyte collaboration agreement and is expected to be recognized over the next six years. Operating Expenses The following is a comparison of operating expenses for the years ended December 31, 2019 and 2018: Research and Development Expense Research and development costs consist principally of the costs associated with our research and development activities, conducting pre-clinical studies and clinical trials, and activities related to our regulatory filings. Our research and development expenses consist of: • salaries for research and development staff and related expenses, including share-based compensation expenses; • expenses incurred under agreements with contract research organizations (CROs) contract manufacturing organizations, and consultants that conduct and support clinical trials and pre-clinical studies; • costs to develop product candidates, including raw materials and supplies, product testing, and facility related expenses; and • amortization and depreciation of tangible and intangible fixed assets used to develop our product candidates. Note that we do not allocate employee-related costs, depreciation, rental and other indirect costs to specific research and development programs because these costs are deployed across multiple programs under research and development and, as such, are separately classified as unallocated research and development expenses. Research and development expense for the year ended December 31, 2019 increased $0.9 million as compared to the year ended December 31, 2018, primarily as a result of an increase in headcount and higher pre-clinical research and development-related costs related to our programs, particularly increases in costs for MCLA-117 offset by decreases in costs for zenocutuzumab and MCLA 145. Research and development activities are central to our business model. We expect research and development costs to increase significantly for the foreseeable future as our development programs progress, as we continue to support the clinical trials of our bispecific antibody candidates as treatments for various cancers and as we move these candidates into additional clinical trials. There are numerous factors associated with the successful commercialization of any of our antibody candidates, including future trial design and various regulatory requirements, many of which cannot be determined with accuracy at this time based on our stage of development. Additionally, future commercial and regulatory factors beyond our control may impact our clinical development programs and plans. General and Administrative Expense General and administrative expenses consist primarily of salaries and related benefits, including stock-based compensation, related to our executive, finance, intellectual property, business development and support functions. Other general and administrative expenses include allocated facility-related costs not otherwise included in research and development expenses, travel expenses and professional fees for auditing, tax and legal services, including intellectual property and general legal services. General and administrative expense for the year ended December 31, 2019 increased $4.8 million as compared to the year ended December 31, 2018, primarily as a result of an increase in headcount, consulting, accounting and professional fees as well as higher facilities-related expenses. We expect general and administrative expenses to increase as we grow as a company, driven by the need to support a growing workforce, engaging in financing transactions, establishing and maintaining our intellectual property rights, fulfilling our compliance requirements as a public company and related legal costs. Other Income, Net The following is a comparison of other income, net, for the years ended December 31, 2019 and 2018: Other income, net consists of interest earned on our cash and cash equivalents held on account, accretion of investment earnings and net foreign exchange gains on our foreign denominated cash, cash equivalents and marketable securities. For the year ended December 31, 2018, other income included a gain recognized upon the settlement of litigation with Regeneron of $8.1 million. Income Tax Expense The following is a comparison of income tax expense for the years ended December 31, 2019 and 2018: We are subject to income taxes in the Netherlands and the U.S. Our current and deferred tax provision represents taxable income attributed to our U.S. operations as a consequence of allocating income to that jurisdiction. No current or deferred provision for income taxes has been made for income taxes in the Netherlands due to losses for tax purposes. Further, given a history of losses in the Netherlands, no deferred tax assets in excess of deferred tax liabilities are recognized as it is not more likely than not that they will be recovered. Net Loss Net loss for the year ended December 31, 2019 was $55.2 million, compared to $28.3 million for the year ended December 31, 2018. The increase in net loss was primarily due to the decrease in collaboration revenue and increases in research and development and general and administrative expenses discussed above. Liquidity and Capital Resources Since inception, we have raised an aggregate of $527.5 million to fund our operations, of which $125.4 million was non-equity funding through our collaboration agreements, $291.4 million was from the sale of common stock in our public offerings and $110.7 million was from private funding sources prior to the Company’s initial public offering. In November 2019, we completed an underwritten follow-on public offering in which we sold 5,462,500 common shares, including 715,500 common shares pursuant to the underwriters’ option to purchase additional shares, at a public offering price of $14.50 per share and received net proceeds of $74.0 million, after deducting underwriting discounts and commissions and offering expenses. As of December 31, 2019, we had $241.8 million in cash, cash equivalents and marketable securities that are available to fund our current operations. In addition to our existing cash, cash equivalents and marketable securities, we may receive research and development co-funding and are eligible to earn a significant amount of milestone payments under our collaboration agreements. Our ability to earn these payments and the timing of earning these payments is dependent upon the outcome of our research and development activities and is uncertain at this time. Funding Requirements Our primary uses of capital are, clinical trial costs, third-party research and development services, laboratory and related supplies, legal and other regulatory expenses and general overhead costs. Because our product candidates are in various stages of clinical and pre-clinical development and the outcome of these efforts is uncertain, we cannot estimate the actual amounts necessary to successfully complete the development and commercialization of our product candidates or whether, or when, we may achieve profitability. Until such time, if ever, as we can generate substantial product revenues, we expect to finance our cash needs through a combination of equity or debt financings, collaboration arrangements and government grants. Except for any obligations of our collaborators to make license, milestone or royalty payments under our agreements with them, and government grants, we do not have any committed external sources of liquidity. To the extent that we raise additional capital through the future sale of equity or debt, the ownership interest of our stockholders may be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect the rights of our existing 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 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 any additional funds that may be needed 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. Outlook Based on our research and development plans and our timing expectations related to the progress of our programs, we expect that our existing cash, cash equivalents and marketable securities as of December 31, 2019, will be sufficient to fund our planned operating expenses and capital expenditure requirements into 2022, without giving effect to any potential milestone payments we may receive under our collaboration agreements. We have based this estimate on assumptions that may prove to be wrong, particularly as the process of testing product candidates in clinical trials is costly and the timing of progress in these trials is uncertain. As a result, we could use our capital resources sooner than we expect. Cash Flows The following is a summary of cash flows for the years ended December 31, 2019 and 2018: Operating Activities Net cash used in operating activities for the year ended December 31, 2019 increased $17.2 million as compared to the year ended December 31, 2018, primarily as a result of the increase in net loss of $26.8 million, and decrease in non-cash stock-based compensation of $1.9 million, offset by an increase in depreciation changes of $0.3 million, a net decrease in foreign exchange gains of $5.1 million, and changes in working capital of $6.2 million. The increase in operating cash outflows for the year ended December 31, 2019 may also be viewed as a result of operating cash receipts related to revenue arrangements decreasing $6.2 million, operating cash out flows related to operating expenses increasing $2.5 million and a non-recurring litigation settlement of $8.1 million that was received in 2018. Investing Activities Net cash provided by investing activities for the year ended December 31, 2019 increased $49.7 million as compared to the year ended December 31, 2018, primarily as a result of the change in net cash inflows from the maturity of debt securities used to fund current operations of $47.6 million offset by the change in purchases of property, equipment and intangibles of $2.1 million. Financing Activities Net cash provided by financing activities for the year ended December 31, 2019 increased $11.2 million as compared to the year ended December 31, 2018, primarily as a result of the increase in receipt of proceeds from our equity issuances of $12.2 million offset by decreases in proceeds received from option exercises of $1.0 million. Contractual Obligations and Contingent Liabilities We enter into contracts in the normal course of business with CROs for clinical and pre-clinical research studies, external manufacturers for product for use in our clinical trials, and other research supplies and other services as part of our operations. These contracts generally provide for termination on notice, and therefore are cancelable contracts and are not contractual obligations. Critical Accounting Policies and Use of Estimates Our accounting policies are more fully described in Note 2 to our Consolidated Financial Statements included elsewhere in the Annual Report on Form 10-K. As disclosed in Note 2, the preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. We believe that the following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results of operations and require management’s most difficult, subjective and complex judgments on material matters. Revenue Recognition Significant judgement is required in applying our accounting policies concerning revenue recognition. Our collaboration arrangements may be subject to the scope of many accounting standards in addition to the standards applicable to revenue from contracts with customers, including whether all or part of the arrangement may be a collaboration arrangement as defined in the accounting standards or whether financial instruments exchanged in the same arrangement may be subject to other guidance. Such matters may impact the initial recognition, subsequent accounting and disclosures concerning the arrangement. Our collaboration arrangements typically include a license to our intellectual property and significant judgement is applied in determining whether the particular license is distinct from other performance obligations in the arrangement. We consider whether the counterparty may be able to utilize the license in the absence of the provision of other performance obligations by us. Each collaboration features unique terms to a license and the provision of other performance obligations also varies. Such considerations impact the timing of recognition of consideration allocated to performance obligations. A key estimate in the application of our revenue recognition policy concerns the method of recognition of revenue over time as performance obligations are completed. Methods may include an input-based, output-based or other rational allocation method. Such estimates are often derived from expectations on the outcome of research and development activities which are subject to uncertainty. Changes in these estimates impact the timing of revenue recognition. Stock-Based Compensation The expense for stock-based compensation for options granted to employees is typically determined based on the grant-date fair value of those options. The grant date fair value is derived from the use of valuation models which are commonly used. These valuation models use inputs which require estimates that are reflective of future expectations including the forward expected risk-free interest rate, volatility of our shares, and the expected exercise behavior of employees. While historical averages may be indicative of future expectations, such assumptions may or may not be accurate. Significant judgement must be employed to derive reasonable estimates in determining the grant-date fair value. Going Concern Our evaluation of our ability to continue as a going concern requires us to evaluate our future sources and uses of cash sufficient to fund our currently expected operations in conducting research and development activities one year from the date our financial statements are issued. We evaluate the probability associated with each source and use of cash resources in making our going concern determination. The research and development of pharmaceutical products is inherently subject to uncertainty. Recent Accounting Pronouncements For a discussion of pending and recently adopted accounting pronouncements, see Note 2 to our Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements and do not have any holdings in variable interest entities.

<s>[INST] Overview We are a clinicalstage oncology company developing innovative antibody therapeutics. Our pipeline of fulllength human multispecific antibody candidates are generated from our proprietary technology platforms, which are able to generate a diverse array of antibody binding domains, or Fabs, against virtually any target. Each antibody binding domain consists of a targetspecific heavy chain paired with a common light chain. Multiple binding domains can be combined to produce novel bispecific and trispecific antibodies that bind to a wide range of targets and display novel and innovative biology. These platforms referred to as Biclonics® and TriclonicsTM allows us to generate large numbers of diverse panels of bispecific and trispecific antibodies, respectively, which can then be functionally screened in largescale cellbased assays to identify those unique molecules that possess novel biology, which we believe are best suited for a given therapeutic application. Further, by binding to multiple targets, Biclonics® and TriclonicsTM may be designed to provide a variety of mechanisms of action, including simultaneously blocking receptors that drive tumor cell growth and survival and mobilizing the patient’s immune response by engaging T cells, and/or activating various killer cells to eradicate tumors. Our technology platforms employ an assortment of patented technologies and techniques to generate human antibodies. We utilize our patented MeMo® mouse to produce a host of antibodies with diverse heavy chains and a common light chain that are capable of binding to virtually any antigen target. We use our patented heavy chain dimerization technology to generate substantially pure bispecific and trispecific antibodies. We also employ our patented Spleen to Screen® technology to efficiently screen panels of diverse heavy chains, designed to allow us to rapidly identify Biclonics® and TriclonicsTM therapeutic candidates with differentiated modes of action for preclinical and clinical testing. Using our Biclonics® platform we have produced, and are currently developing, the following candidates: MCLA128, or zenocutuzumab, for the potential treatment of solid tumors that harbor Neuregulin 1(NRG1) gene fusions; MCLA117 for the potential treatment of acute myeloid leukemia; MCLA158 for the potential treatment of solid tumors; and MCLA145, developed in collaboration with Incyte Corporation, for the potential treatment of solid tumors and a hematological malignancy, Bcell lymphoma. We are also developing a latestage preclinical candidate, MCLA129 in collaboration with Betta Pharmaceuticals, for the potential treatment of solid tumors. Furthermore, we have a pipeline of proprietary antibody candidates in preclinical development and intend to further leverage our Biclonics® technology platform to identify multiple additional antibody candidates and advance them to clinical development. Further, Merus is developing its next generation TriclonicsTM technology, and has preclinical trispecific antibody candidates capable of simultaneously binding three targets at once. Funding Our Operations We are a clinicalstage company and have not generated any revenue from product sales. We expect to incur significant expenses and operating losses for the foreseeable future as we advance our antibody candidates from discovery through preclinical development and into clinical trials, and seek regulatory approval and pursue commercialization of any approved antibody candidate. In addition, if we obtain regulatory approval for any of our antibody candidates, we expect to incur significant commercialization expenses related to product manufacturing, marketing, sales and distribution. We expect to incur expenses in connection with the inlicense or acquisition of additional antibody candidates. We anticipate that we will require 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 and business development opportunities with third parties. Adequate additional financing may not be available to us on acceptable terms, or at all. Our inability to raise capital as and when needed would have a negative impact on our financial condition and our ability to pursue our business strategy. We will need to generate significant revenue to [/INST] Negative. </s>

US Ecology, Inc.

2020-03-02

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General US Ecology is a leading provider of environmental services to commercial and governmental entities. The Company addresses the complex waste management and response needs of its customers, offering treatment, disposal and recycling of hazardous, non-hazardous and radioactive waste, leading emergency response and standby services, and a wide range of complementary field and industrial services. US Ecology’s focus on safety, environmental compliance and best-in-class customer service enables us to effectively meet the needs of our customers and to build long-lasting relationships. We have a network of fixed facilities and service centers operating primarily in the United States, Canada, the United Kingdom and Mexico. Our fixed facilities include five RCRA subtitle C hazardous waste landfills, three landfills serving waste streams regulated by the RRC and one LLRW landfill. We also have various other TSDF facilities located throughout the United States. These facilities generate revenue from fees charged to transport, recycle, treat and dispose of waste and to perform various field and industrial services for our customers. Our operations are managed in two reportable segments reflecting our internal management reporting structure and nature of services offered as follows: Environmental Services-This segment provides a broad range of specialty material management services including transportation, recycling, treatment and disposal of hazardous, non-hazardous and radioactive waste at Company owned or operated landfill, wastewater, deep-well injection and other treatment facilities. Field & Industrial Services-This segment provides specialty field services and total waste management solutions to commercial and industrial facilities and to government entities through our 10-day transfer facilities and at customer sites, both domestic and international. Specialty field services include standby services, emergency response, industrial cleaning and maintenance, remediation, lab packs, retail services, transportation, and other services. Total waste management services include on-site management, waste characterization, transportation and disposal of non- hazardous and hazardous waste. In order to provide insight into the underlying drivers of our waste volumes and related T&D revenues, we evaluate period-to-period changes in our T&D revenue for our Environmental Services segment based on the industry of the waste generator, based on North American Industry Classification System (“NAICS”) codes. The composition of the Environmental Services segment T&D revenues by waste generator industry for the years ended December 31, 2019 and 2018 were as follows: (1) Excludes all transportation service revenue. (2) Excludes NRC which was acquired on November 1, 2019. (3) Includes retail and wholesale trade, rate regulated, construction and other industries. We also categorize our Environmental Services T&D revenue as either “Base Business” or “Event Business” based on the underlying nature of the revenue source. Base Business consists of waste streams from ongoing industrial activities and tends to be reoccurring in nature. We define Event Business as non-recurring projects that are expected to equal or exceed 1,000 tons, with Base Business defined as all other business not meeting the definition of Event Business. The duration of Event Business projects can last from a several-week cleanup of a contaminated site to a multiple year cleanup project. During 2019, Base Business revenue growth, excluding NRC, was up 8% compared to 2018. Base Business revenue was approximately 78% of total 2019 T&D revenue, excluding NRC, down from 80% in 2018. Our business is highly competitive and no assurance can be given that we will maintain these revenue levels or increase our market share. A significant portion of our disposal revenue is attributable to discrete Event Business projects which vary widely in size, duration and unit pricing. For the year ended December 31, 2019, approximately 22% of our T&D revenue, excluding NRC, was derived from Event Business projects. The one-time nature of Event Business, diverse spectrum of waste types received and widely varying unit pricing necessarily creates variability in revenue and earnings. This variability may be influenced by general and industry-specific economic conditions, funding availability, changes in laws and regulations, government enforcement actions or court orders, public controversy, litigation, weather, commercial real estate, closed military bases and other project timing, government appropriation and funding cycles and other factors. The types and amounts of waste received from Base Business also vary from quarter to quarter. This variability can also cause significant quarter-to-quarter and year-to-year differences in revenue, gross profit, gross margin, operating income and net income. While we pursue many projects months or years in advance of work performance, cleanup project opportunities routinely arise with little or no prior notice. These market dynamics are inherent to the waste disposal business and are factored into our projections and externally communicated business outlook statements. Our projections combine historical experience with identified sales pipeline opportunities, new or expanded service line projections and prevailing market conditions. We serve oil refineries, chemical production plants, steel mills, waste brokers/aggregators serving small manufacturers and other industrial customers that are generally affected by the prevailing economic conditions and credit environment. Adverse conditions may cause our customers as well as those they serve to curtail operations, resulting in lower waste production and/or delayed spending on off-site waste shipments, maintenance, waste cleanup projects and other work. Factors that can impact general economic conditions and the level of spending by customers include, but are not limited to, consumer and industrial spending, increases in fuel and energy costs, conditions in the real estate and mortgage markets, labor and healthcare costs, access to credit, consumer confidence and other global economic factors affecting spending behavior. Market forces may also induce customers to reduce or cease operations, declare bankruptcy, liquidate or relocate to other countries, any of which could adversely affect our business. To the extent business is either government funded or driven by government regulations or enforcement actions, we believe it is less susceptible to general economic conditions. Spending by government agencies may be reduced due to declining tax revenues resulting from a weak economy or changes in policy. Disbursement of funds appropriated by Congress may also be delayed for various reasons. Geographical Information For the year ended December 31, 2019, we derived $589.1 million, or 86%, of our revenue in the United States, $88.5 million, or 13%, of our revenue in Canada, $5.1 million, or 1%, of our revenue in the Europe, Middle East and Africa (“EMEA”) region, and less than 1% of our revenue from other international regions. For the year ended December 31, 2018, we derived $495.2 million or 87% of our revenue in the United States and $70.8 million or 13% of our revenue in Canada. For the year ended December 31, 2017, we derived $434.5 million or 86% of our revenue in the United States and $69.5 million or 14% of our revenue in Canada. Additional information about the geographical areas in which our revenues are derived and in which our assets are located is presented in Note 4 and Note 21 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. Significant Events Our results of operations have been affected by certain significant events during the past three fiscal years including, but not limited to: 2019 Events NRC Merger: On November 1, 2019, the Company completed its merger with NRC, a leader in comprehensive environmental, compliance and waste management services to the marine and rail transportation, general industrial and energy industries. The addition of NRC’s substantial service network strengthens and expands US Ecology’s suite of environmental services, including oil and gas exploration and production landfill disposal capabilities, and provides expanded opportunities to establish US Ecology as a leader in standby and emergency response services. The total merger consideration was $1,008.2 million, net of cash acquired, and was funded through the issuance of equity and with proceeds under a new $450.0 million seven-year term loan. The NRC Merger affects the comparability of 2019 with previous years, including as follows: ● Revenue and operating losses from the legacy NRC business for the period from November 1, 2019 to December 31, 2019 included in the Company’s consolidated statements of operations for the year ended December 31, 2019 were $70.2 million and $9.1 million, respectively. ● We incurred $24.4 million of business development expenses during the year ended December 31, 2019 in connection with the NRC Merger, primarily for due diligence, transaction expenses and business integration purposes. ● We recorded $303.6 million of intangible assets and $548.5 million of goodwill on our Consolidated Balance Sheet as a result of the NRC Merger. Acquired finite-lived intangibles will be amortized over their estimated useful life ranging from two to 16 years. Goodwill and indefinite-lived intangibles are tested for impairment at least annually. Acquisition of W.I.S.E. Environmental Solutions Inc. (now known as US Ecology Sarnia): On August 1, 2019, the Company acquired US Ecology Sarnia, an equipment rental and waste services company based in Sarnia, Ontario, Canada. The total purchase price was 23.5 million Canadian dollars, which translated to $17.9 million at the time of the transaction. We recorded $6.2 million of intangible assets and $7.7 million of goodwill on the consolidated balance sheets as a result of the acquisition. Amortizing intangible assets will be amortized over a weighted average life of approximately 14 years. The acquisition of US Ecology Sarnia was not material to our consolidated financial position or results of operations. 2018 Events Explosion at Grand View, Idaho Facility: On November 17, 2018, an explosion occurred at our Grand View, Idaho facility, resulting in one employee fatality and injuries to other employees. The incident severely damaged the facility’s primary waste-treatment building as well as surrounding waste handling, waste storage, maintenance and administrative support structures, resulting in the closure of the entire facility that remained in effect through January 2019. The facility resumed limited operations in February 2019 and regained additional capabilities throughout the remainder of 2019. We expect the completion of the construction of a new treatment building and resumption of full capabilities in late 2020. In addition to initiating and conducting our own investigation into the incident, we fully cooperated with IDEQ, the USEPA and OSHA to support their comprehensive and independent investigations of the incident. On January 10, 2020, we entered into a settlement agreement with OSHA settling a complaint made by OSHA relating to the incident for $50,000. On January 28, 2020, the Occupational Safety and Health Review Commission issued an order terminating the proceeding relating to such OSHA complaint. We have not otherwise been named as a defendant in any action relating to the incident. We maintain workers’ compensation insurance, business interruption insurance and liability insurance for personal injury, property and casualty damage. We believe that any potential third-party claims associated with the explosion, in excess of our deductibles, are expected to be resolved primarily through our insurance policies. Although we carry business interruption insurance, a disruption of our business caused by a casualty event, including the full and partial closure of our Grand View, Idaho facility, may result in the loss of business, profits or customers during the time of such closure. Accordingly, our insurance policies may not fully compensate us for these losses. Acquisition of Ecoserv Industrial Disposal, LLC: On November 14, 2018, the Company acquired Ecoserv Industrial Disposal, LLC (“Winnie”), which provides non-hazardous industrial wastewater disposal solutions and employs deep-well injection technology in the southern United States. The total purchase price was $87.2 million. We recorded $66.5 million of intangible assets and $16.4 million of goodwill on the consolidated balance sheets as a result of the acquisition. Amortizing intangible assets will be amortized over a weighted average life of approximately 52 years. The acquisition of Winnie was not material to our consolidated financial position or results of operations either individually or when aggregated with other acquisitions completed in 2018. Acquisition of ES&H of Dallas, LLC: On August 31, 2018, the Company acquired ES&H of Dallas, LLC (“ES&H Dallas”), which provides emergency and spill response, light industrial services and transportation and logistics for waste disposal and recycling from locations in Dallas and Midland, Texas. The total purchase price was $21.3 million. We recorded $4.2 million of intangible assets and $7.1 million of goodwill on the consolidated balance sheets as a result of the acquisition. Amortizing intangible assets will be amortized over a weighted average life of approximately 13 years. The acquisition of ES&H Dallas was not material to our consolidated financial position or results of operations either individually or when aggregated with other acquisitions completed in 2018. Goodwill and Intangible Asset Impairment Charges: Based on the results of the Company’s interim assessment of the goodwill and intangible assets of our Mobile Recycling reporting unit, we recorded a $1.4 million goodwill impairment charge and impairment charges of $1.8 million and $454,000 on non-amortizing intangible assets and amortizing intangible assets, respectively, associated with our Mobile Recycling business in the third quarter of 2018. See Note 13 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information. 2017 Events Goodwill and Intangible Asset Impairment Charges: Based on the results of the Company’s annual assessment of goodwill and intangible assets, during the fourth quarter we recorded a $5.5 million goodwill impairment charge in our Resource Recovery reporting unit and a $3.4 million impairment charge on the non-amortizing intangible waste collection, recycling and resale permit associated with our Resource Recovery business. Tax Cuts and Jobs Act of 2017: On December 22, 2017, the Tax Act was signed into law, making significant changes to the Internal Revenue Code. Changes include, but are not limited to, a corporate tax rate decrease from 35% to 21% effective for tax years beginning after December 31, 2017, the transition of U.S. international taxation from a worldwide tax system to a territorial system, and a one-time transition tax on the mandatory deemed repatriation of cumulative foreign earnings as of December 31, 2017. In accordance with the Tax Act, we recorded $23.8 million as additional income tax benefit in the fourth quarter of 2017, the period in which the legislation was enacted. The total benefit included $25.2 million related to the re-measurement of certain deferred tax assets and liabilities partially offset by $1.4 million of provisional expense related to one-time transition tax on the mandatory deemed repatriation of foreign earnings. Additionally, Staff Accounting Bulletin No. 118 (“SAB 118”) was issued 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 income tax effects of the Tax Act. December 22, 2018 marked the end of the measurement period for purposes of SAB 118. As such, we have completed our analysis based on legislative updates relating to the Tax Act currently available, which resulted in a net benefit for measurement period adjustments of $193,000 for the year ended December 31, 2018. The total tax provision benefit included a $2.2 million benefit related to the re-measurement of certain deferred tax assets and liabilities offset by $2.0 million of expense related to adjustments to the transition tax. Write-off of Deferred Financing Costs: In connection with the refinancing of the Company’s outstanding debt, we wrote off certain unamortized deferred financing costs and original issue discount that were to be amortized to interest expense in future periods through a charge of $5.5 million to interest expense in 2017. Results of Operations Our operating results and percentage of revenues for the years ended December 31, 2019, 2018 and 2017 were as follows: Management uses Adjusted EBITDA as a financial measure to assess segment performance. Adjusted EBITDA is defined as net income before interest expense, interest income, income tax expense, depreciation, amortization, share-based compensation, accretion of closure and post-closure liabilities, foreign currency gain/loss, non-cash property and equipment impairment charges, non-cash goodwill and intangible asset impairment charges, gain on property insurance recoveries, business development and integration expenses and other income/expense. In 2019, we updated our Adjusted EBITDA definition to include adjustments for business development and integration expenses and gain on property insurance recoveries. Throughout this Annual Report on Form 10-K, our Adjusted EBITDA results for all periods presented have been recast to reflect these adjustments. The reconciliation of Net income to Adjusted EBITDA for the years ended December 31, 2019, 2018 and 2017 is as follows: Adjusted EBITDA is a complement to results provided in accordance with accounting principles generally accepted in the United States (“GAAP”) and we believe that such information provides additional useful information to analysts, stockholders and other users to understand the Company’s operating performance. Since Adjusted EBITDA is not a measurement determined in accordance with GAAP and is thus susceptible to varying calculations, Adjusted EBITDA as presented may not be comparable to other similarly titled measures of other companies. Items excluded from Adjusted EBITDA are significant components in understanding and assessing our financial performance. Adjusted EBITDA should not be considered in isolation or as an alternative to, or substitute for, net income, cash flows generated by operations, investing or financing activities, or other financial statement data presented in the consolidated financial statements as indicators of financial performance or liquidity. Adjusted EBITDA has limitations as an analytical tool and should not be considered in isolation or a substitute for analyzing our results as reported under GAAP. Some of the limitations are: ● Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs; ● Adjusted EBITDA does not reflect our interest expense, or the requirements necessary to service interest or principal payments on our debt; ● Adjusted EBITDA does not reflect our income tax expenses or the cash requirements to pay our taxes; ● Adjusted EBITDA does not reflect our cash expenditures or future requirements for capital expenditures or contractual commitments; ● Although depreciation and amortization charges are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and Adjusted EBITDA does not reflect any cash requirements for such replacements; and ● Adjusted EBITDA does not reflect our business development and integration expenses. 2019 Compared to 2018 Revenue Total revenue increased 21% to $685.5 million in 2019, compared with $565.9 million in 2018. The acquired NRC operations contributed $70.2 million of total revenue subsequent to the NRC Merger on November 1, 2019. Excluding NRC operations, total revenue increased 9% to $615.3 million in 2019, compared with $565.9 million in 2018. Environmental Services Environmental Services segment revenue increased 13% to $453.1 million in 2019, compared to $400.7 million in 2018. The acquired NRC operations contributed $12.5 million of segment revenue subsequent to the NRC Merger on November 1, 2019. Excluding NRC operations, segment revenue increased 10% to $440.6 million in 2019, compared with $400.7 million in 2018. T&D revenue (excluding NRC) increased 12% in 2019 compared to 2018, primarily as a result of a 8% increase in Base Business revenue and a 19% increase in project-based Event Business revenue. 2019 transportation and logistics service revenue (excluding NRC) was consistent with 2018. Tons of waste disposed of or processed (excluding NRC) increased 34% in 2019 compared to 2018, primarily reflecting incremental volumes disposed at our Winnie, Texas deep-well facility that was acquired in the fourth quarter of 2018 as well as a 6% increase in tons of waste disposed of or processed at our other facilities (excluding NRC) in 2019 compared to 2018. T&D revenue (excluding NRC) from recurring Base Business waste generators increased 8% in 2019 compared to 2018 and comprised 78% of total T&D revenue. The increase in Base Business T&D revenue compared to the prior year primarily reflects higher T&D revenue from the broker/TSDF, transportation, “Other,” general manufacturing and government industry groups, partially offset by lower T&D revenue from the refining industry group. T&D revenue (excluding NRC) from Event Business waste generators increased 19% in 2019 compared to 2018 and comprised 22% of total T&D revenue. The increase in Event Business T&D revenue compared to the prior year primarily reflects higher T&D revenue from the government, transportation, chemical manufacturing and metal manufacturing industry groups, partially offset by lower T&D revenue from the “Other” industry group. The following table summarizes combined Base Business and Event Business T&D revenue growth (excluding NRC), within the Environmental Services segment, by waste generator industry for 2019 compared to 2018: Field & Industrial Services Field & Industrial Services segment revenue increased 41% to $232.4 million in 2019 compared with $165.3 million in 2018. The acquired NRC operations contributed $57.7 million of segment revenue subsequent to the NRC Merger on November 1, 2019. Excluding NRC operations, segment revenue increased 6% to $174.7 million in 2019, compared with $165.3 million in 2018. The increase in Field & Industrial Services segment revenue (excluding NRC) is primarily attributable to higher Transportation and Logistics revenues, growth in our Emergency Response business line primarily as a result of our acquisition of ES&H Dallas in the third quarter of 2018 and higher revenues from our Small Quantity Generation business line, partially offset by lower revenues from our Total Waste Management and Industrial Services business lines. Gross Profit Total gross profit increased 23% to $209.8 million in 2019, up from $170.1 million in 2018. Total gross margin was 31% in 2019 compared with 30% in 2018. The acquired NRC operations contributed $14.0 million of total gross profit subsequent to the NRC Merger on November 1, 2019. Excluding NRC operations, total gross profit increased 15% to $195.8 million in 2019, compared with $170.1 million in 2018. Excluding NRC operations, total gross margin was 32% in 2019 compared with 30% in 2018. Environmental Services Environmental Services segment gross profit increased 19% to $174.8 million in 2019, up from $147.5 million in 2018. Total segment gross margin was 39% in 2019 compared with 37% in 2018. The acquired NRC operations contributed $3.8 million of segment gross profit subsequent to the NRC Merger on November 1, 2019. Excluding NRC operations, segment gross profit increased 16% to $171.0 million in 2019, compared with $147.5 million in 2018. Environmental Services segment gross profit (excluding NRC) in 2019 includes $7.0 million in business interruption insurance recoveries for lost profits related to hurricane damage at our Robstown, Texas facility in 2017 and the incident at our Grand View, Idaho facility in the fourth quarter of 2018. Excluding NRC operations, segment gross margin was 39% in 2019 compared with 37% in 2018. T&D gross margin (excluding NRC) was 45% for 2019 compared with 42% for 2018. Field & Industrial Services Field & Industrial Services segment gross profit increased 55% to $35.0 million in 2019, up from $22.6 million in 2018. Total segment gross margin was 15% for 2019 compared with 14% for 2018. The acquired NRC operations contributed $10.2 million of segment gross profit subsequent to the NRC Merger on November 1, 2019. Excluding NRC operations, segment gross profit increased 10% to $24.8 million in 2019, compared with $22.6 million in 2018. Excluding NRC operations, segment gross margin was 14% in both 2019 and 2018. Selling, General and Administrative Expenses (“SG&A”) Total SG&A increased to $141.1 million, or 21% of total revenue, in 2019 compared with $92.3 million, or 16% of total revenue, in 2018. The acquired NRC operations contributed $23.1 million of SG&A subsequent to the NRC Merger on November 1, 2019. Excluding NRC operations, total SG&A increased to $118.0 million, or 19% of total revenue, in 2019 compared with $92.3 million, or 16% of total revenue, in 2018. Environmental Services Environmental Services segment SG&A decreased 13% to $19.7 million, or 4% of segment revenue, in 2019 compared with $22.5 million, or 6% of segment revenue, in 2018. The acquired NRC operations contributed $3.6 million of segment SG&A subsequent to the NRC Merger on November 1, 2019. Excluding NRC operations, segment SG&A decreased to $16.1 million, or 4% of segment revenue, in 2019 compared with $22.5 million, or 6% of segment revenue, in 2018. The decrease in Environmental Services segment SG&A (excluding NRC) primarily reflects property insurance recoveries of $12.4 million recognized in 2019 related to the incident at our Grand View, Idaho facility in the fourth quarter of 2018, partially offset by higher insurance costs, higher intangible asset amortization expense and higher labor and incentive compensation costs. Field & Industrial Services Field & Industrial Services segment SG&A increased 121% to $23.8 million, or 10% of segment revenue, in 2019 compared with $10.7 million, or 7% of segment revenue, in 2018. The acquired NRC operations contributed $8.6 million of segment SG&A subsequent to the NRC Merger on November 1, 2019. Excluding NRC operations, segment SG&A increased to $15.2 million, or 9% of segment revenue, in 2019 compared with $10.7 million, or 7% of segment revenue, in 2018. The increase in Field & Industrial Services segment SG&A (excluding NRC) primarily reflects incremental costs associated with new facilities. Corporate Corporate SG&A was $97.7 million, or 14% of total revenue, in 2019 compared with $59.1 million, or 10% of total revenue, in 2018. The acquired NRC operations contributed $10.9 million of Corporate SG&A subsequent to the NRC Merger on November 1, 2019. Excluding NRC operations, Corporate SG&A increased to $86.8 million, or 14% of total revenue, in 2019 compared with $59.1 million, or 10% of total revenue, in 2018. The increase in Corporate SG&A (excluding NRC) primarily reflects higher business development and integration expenses (including $17.0 million of expenses related to the NRC Merger), higher labor and incentive compensation costs and higher information technology related expenses in 2019 compared to 2018. Components of Adjusted EBITDA Income tax expense Our effective income tax rate for 2019 was 33.5% compared to 23.5% in 2018. The increase was primarily the result of an increase in non-deductible transaction expenses incurred as a result of the NRC Merger, and the implementation of certain tax planning strategies in 2018 that resulted in a one-time reduction to the 2018 effective income tax rate. Interest expense Interest expense was $19.2 million in 2019 compared with $12.1 million in 2018. The increase is the result of higher outstanding debt levels primarily attributable to our new $450.0 million Term Loan used to refinance the indebtedness of NRC and pay transaction expenses incurred in connection with the NRC Merger. See Note 16 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information about the Company’s debt. Foreign currency gain (loss) We recognized a $733,000 non-cash foreign currency loss in 2019 compared with a $55,000 non-cash foreign currency gain in 2018. Foreign currency gains and losses reflect changes in business activity conducted in a currency other than the USD, our functional currency. Additionally, we established intercompany loans with certain of our Canadian subsidiaries, whose functional currency is the Canadian dollar (“CAD”) as part of a tax and treasury management strategy allowing for repayment of third-party bank debt. These intercompany loans are payable by our Canadian subsidiaries to US Ecology in CAD requiring us to revalue the outstanding loan balance through our statements of operations based on USD/CAD currency movements from period to period. At December 31, 2019, we had $31.5 million of intercompany loans subject to currency revaluation. Other income Other income was $455,000 in 2019 compared with other income of $2.6 million in 2018. Other income for 2018 includes a $2.0 million gain on the issuance of a property easement on a portion of unutilized Company-owned land at one of our operating facilities. Impairment charges Based on the results of our 2018 interim assessment of the goodwill and intangible assets of our Mobile Recycling reporting unit, which is part of our Environmental Services segment, we recorded impairment charges of $3.7 million in the third quarter of 2018. See Note 13 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information on these impairment charges. Depreciation and amortization of plant and equipment Depreciation and amortization expense increased 42% to $41.4 million in 2019 compared with $29.2 million in 2018. The acquired NRC operations contributed $5.5 million of depreciation and amortization expense subsequent to the NRC Merger on November 1, 2019. Excluding NRC operations, depreciation and amortization expense was $35.9 million in 2019 compared with $29.2 million in 2018, primarily reflecting additional depreciation expense on assets placed in service, including assets associated with the ES&H Dallas, Winnie and US Ecology Sarnia acquisitions. Amortization of intangibles Intangible assets amortization expense increased 61% to $15.5 million in 2019 compared with $9.6 million in 2018. The acquired NRC operations contributed $3.9 million of intangible assets amortization expense subsequent to the NRC Merger on November 1, 2019. Excluding NRC operations, intangible assets amortization expense was $11.6 million in 2019 compared with $9.6 million in 2018, primarily reflecting additional amortization of intangible assets recorded as a result of ES&H Dallas, Winnie and US Ecology Sarnia acquisitions. Share-based compensation Share-based compensation expense increased 27% to $5.5 million in 2019, compared with $4.4 million 2018 as a result of an increase in equity-based awards granted to employees and incremental post-merger share-based compensation of $605,000 associated with the replacement restricted stock units issued in connection with NRC Merger. Accretion and non-cash adjustment of closure and post-closure liabilities Accretion and non-cash adjustment of closure and post-closure liabilities increased to $4.4 million in 2019 compared with $3.7 million in 2018, primarily reflecting higher favorable non-cash adjustments to post-closure liabilities recorded in 2018 due to changes in cost estimates and timing associated with closed sites. Gain on property insurance recoveries The Company recognized gains on property-related insurance recoveries of $12.4 million in 2019 and $347,000 in 2018 related to the incident at our Grand View, Idaho facility in the fourth quarter of 2018. Business development and integration expenses Business development and integration expenses increased to $26.2 million in 2019, compared to $748,000 in 2018, primarily attributable to $24.4 million of pre-acquisition business development costs and post-acquisition integration expenses associated with the NRC Merger in 2019. The remaining increase is attributable to a larger number of business development projects in 2019 compared to 2018. 2018 Compared to 2017 Revenue Total revenue increased 12% to $565.9 million in 2018, compared with $504.0 million in 2017. Environmental Services Environmental Services segment revenue increased 9% to $400.7 million in 2018, compared to $366.3 million in 2017. T&D revenue increased 7% in 2018 compared to 2017, primarily as a result of a 7% increase in Base Business revenue, partially offset by a 3% decrease in project-based Event Business revenue. Transportation and logistics service revenue increased 18% in 2018 compared to 2017, reflecting more Event Business projects utilizing the Company’s transportation and logistics services. Tons of waste disposed of or processed increased 2% in 2018 compared to 2017. T&D revenue from recurring Base Business waste generators increased 7% in 2018 compared to 2017 and comprised 80% of total T&D revenue. The increase in Base Business T&D revenue compared to the prior year primarily reflects higher T&D revenue from the chemical manufacturing, broker/TSDF, “Other,” metal manufacturing and refining industry groups. T&D revenue from Event Business waste generators decreased 3% in 2018 compared to 2017 and comprised 20% of total T&D revenue. The decrease in Event Business T&D revenue compared to the prior year primarily reflects lower T&D revenue from the general manufacturing, mining, exploration and production and refining industry groups, partially offset by higher T&D revenue from the government and “Other” industry groups. The following table summarizes combined Base Business and Event Business T&D revenue growth, within the Environmental Services segment, by waste generator industry for 2018 compared to 2017: Field & Industrial Services Field & Industrial Services segment revenue increased 20% to $165.3 million in 2018 compared with $137.7 million in 2017. The increase in Field & Industrial Services segment revenue is primarily attributable to revenue from new facilities in 2018 and stronger overall market conditions. Gross Profit Total gross profit increased 11% to $170.1 million in 2018, up from $153.1 million in 2017. Total gross margin was 30% for both 2018 and 2017. Environmental Services Environmental Services segment gross profit increased 9% to $147.5 million in 2018, up from $135.0 million in 2017. This increase primarily reflects higher T&D volumes in 2018 compared to 2017. Total segment gross margin was 37% for both 2018 and 2017. T&D gross margin was 42% for 2018 compared with 40% for 2017. 2017 T&D gross margin reflects the impact of the temporary closure of one of our treatment facilities due to wind damage and incremental costs associated with the hurricanes in the Gulf Coast and Florida that impacted our operations in 2017. Field & Industrial Services Field & Industrial Services segment gross profit increased 25% to $22.6 million in 2018, up from $18.2 million in 2017. Total segment gross margin was 14% for 2018 compared with 13% for 2017. The increase in segment gross margin is primarily attributable to contract wins and associated revenue in our small quantity generation services and total waste management businesses, stronger market conditions in our remediation business and the contribution from new facilities in 2018. Selling, General and Administrative Expenses (“SG&A”) Total SG&A increased to $92.3 million, or 16% of total revenue, in 2018 compared with $84.5 million, or 17% of total revenue, in 2017. Environmental Services Environmental Services segment SG&A decreased 7% to $22.5 million, or 6% of segment revenue, in 2018 compared with $24.2 million, or 7% of segment revenue, in 2017, primarily reflecting lower property tax expense and lower amortization expense. The decrease in property tax expense in 2018 was the result of a settlement in the second quarter of 2018 on a dispute related to a $1.1 million property tax assessment for tax years 2015 through 2017 associated with our 2014 acquisition of EQ Holdings, Inc. recorded in the third quarter of 2017. Field & Industrial Services Field & Industrial Services segment SG&A increased 16% to $10.7 million, or 7% of segment revenue, in 2018 compared with $9.3 million, or 7% of segment revenue, in 2017. The increase in segment SG&A primarily reflects incremental costs associated with new facilities in 2018. Corporate Corporate SG&A was $59.1 million, or 10% of total revenue, in 2018 compared with $51.0 million, or 10% of total revenue, in 2017, primarily reflecting higher employee labor costs and higher consulting and professional services expenses in 2018 compared to 2017. Components of Adjusted EBITDA Income tax expense Our effective income tax rate for 2018 was 23.5% compared to -14.9% in 2017. The increase was primarily the result of the impact the Tax Act, enacted on December 22, 2017, had on our 2017 effective tax rate. Among other provisions, the Tax Act reduces the federal corporate tax rate to 21% from the existing maximum rate of 35%, effective for tax years beginning after December 31, 2017, and imposes a deemed repatriation tax on previously untaxed accumulated earnings and profits of foreign subsidiaries. As required in the period of enactment, we re-measured our net deferred tax assets and liabilities and recorded a provisional benefit of $25.2 million to our income tax expense. We also recorded a provisional charge of $1.4 million to our income tax expense for the deemed repatriation transition tax. Interest expense Interest expense was $12.1 million in 2018 compared with $18.2 million in 2017. The decrease in interest expense in 2018 was primarily the result of a non-cash charge of $5.5 million to interest expense in 2017 related to the refinancing of Predecessor US Ecology’s credit agreement with Wells Fargo, dated June 17, 2014 (the “2014 Credit Agreement”). The remaining decrease is attributable to a lower effective interest rate under our the Credit Agreement, partially offset by additional interest expense on borrowings used to finance the Winnie acquisition. Foreign currency gain (loss) We recognized a $55,000 non-cash foreign currency gain in 2018 compared with a $516,000 non-cash foreign currency gain in 2017. Foreign currency gains and losses reflect changes in business activity conducted in a currency other than the USD, our functional currency. Our Canadian subsidiaries’ facilities are located in Blainville, Québec and Tilbury, Ontario, Canada and use the Canadian dollar as their functional currency. Additionally, we established intercompany loans with our Canadian subsidiaries, whose functional currency is the CAD, as part of a tax and treasury management strategy allowing for repayment of third-party bank debt. These intercompany loans are payable by our Canadian subsidiaries to US Ecology in CAD requiring us to revalue the outstanding loan balance through our statements of operations based on USD/CAD currency movements from period to period. At December 31, 2018, we had $20.3 million of intercompany loans subject to currency revaluation. Other income Other income was $2.6 million in 2018 compared with other income of $791,000 in 2017, primarily reflecting a $2.0 million gain in 2018 on the issuance of a property easement on a portion of unutilized Company-owned land at one of our operating facilities. Depreciation and amortization of plant and equipment Depreciation and amortization expense increased to $29.2 million in 2018 compared with $28.3 million in 2017, primarily reflecting additional depreciation expense on assets placed in service in 2018, including assets associated with the ES&H Dallas and Winnie acquisitions. Amortization of intangibles Intangible assets amortization expense was $9.6 million in 2018 compared with $9.9 million in 2017, primarily reflecting the full amortization of certain intangible assets in 2017, partially offset by additional amortization of intangible assets recorded as a result of the ES&H Dallas and Winnie acquisitions. Share-based compensation Share-based compensation expense increased 11% to $4.4 million in 2018, compared with $3.9 million 2017 as a result of an increase in equity-based awards granted to employees. Accretion and non-cash adjustment of closure and post-closure liabilities Accretion and non-cash adjustment of closure and post-closure liabilities increased to $3.7 million in 2018 compared with $3.0 million in 2017, primarily reflecting higher non-cash adjustments to post-closure liabilities recorded in 2017 due to changes in cost estimates and timing associated with closed sites. Impairment charges Based on the results of our 2018 interim assessment of the goodwill and intangible assets of our Mobile Recycling reporting unit, which is part of our Environmental Services segment, we recorded impairment charges of $3.7 million in the third quarter of 2018. Based on the results of our 2017 annual assessment of goodwill and intangible assets, we recorded impairment charges of $8.9 million in our Resource Recovery reporting unit, which is part of our Environmental Services segment, in the fourth quarter of 2017. See Note 13 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information. Liquidity and Capital Resources Our primary sources of liquidity are cash and cash equivalents, cash generated from operations and borrowings under the Credit Agreement. At December 31, 2019, we had $41.3 million in unrestricted cash and cash equivalents immediately available and $166.3 million of borrowing capacity available under our Revolving Credit Facility. We assess our liquidity in terms of our ability to generate cash to fund our operating, investing and financing activities. Our primary ongoing cash requirements are funding operations, capital expenditures, paying principal and interest on our long-term debt, and paying declared dividends pursuant to our dividend policy. We believe future operating cash flows will be sufficient to meet our future operating, investing and dividend cash needs for the foreseeable future. Furthermore, existing cash balances and availability of additional borrowings under the Credit Agreement provide additional sources of liquidity should they be required. Operating Activities. In 2019, net cash provided by operating activities was $79.6 million. This primarily reflects net income of $33.1 million, non-cash depreciation, amortization and accretion of $61.3 million, share-based compensation and business development and integration expenses of $9.3 million, an increase in accrued salaries and benefits of $8.3 million and deferred income taxes of $6.6 million, partially offset by a $12.4 million gain on insurance proceeds from damaged property and equipment, a decrease in accounts payable and accrued liabilities of $10.7 million, an increase in accounts receivable of $9.4 million and an increase in income taxes receivable of $4.2 million. Impacts on net income are due to the factors discussed above under “Results of Operations.” The increase in accrued salaries and benefits is primarily attributable to higher employee-incentive plan accruals and higher employee-termination benefits accruals associated with the NRC Merger in 2019. The decrease in accounts payable and accrued liabilities is primarily attributable to the timing of payments to vendors for products and services. We recognized property-related insurance recoveries in 2019 related to the incident at our Grand View, Idaho facility in the fourth quarter of 2018. The increase in receivables is primarily attributable to the timing of customer payments. The change in income taxes receivable and deferred income taxes is primarily attributable to the timing of income tax payments as well as the Company’s ability to use NRC’s tax attributes to offset cash taxes for 2019. We calculate days sales outstanding (“DSO”) as a rolling four quarter average of our net accounts receivable divided by our quarterly revenue. In the fourth quarter of 2019, we modified our DSO calculation methodology to exclude non-trade receivables from our net accounts receivable balance. Our net accounts receivable balance for the DSO calculation historically included trade accounts receivable, net of allowance for doubtful accounts, unbilled accounts receivable and other non-trade receivables, adjusted for changes in deferred revenue. Under this modified method, our DSO as of December 31, 2019, excluding NRC operations, was 80 days as compared to 74 days as of December 31, 2018. Under our historical method, our DSO as of December 31, 2019, excluding NRC operations, was 86 days as compared to 77 days as of December 31, 2018. In 2018, net cash provided by operating activities was $81.5 million. This primarily reflects net income of $49.6 million, non-cash depreciation, amortization and accretion of $42.6 million, an increase in accounts payable and accrued liabilities of $14.3 million, deferred income taxes of $5.9 million, share-based compensation expense of $4.4 million and non-cash impairment charges of $3.7 million, partially offset by an increase in accounts receivable of $32.3 million and an increase in income taxes receivable of $7.1 million. Impacts on net income are due to the factors discussed above under “Results of Operations.” The decrease in accounts payable and accrued liabilities is primarily attributable to the timing of payments to vendors for products and services. The increase in receivables is primarily attributable to the timing of customer payments. Changes in income taxes receivable are primarily attributable to the timing of income tax payments. In 2017, net cash provided by operating activities was $79.7 million. This primarily reflects net income of $49.4 million, non-cash depreciation, amortization and accretion of $41.2 million, non-cash impairment charges of $8.9 million, amortization and write-off of debt issuance costs of $6.0 million, a decrease in income taxes receivable of $4.1 million, share-based compensation expense of $3.9 million, an increase in income taxes payable of $3.9 and an increase in accrued salaries and benefits of $3.4 million, partially offset by a decrease in deferred income taxes of $25.3 million, an increase in accounts receivable of $13.9 million, and a decrease in closure and post-closure obligations of $1.8 million. Impacts on net income are due to the factors discussed above under “Results of Operations.” The increase in receivables is primarily attributable to the timing of customer payments. Changes in income taxes receivable and payable are primarily attributable to the timing of income tax payments. Changes in deferred income taxes are primarily attributable to the re-measurement of our deferred tax assets and liabilities based on the provisions of the Tax Act. Investing Activities. In 2019, net cash used in investing activities was $455.7 million, primarily used to refinance the indebtedness of NRC and pay transaction expenses incurred in connection with the NRC Merger in the aggregate amount of $381.7 million, net of cash acquired, capital expenditures of $58.1 million, the acquisition of US Ecology Sarnia for $17.9 million, a $7.9 million investment in the preferred stock of a privately held company and a $4.0 million payment of a contingent consideration liability acquired in connection with the NRC Merger, partially offset by property insurance proceeds of $12.7 million related to the incident at our Grand View, Idaho facility in the fourth quarter of 2018. Significant capital projects included construction of additional disposal capacity at our Belleville, Michigan; Robstown, Texas; and Blainville, Québec, Canada facilities, as well as equipment purchases and infrastructure upgrades at our corporate and operating facilities. In 2018, net cash used in investing activities was $148.8 million, primarily related the acquisition of Winnie for $87.1 million, the acquisition of ES&H Dallas for $21.3 million, and capital expenditures of $40.8 million. Significant capital projects included continuing construction of additional disposal capacity and railway expansions at our Blainville, Québec, Canada location and infrastructure upgrades at our corporate and operating facilities. In 2017, net cash used in investing activities was $33.9 million, primarily related to capital expenditures. Significant capital projects included construction of additional disposal capacity at our Beatty, Nevada and Blainville, Québec, Canada locations and equipment purchases and infrastructure upgrades at our corporate and operating facilities. Financing Activities. During 2019, net cash provided by financing activities was $384.4 million, consisting primarily of $448.9 million of borrowings, net of original issue discount, under the new Term Loan used primarily to refinance the indebtedness of NRC and pay transaction expenses incurred in connection with the NRC Merger and $43.0 million of Revolving Credit Facility borrowings primarily used for the payment of NRC Merger-related expenses and to fund the purchase of US Ecology Sarnia, partially offset by $80.0 million of repayments of outstanding Revolving Credit Facility borrowings, $15.9 million of dividend payments to our stockholders and $9.4 million of deferred financing costs paid in connection with the amendment of the Credit Agreement and the issuance of the new Term Loan. During 2018, net cash provided by financing activities was $72.9 million, consisting primarily of $87.0 million in proceeds under the Credit Agreement to fund the acquisition of Winnie and $2.4 million in proceeds received from the exercise of stock options, partially offset by $15.8 million of dividend payments to our stockholders. During 2017, net cash used in financing activities was $26.3 million, consisting primarily of $283.0 million of repayment of the Company’s long-term debt under the 2014 Credit Agreement, $281.0 million of initial proceeds from the borrowing of long-term debt under the Credit Agreement, $4.0 million of subsequent repayments of long-term debt under the Credit Agreement, $15.7 million of dividend payments to our stockholders, $3.0 million of deferred financing costs associated with the Credit Agreement and net payment activity on the Company’s short-term borrowings of $2.2 million. Credit Facility On April 18, 2017, Predecessor US Ecology, a wholly-owned subsidiary of the Company, entered into a new senior secured credit agreement (the “Credit Agreement”) with Wells Fargo, as administrative agent for the lenders, swingline lender and issuing lender, and Bank of America, N.A., as an issuing lender, that provides for a $500.0 million, five-year revolving credit facility (the “Revolving Credit Facility”), including a $75.0 million sublimit for the issuance of standby letters of credit and a $25.0 million sublimit for the issuance of swingline loans used to fund short-term working capital requirements. The Credit Agreement also contains an accordion feature whereby Predecessor US Ecology may request up to $200.0 million of additional funds through an increase to the Revolving Credit Facility, through incremental term loans, or some combination thereof. As described below, the Credit Agreement was amended in November 2019 in connection with the NRC Merger. In addition, as a result of the consummation of the NRC Merger, the borrower under the Credit Facility is Predecessor US Ecology, a wholly-owned subsidiary of the Company. In connection with Predecessor US Ecology’s entry into the Credit Agreement, Predecessor US Ecology terminated the 2014 Credit Agreement. Immediately prior to the termination of the 2014 Credit Agreement, there were $278.3 million of term loans and no revolving loans outstanding under the 2014 Credit Agreement. No early termination penalties were incurred as a result of the termination of the 2014 Credit Agreement. Predecessor US Ecology wrote off certain unamortized deferred financing costs and original issue discount associated with the 2014 Credit Agreement that were to be amortized to interest expense in future periods through a non-cash charge of $5.5 million to interest expense in 2017. During the year ended December 31, 2019, the effective interest rate on the Revolving Credit Facility, after giving effect to the impact of our interest rate swap and the amortization of the loan discount and debt issuance costs, was 3.98%. Interest only payments are due either quarterly or on the last day of any interest period, as applicable. In October 2014, Predecessor US Ecology entered into an interest rate swap agreement, effectively fixing the interest rate on $150.0 million, or 46%, of the Revolving Credit Facility borrowings as of December 31, 2019. Predecessor US Ecology is required to pay a commitment fee ranging from 0.175% to 0.35% on the average daily unused portion of the Revolving Credit Facility, with such commitment fee to be reduced based upon Predecessor US Ecology’s total net leverage ratio (as defined in the Credit Agreement). The maximum letter of credit capacity under the Revolving Credit Facility is $75.0 million and the Credit Agreement provides for a letter of credit fee equal to the applicable margin for LIBOR loans under the Revolving Credit Facility. At December 31, 2019, there were $327.0 million of borrowings outstanding on the Revolving Credit Facility. These borrowings are due on the revolving credit maturity date (as defined in the Credit Agreement) and presented as long-term debt in the consolidated balance sheets. Predecessor US Ecology has entered into a sweep arrangement whereby day-to-day cash requirements in excess of available cash balances are advanced to the Company on an as-needed basis with repayments of these advances automatically made from subsequent deposits to our cash operating accounts (the “Sweep Arrangement”). Total advances outstanding under the Sweep Arrangement are subject to the $40.0 million swingline loan sublimit under the Revolving Credit Facility. Predecessor US Ecology’s revolving credit loans outstanding under the Revolving Credit Facility are not subject to repayment through the Sweep Arrangement. As of December 31, 2019, there were no amounts outstanding subject to the Sweep Arrangement. As of December 31, 2019, the availability under the Revolving Credit Facility was $166.3 million with $6.7 million of the Revolving Credit Facility issued in the form of standby letters of credit utilized as collateral for closure and post-closure financial assurance and other assurance obligations. Amendments to the Credit Agreement On August 6, 2019, Predecessor US Ecology entered into the first amendment (the “First Amendment”) to the Credit Agreement, by and among Predecessor US Ecology, the subsidiaries of Predecessor US Ecology party thereto, the lenders referred to therein and Wells Fargo, as issuing lender, swingline lender and administrative agent. Effective November 1, 2019, the First Amendment, among other things, extended the expiration of the Revolving Credit Facility to November 1, 2024, permitted the issuance of a $400.0 million incremental term loan to be used to refinance the indebtedness of NRC and pay related transaction expenses in connection with the NRC Merger, modified the accordion feature allowing Predecessor US Ecology to request up to the greater of (x) $250.0 million and (y) 100% of consolidated EBITDA plus certain additional amounts, increased the sublimit for the issuance of swingline loans to $40.0 million and increased the maximum consolidated total net leverage ratio to 4.00 to 1.00. On November 1, 2019, Predecessor US Ecology entered into the lender joinder agreement and second amendment (the “Second Amendment”) to the Credit Agreement. Effective November 1, 2019, the Second Amendment, among other things, amended the Credit Agreement to increase the capacity for incremental term loans by $50.0 million and provided for Wells Fargo lending $450.0 million in incremental term loans to Predecessor US Ecology to pay off the existing debt of NRC in connection with the NRC Merger, to pay certain fees, costs and expenses incurred in connection with the NRC Merger and to repay outstanding borrowings under the Revolving Credit Facility. The seven-year incremental term loan matures November 1, 2026, requires principal repayment of 1% annually, and bears interest at LIBOR plus 2.25% or a base rate plus 1.25% (with a step-up to LIBOR plus 2.50% or a base rate plus 1.50% in the event that US Ecology credit ratings are not BB (with a stable or better outlook) or better from S&P and Ba2 (with a stable or better outlook) or better from Moody’s). The effective interest rate on the term loan, including the impact of the amortization of debt issuance costs, was 4.45% from the issue date through December 31, 2019. See Note 16 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information on the Company’s debt. Contractual Obligations and Guarantees Contractual Obligations US Ecology’s contractual obligations at December 31, 2019 become due as follows: (1) For the purposes of the table above, closure and post-closure obligations are shown on an undiscounted basis and inflated using an estimated annual inflation rate of 2.6%. Cash payments for closure and post-closure obligation extend to the year 2105. (2) At December 31, 2019, there were $327.0 million of revolving credit loans outstanding on the Revolving Credit Facility. These revolving credit loans are due upon the earliest to occur of (a) November 1, 2024 (or, with respect to any lender, such later date as requested by us and accepted by such lender), (b) the date of termination of the entire revolving credit commitment (as defined in the Credit Agreement, as amended) by us, and (c) the date of termination of the revolving credit commitment. At December 31, 2019 there were $450.0 million of Term Loan borrowings outstanding. The Term Loan matures on November 1, 2026 and requires principal repayment of 1% annually. (3) Interest expense has been calculated using the interest rate of 3.20% in effect at December 31, 2019 on the unhedged variable rate portion of the Revolving Credit Facility borrowings, 3.67% on the fixed rate hedged portion of the Revolving Credit Facility borrowings and 4.20% on Term Loan borrowings. The interest expense calculation reflects assumed payments on the Revolving Credit Facility and the Term Loan borrowings consistent with the disclosures in footnote (2) above. (4) As we are not able to reasonably estimate when we would make any cash payments to settle unrecognized tax benefits of $247,000, such amounts have not been included in the table above. Guarantees We enter into a wide range of indemnification arrangements, guarantees and assurances in the ordinary course of business and have evaluated agreements that contain guarantees and indemnification clauses. These include tort indemnities, tax indemnities, indemnities against third-party claims arising out of arrangements to provide services to us and indemnities related to the sale of our securities. We also indemnify individuals made party to any suit or proceeding if that individual was acting as an officer or director of US Ecology or was serving at the request of US Ecology or any of its subsidiaries during their tenure as a director or officer. We also provide guarantees and indemnifications for the benefit of our wholly-owned subsidiaries to satisfy performance obligations, including closure and post-closure financial assurances. It is difficult to quantify the maximum potential liability under these indemnification arrangements; however, we are not currently aware of any material liabilities to the Company or any of its subsidiaries arising from these arrangements. Environmental Matters We maintain funded trust agreements, surety bonds and insurance policies for future closure and post-closure obligations at both current and formerly operated disposal facilities. These funded trust agreements, surety bonds and insurance policies are based on management estimates of future closure and post-closure monitoring using engineering evaluations and interpretations of regulatory requirements which are periodically updated. Accounting for closure and post-closure costs includes final disposal cell capping and revegetation, soil and groundwater monitoring and routine maintenance and surveillance required after a site is closed. We estimate that our undiscounted future closure and post-closure costs for all facilities was approximately $320.3 million at December 31, 2019, with a median payment year of 2063. Our future closure and post-closure estimates are our best estimate of current costs and are updated periodically to reflect current technology, cost of materials and services, applicable laws, regulations, permit conditions or orders and other factors. These current costs are adjusted for anticipated annual inflation, which we assumed to be 2.6% as of December 31, 2019. These future closure and post-closure estimates are discounted to their present value for financial reporting purposes using our credit-adjusted risk-free interest rate, which approximates our incremental long-term borrowing rate in effect at the time the obligation is established or when there are upward revisions to our estimated closure and post-closure costs. At December 31, 2019, our weighted-average credit-adjusted risk-free interest rate was 5.9%. For financial reporting purposes, our recorded closure and post-closure obligations were $86.4 million and $78.4 million as of December 31, 2019 and 2018, respectively. Through December 31, 2019, we have met our financial assurance requirements through insurance, surety bonds, standby letters of credit and self-funded restricted trusts. U.S. Operating and Non-Operating Facilities We cover our closure and post-closure obligations for our U.S. operating facilities through the use of third-party insurance policies, surety bonds and standby letters of credit. As of December 31, 2019, we had provided collateral of $5.1 million in funded trust agreements, $23.1 million in surety bonds, issued $3.6 million in letters of credit for financial assurance and have insurance policies of approximately $103.5 million for closure and post-closure obligations at covered U.S. operating and non-operating facilities. Cash held in funded trust agreements for our closure and post-closure obligations is identified as Restricted cash and investments on our consolidated balance sheets. All closure and post-closure funding obligations for our Beatty, Nevada and Richland, Washington facilities revert to the respective state. Volume based fees are collected from our customers and remitted to state controlled trust funds to cover the estimated cost of closure and post-closure obligations. Stablex We use commercial surety bonds to cover our closure obligations for our Stablex facility located in Blainville, Québec, Canada. Our lease agreement with the Province of Québec requires that the surety bond be maintained for 25 years after the lease expires in 2023. At December 31, 2019 we had $775,000 in commercial surety bonds dedicated for closure obligations. These bonds were renewed in November and December 2019 and expire in November and December 2020. Post-closure funding obligations for the Stablex landfill revert back to the Province of Québec through a dedicated trust account that is funded based on a per-metric-ton disposed fee by Stablex. We expect to renew insurance policies and commercial surety bonds in the future. If we are unable to obtain adequate closure, post-closure or environmental liability insurance and/or commercial surety bonds in future years, any partial or completely uninsured claim against us, if successful and of sufficient magnitude, could have a material adverse effect on our financial condition, results of operations or cash flows. Additionally, continued access to casualty and pollution legal liability insurance with sufficient limits, at acceptable terms, is important to obtaining new business. Failure to maintain adequate financial assurance could also result in regulatory action including early closure of facilities. While we believe we will be able to maintain the requisite financial assurance policies at a reasonable cost, premium and collateral requirements may materially increase. Operation of disposal facilities creates operational, closure and post-closure obligations that could result in unplanned monitoring and corrective action costs. We cannot predict the likelihood or effect of all such costs, new laws or regulations, litigation or other future events affecting our facilities. We do not believe that continuing to satisfy our environmental obligations will have a material adverse effect on our financial condition or results of operations. Seasonal Effects Seasonal fluctuations due to weather and budgetary cycles can influence the timing of customer spending for our services. Typically, in the first quarter of each calendar year there is less demand for our services due to weather-related reduced construction and business activities while we experience improvement in our second and third quarters of each calendar year as weather conditions and other business activity improves. Critical Accounting Policies 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. The preparation of these financial statements require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates included in our critical accounting policies discussed below and those accounting policies and use of estimates discussed in Notes 2 and 3 to the Consolidated Financial Statements located in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. We base our estimates on historical experience and on various assumptions and other factors we believe to be reasonable, 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 make adjustments to judgments and estimates based on current facts and circumstances on an ongoing basis. Historically, actual results have not deviated significantly from those determined using the estimates described below or in Notes 2 and 3 to the Consolidated Financial Statements located in “Part II, Item 8. Financial Statements and Supplementary Data” to this Annual Report on Form 10-K. However, actual amounts could differ materially from those estimated at the time the consolidated financial statements are prepared. We believe the following critical accounting policies are important to understand our financial condition and results of operations and require management’s most difficult, subjective or complex judgments, often as a result of the need to estimate the effect of matters that are inherently uncertain. Revenue Recognition Revenues are recognized when control of the promised services is transferred to our customers, in an amount that reflects the consideration we expect to be entitled to in exchange for those services. We recognize revenue from three primary sources: (1) waste treatment, recycling and disposal services, (2) field and industrial waste management services and (3) waste transportation services. Our waste treatment and disposal customers are legally obligated to properly treat and dispose of their waste in accordance with local, state and federal laws and regulations. As our customers do not possess the resources to properly treat and dispose of their waste independently, they contract with the Company to perform the services. Waste treatment, recycling, and disposal revenue results primarily from fixed fees charged to customers for treatment and/or disposal or recycling of specified wastes. Waste treatment, recycling, and disposal revenue is generally charged on a per-ton or per-yard basis at contracted prices and is recognized over time as the services are performed. Our treatment and disposal services are generally performed as the waste is received and considered complete upon final disposal. Field and industrial waste management services revenue results primarily from specialty onsite services such as high-pressure cleaning, tank cleaning, decontamination, remediation, transportation, spill cleanup and emergency response at refineries, chemical plants, steel and automotive plants, and other government, commercial and industrial facilities. We also provide hazardous waste packaging and collection services and total waste management solutions at customer sites and through our 10-day transfer facilities. These services are provided based on purchase orders or agreements with the customer and include prices based upon daily, hourly or job rates for equipment, materials and personnel. Generally, the pricing in these types of contracts is fixed, but the quantity of services to be provided during the contract term is variable and revenues are recognized over the term of the agreements or as services are performed. As we have a right to consideration from our customers in an amount that corresponds directly with the value to the customer of the Company’s performance completed to date, we have applied the practical expedient to recognize revenue in the amount to which we have the right to invoice. Additionally, we have customers that pay annual retainer fees, primarily for our standby services, under long-term or evergreen contracts. Such retainer fees are recognized over time as the services are performed and it is probable that a significant reversal in the amount of cumulative revenue recognized on the contracts will not occur. Transportation and logistics revenue results from delivering customer waste to a disposal facility for treatment and/or disposal or recycling. Transportation services are generally not provided on a stand-alone basis and instead are bundled with other Company services. However, in some instances we provide transportation and logistics services for shipment of waste from cleanup sites to disposal facilities operated by other companies. For such arrangements, we allocate revenue to each performance obligation based on its relative standalone selling price. We generally determine standalone selling prices based on the prices charged to customer or using expected cost plus margin. Transportation revenue is recognized over time as the waste is transported. Taxes and fees collected from customers concurrent with revenue-producing transactions to be remitted to governmental authorities are excluded from revenue. Our Richland, Washington disposal facility is regulated by the WUTC, which approves our rates for disposal of LLRW. Annual revenue levels are established based on a rate agreement with the WUTC at amounts sufficient to cover our costs of operation, including facility maintenance, equipment replacement and related costs, and provide us with a reasonable profit. Per-unit rates charged to LLRW customers during the year are based on our evaluation of disposal volume and radioactivity projections submitted to us by waste generators. Our proposed rates are then reviewed and approved by the WUTC. If annual revenue exceeds the approved levels set by the WUTC, we are required to refund excess collections to facility users on a pro-rata basis. Refundable excess collections, if any, are recorded in Accrued liabilities in the consolidated balance sheets. The current rate agreement with the WUTC was extended in 2019 and is effective until December 31, 2025. Disposal Facility Accounting We amortize landfill and disposal assets and certain related permits over their estimated useful lives. The units-of-consumption method is used to amortize landfill cell construction and development costs and asset retirement costs. Under the units-of-consumption method, we include costs incurred to date as well as future estimated construction costs in the amortization base of the landfill assets. Additionally, where appropriate, as discussed below, we also include probable expansion airspace that has yet to be permitted in the calculation of the total remaining useful life of the landfill asset. If we determine that expansion capacity should no longer be considered in calculating the total remaining useful life of a landfill asset, we may be required to recognize an asset impairment or incur significantly higher amortization expense over the remaining estimated useful life of the landfill asset. If at any time we make the decision to abandon the expansion effort, the capitalized costs related to the expansion effort would be expensed in the period of abandonment. Our landfill assets and liabilities fall into the following two categories, each of which require accounting judgments and estimates: ● Landfill assets comprised of capitalized landfill development costs. ● Disposal facility retirement obligations relating to our capping, closure and post-closure liabilities that result in corresponding retirement assets. Landfill Assets Landfill assets include the costs of landfill site acquisition, permits and cell design and construction incurred to date. Landfill cells represent individual disposal areas within the overall treatment and disposal site and may be subject to specific permit requirements in addition to the general permit requirements associated with the overall site. To develop, construct and operate a landfill cell, we must obtain permits from various regulatory agencies at the local, state and federal levels. The permitting process requires an initial site study to determine whether the location is feasible for landfill operations. The initial studies are reviewed by our environmental management group and then submitted to the regulatory agencies for approval. During the development stage we capitalize certain costs that we incur after site selection but before the receipt of all required permits if we believe that it is probable that the landfill cell will be permitted. Upon receipt of regulatory approval, technical landfill cell designs are prepared. The technical designs, which include the detailed specifications to develop and construct all components of the landfill cell including the types and quantities of materials that will be required, are reviewed by our environmental management group. The technical designs are submitted to the regulatory agencies for approval. Upon approval of the technical designs, the regulatory agencies issue permits to develop and operate the landfill cell. The types of costs that are detailed in the technical design specifications generally include excavation, natural and synthetic liners, construction of leachate collection systems, installation of groundwater monitoring wells, construction of leachate management facilities and other costs associated with the development of the site. We review the adequacy of our cost estimates at least annually. These development costs, together with any costs incurred to acquire, design and permit the landfill cell, including personnel costs of employees directly associated with the landfill cell design, are recorded to the landfill asset on the balance sheet as incurred. To match the expense related to the landfill asset with the revenue generated by the landfill operations, we amortize the landfill asset on a units-of-consumption basis over its operating life, typically on a cubic yard or cubic meter of disposal space consumed. The landfill asset is fully amortized at the end of a landfill cell’s operating life. The per-unit amortization rate is calculated by dividing the sum of the landfill asset net book value plus estimated future development costs (as described above) for the landfill cell, by the landfill cell’s estimated remaining disposal capacity. Amortization rates are influenced by the original cost basis of the landfill cell, including acquisition costs, which in turn is determined by geographic location and market values. We have secured significant landfill assets through business acquisitions and valued them at the time of acquisition based on fair value. Included in the technical designs are factors that determine the ultimate disposal capacity of the landfill cell. These factors include the area over which the landfill cell will be developed, such as the depth of excavation, the height of the landfill cell elevation and the angle of the side-slope construction. Landfill cell capacity used in the determination of amortization rates of our landfill assets includes both permitted and unpermitted disposal capacity. Unpermitted disposal capacity is included when management believes achieving final regulatory approval is probable based on our analysis of site conditions and interactions with applicable regulatory agencies. We review the estimates of future development costs and remaining disposal capacity for each landfill cell at least annually. These costs and disposal capacity estimates are developed using input from independent engineers and internal technical and accounting managers and are reviewed and approved by our environmental management group. Any changes in future estimated costs or estimated disposal capacity are reflected prospectively in the landfill cell amortization rates. We assess our long-lived landfill assets for impairment when an event occurs or circumstances change that indicate the carrying amount may not be recoverable. Examples of events or circumstances that may indicate impairment of any of our landfill assets include, but are not limited to, the following: ● Changes in legislative or regulatory requirements impacting the landfill site permitting process making it more difficult and costly to obtain and/or maintain a landfill permit; ● Actions by neighboring parties, private citizen groups or others to oppose our efforts to obtain, maintain or expand permits, which could result in denial, revocation or suspension of a permit and adversely impact the economic viability of the landfill. As a result of opposition to our obtaining a permit, improved technical information as a project progresses, or changes in the anticipated economics associated with a project, we may decide to reduce the scope of, or abandon, a project, which could result in an asset impairment; and ● Unexpected significant increases in estimated costs, significant reductions in prices we are able to charge our customers or reductions in disposal capacity that affect the ongoing economic viability of the landfill. Disposal Facility Retirement Obligations Disposal facility retirement obligations include the cost to close, maintain and monitor landfill cells and support facilities. As individual landfill cells reach capacity, we must cap and close the cells in accordance with the landfill cell permits. These capping and closure requirements are detailed in the technical design of each landfill cell and included as part of our approved regulatory permit. After the entire landfill cell has reached capacity and is certified closed, we must continue to maintain and monitor the landfill cell for a post-closure period, which generally extends for 30 years. Costs associated with closure and post-closure requirements generally include maintenance of the landfill cell and groundwater systems, and other activities that occur after the landfill cell has ceased accepting waste. Costs associated with post-closure monitoring generally include groundwater sampling, analysis and statistical reports, transportation and disposal of landfill leachate and erosion control costs related to the final cap. We have a legally enforceable obligation to operate our landfill cells in accordance with the specific requirements, regulations and criteria set forth in our permits. This includes executing the approved closure/post-closure plan and closing/capping the entire landfill cell in accordance with the established requirements, design and criteria contained in the permit. As a result, we record the fair value of our disposal facility retirement obligations as a liability in the period in which the regulatory obligation to retire a specific asset is triggered. For our individual landfill cells, the required closure and post-closure obligations under the terms of our permits and our intended operation of the landfill cell are triggered and recorded when the cell is placed into service and waste is initially disposed in the landfill cell. The fair value is based on the total estimated costs to close the landfill cell and perform post-closure activities once the landfill cell has reached capacity and is no longer accepting waste, discounted using a credit-adjusted risk-free rate. Retirement obligations are increased each year to reflect the passage of time by accreting the balance at the weighted average credit-adjusted risk-free rate that is used to calculate the recorded liability, with accretion charged to direct operating costs. Actual cash expenditures to perform closure and post-closure activities reduce the retirement obligation liabilities as incurred. After initial measurement, asset retirement obligations are adjusted at the end of each period to reflect changes, if any, in the estimated future cash flows underlying the obligation. Disposal facility retirement assets are capitalized as the related disposal facility retirement obligations are incurred. Disposal facility retirement assets are amortized on a units-of-consumption basis as the disposal capacity is consumed. Our disposal facility retirement obligations represent the present value of current cost estimates to close, maintain and monitor landfills and support facilities as described above. Cost estimates are developed using input from independent engineers, internal technical and accounting managers, as well as our environmental management group’s interpretation of current legal and regulatory requirements, and are intended to approximate fair value. We estimate the timing of future payments based on expected annual disposal airspace consumption and then inflate the current cost estimate by an inflation rate, estimated at December 31, 2019 to be 2.6%. Inflated current costs are then discounted using our credit-adjusted risk-free interest rate, which approximates our incremental borrowing rate in effect at the time the obligation is established or when there are upward revisions to our estimated closure and post-closure costs. Our weighted-average credit-adjusted risk-free interest rate at December 31, 2019 was approximately 5.9%. Final closure and post-closure obligations are currently estimated as being paid through the year 2105. During 2019 we updated several assumptions, including estimated costs and timing of closing our disposal cells. These updates resulted in a net decrease to our post-closure obligations of $221,000 in 2019. We update our estimates of future capping, closure and post-closure costs and of future disposal capacity for each landfill cell on an annual basis. Changes in inflation rates or the estimated costs, timing or extent of the required future activities to close, maintain and monitor landfills and facilities result in both: (i) a current adjustment to the recorded liability and related asset and (ii) a change in accretion and amortization rates which are applied prospectively over the remaining life of the asset. A hypothetical 1% increase in the inflation rate would increase our closure/post-closure obligation by $18.3 million. A hypothetical 10% increase in our cost estimates would increase our closure/post-closure obligation by $8.0 million. Goodwill and Intangible Assets Goodwill As of December 31, 2019, the Company’s goodwill balance was $767.0 million. We assess goodwill for impairment during the fourth quarter as of October 1 of each year, and also if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. The assessment consists of comparing the fair value of the reporting unit to the carrying value of the net assets assigned to the reporting unit, including goodwill. Some of the factors that could indicate impairment include a significant adverse change in legal factors or in the business climate, an adverse action or assessment by a regulator, or failure to generate sufficient cash flows at the reporting unit. For example, field and industrial services represents an emerging business for the Company and has been the focus of a shift in strategy since the acquisition of EQ. Failure to execute on planned growth initiatives within this business could lead to the impairment of goodwill and intangible assets in future periods. We determine our reporting units by identifying the components of each operating segment, and then aggregate components having similar economic characteristics based on quantitative and/or qualitative factors. At December 31, 2019, we had 14 reporting units, nine of which had allocated goodwill. Fair values are generally determined by an income approach, discounting projected future cash flows based on our expectations of the current and future operating environment, using a market approach, applying a multiple of earnings based on guideline for publicly traded companies, or a combination thereof. Estimating future cash flows requires significant judgment about factors such as general economic conditions and projected growth rates, and our estimates often vary from the cash flows eventually realized. The rates used to discount projected future cash flows reflect a weighted average cost of capital based on our industry, capital structure and risk premiums including those reflected in the current market capitalization. In the event the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired. If the carrying amount of a reporting unit exceeds its fair value, goodwill of the reporting unit is considered impaired, and an impairment charge would be recognized during the period in which the determination has been made 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 that reporting unit. The result of the annual assessment of goodwill undertaken in the fourth quarter of 2019 indicated that the fair value of each of our reporting units was in excess of its respective carrying value. In connection with our annual budgeting process commencing in the third quarter of 2018 and review of the projected future cash flows of our reporting units used in our annual assessment of goodwill, it was determined that the projected future cash flows of our Mobile Recycling reporting unit, which is part of our Environmental Services segment, indicated that the fair value of the reporting unit may be below its carrying amount. Accordingly, we performed an interim assessment of the reporting unit’s goodwill as of September 30, 2018. Based on the results of that assessment, goodwill was deemed impaired and we recognized an impairment charge of $1.4 million in the third quarter of 2018, representing the reporting unit’s entire goodwill balance. The factors contributing to the $1.4 million goodwill impairment charge recorded in 2018 principally related to declining business and cash flows, which negatively impacted the reporting unit’s prospective financial information in its discounted cash flow model and the reporting unit’s estimated fair value as compared to previous estimates. The result of the annual assessment of goodwill undertaken in the fourth quarter of 2018 indicated that the fair value of each of our reporting units was in excess of its respective carrying value. The result of the annual assessment of goodwill undertaken in the fourth quarter of 2017 indicated that the fair value of each of our reporting units was in excess of its respective carrying value, with the exception of the Resource Recovery reporting unit. Our Resource Recovery reporting unit offers full-service storm water management and propylene glycol (“PG”) deicing fluid recovery at major airports. Recovered fluids are transported to our recycling facility in Romulus, Michigan where they are distilled and resold to industrial users. The Resource Recovery reporting unit also generates revenues from brokered PG sales and services revenues for PG collection at the airports we service. Weak PG commodity prices and reduced PG collection volumes at the airports we service negatively impacted the reporting unit’s prospective financial information in its discounted cash flow model and the reporting unit’s estimated fair value. A longer-than-expected recovery in PG commodity pricing and PG collection volumes became evident during the fourth quarter of 2017 as management completed its 2018 budgeting cycle and updated the long-term projections for the reporting unit which, as a result, decreased the reporting unit’s anticipated future cash flows as compared to those estimated previously. The estimated fair value of the Resource Recovery reporting unit was determined under an income approach using discounted projected future cash flows and then compared to the reporting unit’s carrying amount as of October 1, 2017. Based on the results of that comparison, the carrying amount of the Resource Recovery reporting unit, including $5.5 million of goodwill, exceeded the estimated fair value of the reporting unit by more than $5.5 million and, as a result, we recognized a $5.5 million impairment charge, representing the reporting unit’s entire goodwill balance, in the fourth quarter of 2017. Non-amortizing Intangible Assets We review non-amortizing intangible assets for impairment during the fourth quarter as of October 1 of each year. Fair value is generally determined by considering an internally developed discounted projected cash flow analysis. Estimating future cash flows requires significant judgment about factors such as general economic conditions and projected growth rates, and our estimates often vary from the cash flows eventually realized. If the fair value of an asset is determined to be less than the carrying amount of the intangible asset, an impairment in the amount of the difference is recorded in the period in which the annual assessment occurs. The results of the annual assessment of non-amortizing intangible assets undertaken in the fourth quarter of 2019 indicated no impairment charges were required. In connection with the interim goodwill impairment assessment of the Mobile Recycling reporting unit, we also assessed the reporting unit’s non-amortizing intangible permit asset for impairment as of September 30, 2018. Based on the results of that assessment, the carrying amounts of the non-amortizing intangible permit asset exceeded its estimated fair value and, as a result, we recognized a $1.8 million impairment charge in the third quarter of 2018. The factors and timing contributing to the non-amortizing intangible asset charge were the same as the factors and timing described above with regards to the Mobile Recycling reporting unit goodwill impairment charge. The results of the annual assessment of non-amortizing intangible assets undertaken in the fourth quarter of 2018 indicated no impairment charges were required. The result of the annual assessment of non-amortizing intangible assets undertaken in the fourth quarter of 2017 indicated no impairment charges were required, with the exception of the non-amortizing intangible waste collection, recycling and resale permit associated with our Resource Recovery business. In performing the annual non-amortizing intangible assets impairment test, the estimated fair value of the Resource Recovery business’ waste collection, recycling and resale permit was determined under an income approach using discounted projected future cash flows associated with the permit and then compared to the $3.7 million carrying amount of the permit as of October 1, 2017. Based on the results of that evaluation, the carrying amount of the permit exceeded the estimated fair value of the permit and, as a result, we recognized a $3.4 million impairment charge in the fourth quarter of 2017. The factors and timing contributing to the non-amortizing permit impairment charge were the same as the factors and timing described above with regards to the Resource Recovery reporting unit goodwill impairment charge. We also review amortizing tangible and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. In order to assess whether a potential impairment exists, the assets’ carrying values are compared with their undiscounted expected future cash flows. Estimating future cash flows requires significant judgment about factors such as general economic conditions and projected growth rates, and our estimates often vary from the cash flows eventually realized. Impairments are measured by comparing the fair value of the asset to its carrying value. Fair value is generally determined by considering: (i) the internally developed discounted projected cash flow analysis; (ii) a third-party valuation; and/or (iii) information available regarding the current market environment for similar assets. If the fair value of an asset is determined to be less than the carrying amount of the asset, an impairment in the amount of the difference is recorded in the period in which the events or changes in circumstances that indicated the carrying value of the asset may not be recoverable occurred. Amortizing Tangible and Intangible Assets In connection with the interim goodwill impairment assessment of the Mobile Recycling reporting unit, we also assessed the reporting unit’s amortizing tangible and intangible assets for impairment as of September 30, 2018. Based on the results of that assessment, the carrying amounts of the amortizing intangible assets exceeded their estimated fair values and, as a result, we recognized a $454,000 impairment charge in the third quarter of 2018. The factors and timing contributing to the amortizing intangible asset impairment charge were the same as the factors and timing described above with regards to the Mobile Recycling reporting unit goodwill impairment charge. Otherwise, no events or circumstances occurred during 2018 that would indicate that our amortizing tangible and intangible assets may by impaired, therefore no other impairment tests were performed during 2018. In the fourth quarter of 2017, we performed an assessment of the Resource Recovery business’ amortizing tangible and intangible assets, as events indicated their carrying values may not be recoverable. The result of the assessment indicated no impairment charges were required. Otherwise, no events or circumstances occurred during 2017 that would indicate that our amortizing tangible and intangible assets were impaired, therefore no other impairment tests were performed during 2017. Our acquired permits and licenses generally have renewal terms of approximately 5-10 years. We have a history of renewing these permits and licenses as demonstrated by the fact that each of the sites’ treatment permits and licenses have been renewed regularly since the facility began operations. We intend to continue to renew our permits and licenses as they come up for renewal for the foreseeable future. Costs incurred to renew or extend the term of our permits and licenses are recorded in Selling, general and administrative expenses in our consolidated statements of operations. Share Based Payments On May 27, 2015, the stockholders of Predecessor US Ecology approved the Omnibus Incentive Plan (as amended, “Omnibus Plan”), which was approved by Predecessor US Ecology’s Board of Directors on April 7, 2015. In connection with the closing of the NRC Merger, the Company assumed the Omnibus Plan by adopting the Amended and Restated US Ecology, Inc. Omnibus Incentive Plan for the purposes of issuing replacement awards to award recipients under the Omnibus Plan pursuant to the Merger Agreement, and for the issuance of additional awards in the future. The Omnibus Plan was developed to provide additional incentives through equity ownership in US Ecology and, as a result, encourage employees and directors to contribute to our success. The Omnibus Plan provides, among other things, the ability for the Company to grant restricted stock, performance stock, options, stock appreciation rights, restricted stock units, performance stock units and other share-based awards or cash awards to officers, employees, consultants and non-employee directors. The Omnibus Plan expires on April 7, 2025 and authorizes 1,500,000 shares of common stock for grant over the life of the Omnibus Plan. As of December 31, 2019, 725,966 shares of common stock remain available for grant under the Omnibus Plan. Subsequent to the approval of the Omnibus Plan by Predecessor US Ecology in May 2015, we stopped granting equity awards under our 2008 Stock Option Incentive Plan (the “2008 Stock Option Plan”). However, in connection with the closing of the NRC Merger, the Company assumed the 2008 Stock Option Plan for the purpose of issuing replacement awards to award recipients thereunder and will remain in effect solely for the settlement of awards granted under such plan. No shares that are reserved but unissued under the 2008 Stock Option Plan or that are outstanding under the 2008 Stock Option Plan and reacquired by the Company for any reason will be available for issuance under the Omnibus Plan. In addition, in connection with the closing of the NRC Merger, the Company assumed the NRC Group Holdings Corp. 2018 Equity Incentive Plan previously maintained by NRC by adopting the Amended and Restated US Ecology, Inc. 2018 Equity and Incentive Compensation Plan. Like the 2008 Stock Option Plan, the NRC Group Holdings Corp. 2018 Equity Incentive Plan was assumed by the Company solely for the purpose of issuing replacement awards to award recipients pursuant to the Merger Agreement, and no future grants may be made under the 2018 Equity and Incentive Compensation Plan. As of December 31, 2019, we have performance share units (“PSUs”) outstanding under the Omnibus Plan. Each PSU represents the right to receive, on the settlement date, one share of the Company’s common stock. The total number of PSUs each participant is eligible to earn ranges from 0% to 200% of the target number of PSUs granted in 2018 and 2017. The actual number of 2018 and 2017 PSUs that will vest and be settled in shares is determined based on total stockholder return relative to a set of peer companies, over a three-year performance period. The total number of PSUs each participant is eligible to earn ranges from 0% to 300% of the target number of PSUs granted in 2019. The actual number of 2019 PSUs that will vest and be settled in shares is determined based on achievement of certain Company financial performance metrics and total stockholder return relative to a set of peer companies, over a three-year performance period. Refer to Note 19 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for a summary of the assumptions utilized in the Monte Carlo valuation of awards granted during 2019, 2018 and 2017. As of December 31, 2019, we have stock option awards outstanding under the 2008 Stock Option Plan and the Omnibus Plan. Subsequent to the approval of the Omnibus Plan in May 2015, we stopped granting equity awards under the 2008 Stock Option Plan. The 2008 Stock Option Plan will remain in effect solely for the settlement of awards previously granted. The determination of fair value of stock option awards on the date of grant using the Black-Scholes model is affected by our stock price and subjective assumptions. These assumptions include, but are not limited to, the expected term of stock options and expected stock price volatility over the term of the awards. Refer to Note 19 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for a summary of the assumptions utilized in 2019, 2018 and 2017. Our stock options have characteristics significantly different from those of traded options, and changes in the assumptions can materially affect the fair value estimates. The Company has elected to account for forfeitures as they occur, rather than estimate expected forfeitures. Income Taxes We account for income taxes using an asset and liability method, which requires the recognition of taxes payable or refundable for the current year and deferred tax assets and liabilities for the expected future tax consequences of temporary differences that currently exist between the tax basis and the financial reporting basis of our taxable subsidiaries’ assets and liabilities using the enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in operations in the period that includes the enactment date. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized. We regularly assess the need for a valuation allowance against our deferred tax assets. In making that assessment, we consider both positive and negative evidence related to the likelihood of realization of the deferred tax assets on a jurisdictional basis to determine, based on the weight of available evidence, whether it is more-likely-than-not that some or all of the deferred tax assets will not be realized. Examples of positive and negative evidence include future growth, forecasted earnings, future taxable income, the mix of earnings in the jurisdictions in which we operate, historical earnings, taxable income in prior years, if carryback is permitted under the law and prudent and feasible tax planning strategies. In the event we were to 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 valuation allowance would be charged to earnings in the period in which we make such a determination, or goodwill would be adjusted at our final determination of the valuation allowance related to an acquisition within the measurement period. If we later determine that it is more-likely-than-not that the net deferred tax assets would be realized, we would reverse the applicable portion of the previously-provided valuation allowance as an adjustment to earnings at such time. We account for unrecognized tax benefits using a more-likely-than-not threshold for financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. We establish reserves for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes will be due. We record an income tax liability, if any, for the difference between the benefit recognized and measured and the tax position taken or expected to be taken on our tax returns. At December 31, 2019, our estimated gross unrecognized tax benefits were $8.3 million, of which $236,000, if recognized, would favorably impact our future earnings. We recognize interest assessed by taxing authorities or interest associated with uncertain tax positions as a component of interest expense. We recognize any penalties assessed by taxing authorities or penalties associated with uncertain tax positions as a component of selling, general and administrative expenses. To the extent that the assessment of such tax positions change, the change in estimate is recorded in the period in which the determination is made. The reserves are adjusted in light of changing facts and circumstances, such as the outcome of a tax audit. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate. See Note 17 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information regarding income taxes. Litigation We have, in the past, been involved in litigation requiring estimates of timing and loss potential whose timing and ultimate disposition is controlled by the judicial process. In the ordinary course of business, we are involved in judicial and administrative proceedings involving federal, state, provincial or local governmental authorities, including regulatory agencies that oversee and enforce compliance with permits. Fines or penalties may be assessed by our regulators for noncompliance. Actions may also be brought by individuals or groups in connection with permitting of planned facilities, modification or alleged violations of existing permits, or alleged damages suffered from exposure to hazardous substances purportedly released from our operated sites, as well as other litigation. We maintain insurance intended to cover property and damage claims asserted as a result of our operations. Periodically, management reviews and may establish reserves for legal and administrative matters, or other fees expected to be incurred in relation to these matters. In December 2010, National Response Corporation, a subsidiary of NRC acquired by the Company in the NRC Merger, was named as one of many “Dispersant Defendants” in multi-district litigation, arising out of the explosion of the BP oil rig, filed in the U.S. District Court for the Eastern District of Louisiana (“In re Deepwater Horizon” or the “MDL”). The claims against National Response Corporation, and other “Dispersant Defendants,” were brought by workers and others who alleged injury arising from post-explosion clean-up efforts, including particularly the use of certain chemical dispersants. In January 2013, the Court approved a Medical Benefits Class Action Settlement, which, among other things, provided for a “class wide” settlement as well as a release of claims against Dispersant Defendants, including National Response Corporation. Further, National Response Corporation successfully moved the District Court to dismiss all claims against it based on derivative immunity, as it was acting at the direction of the U.S. Government. In early 2018, BP began asserting an alleged contractual right of indemnity against National Response Corporation and others in post-settlement lawsuits brought by persons who had either chosen not to participate in the class-wide agreement or whose injuries were allegedly manifest after the period covered by the claim submission process. The Company has advised BP that it considers the attempt to bring National Response Corporation back into previously settled litigation to be improper and has moved for a declaratory judgment that it owes no indemnity or contribution to BP, raising various arguments including inter alia, BP’s own actions and conduct over the preceding nine years with respect to these claims (including its failure to seek indemnity) and the resultant prejudice to National Response Corporation, BP’s waiver of any indemnity, and the Court’s prior finding that National Response Corporation is entitled to derivative immunity. In response, BP asserted counterclaims against National Response Corporation for a declaratory judgment that National Response Corporation must indemnify BP under certain circumstances and for unjust enrichment. National Response Corporation successfully moved to dismiss the unjust enrichment claim. The Court has also ordered the parties to file simultaneous judgment on the pleadings briefs by February 14, 2020, and any oppositions by March 16, 2020. As such, the Company is currently unable to estimate the range of possible losses associated with this proceeding. However, the Company also believes that, were it deemed to have liability arising out of or related to BP’s indemnity claims, such liability would be covered by an indemnity by SEACOR Holdings Inc., the former owner of National Response Corporation, in favor of National Response Corporation and its affiliates. In January 2019, Kevin Sullivan, a driver for NRC from May 1, 2018 to August 22, 2018 filed a class action complaint against NRC in California Superior Court (Kevin Sullivan et. Al. v. National Response Corp., NRC Environmental Services, Inc. and Paul Taveira et al.) alleging the failure by the defendants to provide meal and rest breaks required by California law and requiring employees to work off the clock. Mr. Sullivan’s complaint also asserted a claim under the California Labor Code Private Attorneys General Act (“PAGA”), which permits an employee to assert a claim for violations of certain California Labor Code provisions on behalf of all aggrieved employees to recover statutory penalties that could be recovered by the State of California. On April 17, 2019, NRC filed a motion to compel individual arbitration, strike Mr. Sullivan’s class action claims and stay the PAGA claim pending the outcome of Mr. Sullivan’s individual claim; the Court subsequently granted the NRC’s motion to compel. In response, Mr. Sullivan amended his complaint to dismiss the class claims without prejudice and proceed solely with the PAGA claim. Unlike class claims, PAGA claims cannot be waived by an employee’s agreement to individual arbitration; therefore, the case is proceeding as a pure representative PAGA claim only, absent any individual or class claims against the Company or NRC. While the Company believes that Mr. Sullivan’s claims lack merit, the Company is currently unable to estimate the range of possible losses associated with this proceeding. On November 17, 2018, an explosion occurred at our Grand View, Idaho facility, resulting in one employee fatality and injuries to other employees. The incident severely damaged the facility’s primary waste-treatment building as well as surrounding waste handling, waste storage, maintenance and administrative support structures, resulting in the closure of the entire facility that remained in effect through January 2019. We resumed limited operations at our Grand View, Idaho facility in February 2019 and regained additional capabilities throughout the remainder of 2019. In addition to initiating and conducting our own investigation into the incident, we fully cooperated with IDEQ, the USEPA and OSHA to support their comprehensive and independent investigations of the incident. On January 10, 2020, we entered into a settlement agreement with OSHA settling a complaint made by OSHA relating to the incident for $50,000. On January 28, 2020, the Occupational Safety and Health Review Commission issued an order terminating the proceeding relating to such OSHA complaint. We have not otherwise been named as a defendant in any action relating to the incident. We maintain workers’ compensation insurance, business interruption insurance and liability insurance for personal injury, property and casualty damage. We believe that any potential third-party claims associated with the explosion, in excess of our deductibles, are expected to be resolved primarily through our insurance policies. Although we carry business interruption insurance, a disruption of our business caused by a casualty event, including the full and partial closure of our Grand View, Idaho facility, may result in the loss of business, profits or customers during the time of such closure. Accordingly, our insurance policies may not fully compensate us for these losses. Other than as described herein, we are not currently a party to any material pending legal proceedings and are not aware of any other claims that could, individually or in the aggregate, have a materially adverse effect on our financial position, results of operations or cash flows. The decision to accrue costs or write-off assets is based on the pertinent facts and our evaluation of present circumstances. Off Balance Sheet Arrangements We do not have any off balance sheet arrangements or interests in variable interest entities that would require consolidation. US Ecology operates through its direct and indirect subsidiaries.

<s>[INST] US Ecology is a leading provider of environmental services to commercial and governmental entities. The Company addresses the complex waste management and response needs of its customers, offering treatment, disposal and recycling of hazardous, nonhazardous and radioactive waste, leading emergency response and standby services, and a wide range of complementary field and industrial services. US Ecology’s focus on safety, environmental compliance and bestinclass customer service enables us to effectively meet the needs of our customers and to build longlasting relationships. We have a network of fixed facilities and service centers operating primarily in the United States, Canada, the United Kingdom and Mexico. Our fixed facilities include five RCRA subtitle C hazardous waste landfills, three landfills serving waste streams regulated by the RRC and one LLRW landfill. We also have various other TSDF facilities located throughout the United States. These facilities generate revenue from fees charged to transport, recycle, treat and dispose of waste and to perform various field and industrial services for our customers. Our operations are managed in two reportable segments reflecting our internal management reporting structure and nature of services offered as follows: Environmental ServicesThis segment provides a broad range of specialty material management services including transportation, recycling, treatment and disposal of hazardous, nonhazardous and radioactive waste at Company owned or operated landfill, wastewater, deepwell injection and other treatment facilities. Field & Industrial ServicesThis segment provides specialty field services and total waste management solutions to commercial and industrial facilities and to government entities through our 10day transfer facilities and at customer sites, both domestic and international. Specialty field services include standby services, emergency response, industrial cleaning and maintenance, remediation, lab packs, retail services, transportation, and other services. Total waste management services include onsite management, waste characterization, transportation and disposal of non hazardous and hazardous waste. In order to provide insight into the underlying drivers of our waste volumes and related T&D revenues, we evaluate periodtoperiod changes in our T&D revenue for our Environmental Services segment based on the industry of the waste generator, based on North American Industry Classification System (“NAICS”) codes. The composition of the Environmental Services segment T&D revenues by waste generator industry for the years ended December 31, 2019 and 2018 were as follows: (1) Excludes all transportation service revenue. (2) Excludes NRC which was acquired on November 1, 2019. (3) Includes retail and wholesale trade, rate regulated, construction and other industries. We also categorize our Environmental Services T&D revenue as either “Base Business” or “Event Business” based on the underlying nature of the revenue source. Base Business consists of waste streams from ongoing industrial activities and tends to be reoccurring in nature. We define Event Business as nonrecurring projects that are expected to equal or exceed 1,000 tons, with Base Business defined as all other business not meeting the definition of Event Business. The duration of Event Business projects can last from a severalweek cleanup of a contaminated site to a multiple year cleanup project. During 2019, Base Business revenue growth, excluding NRC, was up 8% compared to 2018. Base Business revenue was approximately 78% of total 2019 T&D revenue, excluding NRC, down from 80% in 2018. Our business is highly competitive and no assurance can be given that we will maintain these revenue levels or increase our market share. A significant portion of our disposal revenue is attributable to discrete Event Business projects which vary widely in size, duration and unit pricing. For the year ended December 31, 2019, approximately 22% of our T&D revenue, excluding NRC, was derived from Event Business projects. The onetime nature of Event Business, diverse spectrum of waste types received and widely varying unit pricing necessarily creates variability in revenue and earnings. This variability may be influenced by general and industryspecific economic conditions, funding availability, changes in laws and regulations, government enforcement actions or court orders, public controversy, litigation, weather, commercial real estate, closed military bases and other project timing, government appropriation and funding cycles and other factors. The types and amounts of waste received from Base Business [/INST] Positive. </s>

Orion Engineered Carbons S.A.

2020-02-20

2019-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis summarizes the significant factors affecting our results of operations and financial condition during the years ended December 31, 2019, 2018 and 2017 and should be read in conjunction with the information included under Item 1. Business and Item 8. Financial Statements and Supplementary Data included elsewhere in this Annual Report. We prepare our financial statements in accordance with accounting principles generally accepted in the United States and in US Dollars. Overview In 2019, we generated revenue of $1,476.4 million on a volume of 1,023.2 kmt, a net income of $86.9 million, and Adjusted EBITDA of $267.3 million. Adjusted EBITDA for our Specialty Carbon Black segment was $122.2 million, and the Segment Adjusted EBITDA Margin was 24.0%. This segment accounted for 34.4% of our total revenue, 45.7% of total Adjusted EBITDA and 24.3% of our total volume in kmt in 2019. Adjusted EBITDA for our Rubber Carbon Black segment was $145.2 million, and Segment Adjusted EBITDA Margin was 15.0%. This segment accounted for 65.6% of our total revenue, 54.3% of total Adjusted EBITDA and 75.7% of our total volume in kmt in 2019. Key Factors Affecting Our Results of Operations We believe that certain factors have had, and will continue to have, a material effect on our results of operations and financial condition. As many of these factors are beyond our control and certain of these factors have historically been volatile, past performance will not necessarily be indicative of future performance and it is difficult to predict future performance with any degree of certainty. In addition, important factors that could cause our actual results of operations or financial conditions to differ materially from those expressed or implied below, include, but are not limited to, factors indicated under “Item 1A. Risk Factors”, “Note Regarding Forward-Looking Statements” of this report. General Economic Conditions, Cyclicality and Seasonality Our results of operations are affected by worldwide economic conditions. Because carbon black is used in a diverse group of end products, demand for carbon black has historically been related to real GDP and general global economic conditions. In particular, a large part of our sales has direct exposure to the cyclical automotive industry and, to a lesser extent, the construction industry. As a result, our results of operations experience a level of inherent cyclicality. The nature of our business and our large fixed asset base make it difficult to rapidly adjust our fixed costs downward when demand for our products declines, which materially affects our results of operations. Our business is generally not seasonal in nature, although we may experience some regional seasonal declines during holiday periods and our results of operations are generally weaker in the last three months of the year. Drivers of Demand Besides general global economic conditions, certain specific drivers of demand for carbon black differ among our operating segments. Specialty carbon black has a wide variety of end-uses and demand is largely driven by the development of the coatings, polymers and printing industries. Demand for specialty carbon black in the coatings and polymers industries is mainly influenced by the levels of industrialization, automobile OEM demand, infrastructure, consumer goods and construction. Demand for specialty carbon black in the printing industry is mainly influenced by developments in print media and packaging materials. Demand for rubber carbon black is largely driven by the development of the tire and mechanical rubber goods industries. Demand for rubber carbon black in tires is mainly influenced by the number of replacement and original equipment tires produced, which in turn is driven by (i) vehicle trends, including the number of vehicles produced and registered, and the number of miles driven, (ii) demand for high-performance tires, (iii) demand for larger vehicles, such as trucks and buses and (iv) changes in regulatory requirements. Demand for rubber carbon black in mechanical rubber goods is mainly influenced by vehicle trends, construction activity and general industrial production. Demand in the developed West European and North American regions is mainly driven by demographic changes, customers’ high-quality requirements, stringent tire regulation standards and relatively stable tire replacement demand. Demand in emerging markets, such as China, Southeastern Asia, South America and Eastern Europe, is mainly driven by the growing middle class, rapid industrialization, new infrastructure spending and increasing car ownership trends. The growth in vehicle production in turn drives demand for both original equipment tire manufacturing and replacement tires in developing regions. Asset Utilization Margins in the carbon black industry, and the chemical industry generally, are strongly influenced by industry capacity utilization. As demand for products approaches available supply, utilization rates rise, and prices and margins typically increase over time. Historically, this relationship has been highly cyclical, due to fluctuations in supply resulting from the timing of new investments in capacity and general economic conditions affecting the relative strength or weakness of demand. Generally, capacity is more likely to be added in periods when current or expected future demand is strong and margins are, or are expected to be, high. Investments in new capacity can result, and in the past frequently have resulted, in over-capacity, which typically leads to a reduction of margins. For example, some of our customers have shifted, and may continue to shift, manufacturing capacity from mature regions, such as North America and Europe, to emerging regions, such as Asia and South America. Consequently, competitors in China have added capacity (particularly regarding production of standard tire grades), at far greater proportion than demand has risen, which resulted in pressured margins in the region. In response, producers typically reduce capacity utilization or limit further capacity additions, eventually causing the industry to be relatively undersupplied. In recent years, a systematic reduction in capacity in North America and Europe, together with increased manufacturing efficiencies, has enabled us to largely preserve margins and maintain high utilization rates. Although utilization levels can differ significantly by plant, these levels tend to be driven more by variations in demand from specific customers served by each plant rather than by general trends in the region where the plant is located. We estimate our average plant utilization rate to have been at approximately 91% in 2019, approximately 91% in 2018 and approximately 90% in 2017. We have made recent investments in strategic sites to increase the flexibility of our production platform and closed production facilities in Europe and South Korea in order to consolidate capacities in the European and Asian regions. Both actions allow us to opportunistically upgrade and expand our capacity to produce higher margin products, as demand allows, and positions us better to shift additional production capacity to specialty carbon black products and rubber carbon black for higher-end mechanical rubber goods. We intend to achieve further growth in production volume, as customer demand allows, by improving utilization rates, improving the availability of our assets by minimizing planned and unplanned facility downtime and improving the capacity of our assets through systematic supply chain planning and improved operating technologies. In addition a new specialty carbon black line is under construction at our Ravenna (Italy) plant, which is expected to commence production in 2021. Unplanned outages can impact our operating results. Similarly, planned or unplanned outages of our competitors can positively affect our operating results by decreasing the product supply in the industry. Raw Material and Energy Costs Our results of operations are affected, directly and indirectly, by fluctuations in raw material and energy prices. Our manufacturing processes consume significant amounts of raw materials and energy, the costs of which are subject to fluctuations in worldwide supply and demand, in addition to other factors beyond our control. In 2019, raw materials accounted for approximately 75% of our cost of sales. Approximately 79% of the cost of raw material used in the production of carbon black is related to petroleum-based or coal-based feedstock known as carbon black oil, with some limited use of other raw materials, such as acetylene, nitrogen tetroxide, hydrogen and natural gas. The pricing of carbon black oil is typically indexed to the price of fuel oil. In general, we benchmark against Platts indices in the sourcing regions e.g. USGC, New York, Rotterdam and Singapore. In some areas the Gasoil index is used. While the majority of our purchases are based on underlying fuel oil indices, the ultimate carbon black oil price also depends on carbon black oil specific quality characteristics, differentials (premiums or discounts to Platts indices), freight costs and region-specific supply and demand as well as regulatory factors. Carbon black oil procurement is an important factor in achieving best-in-class production costs. Approximately 50% of our carbon black oil supply is covered by short- and long-term contracts with a wide variety of suppliers. A significant portion of approximately 75% of our volume is sold based on formula-driven price adjustment mechanisms for changes in costs of raw materials, Sales prices under our non-indexed contracts are reviewed regularly with a view to reflecting raw material and energy price fluctuations as overall market conditions allow. In addition, there can be no guarantee that we will be able to timely adjust prices under our non-indexed contracts in the future, see “Item 1A. Risk Factors-Risks Related to Our Business-We are subject to volatility in the costs, quality and availability of raw materials and energy, which could decrease our production volumes and margins and adversely affect our business, financial condition, results of operations and cash flows.” Costs for raw materials and energy have fluctuated significantly and may continue to fluctuate in the future. We believe that our contracts enable us generally to maintain our Segment Adjusted EBITDA Margins, however, rapid and significant oil or energy price fluctuations have had and are likely to continue to have significant and varying effects on our earnings and results of operations, partly because oil price changes affect our sales prices and our cost of raw materials and energy at different times and amounts, and partly due to other factors, such as differentials affecting the ultimate carbon black oil price paid by us (versus a particular reference price index), actual carbon black oil usage amounts and our ongoing efficiency initiatives. As a result of the significant decline in oil prices in particular in 2014, we have seen one or more of these factors come into play at different times and adversely affect our profitability, and this is likely to be seen again in future periods of a declining oil pricing environment. It is also possible that in this environment, other factors come into play and interact adversely with our longer-term formula-based customer pricing arrangements. It is difficult to predict the impact of these factors going forward. In general, our customer pricing arrangements, and in particular the price adjustment formulas, are designed to protect us against rising or higher oil prices, and while we may seek to adjust them to accommodate the current environment, they may be difficult to change quickly, and if changed, may not be as protective if and when oil prices begin to rise. Foreign Currency Exchange Rate Fluctuations Our results of operations and Net Working Capital are affected by foreign currency exchange rate fluctuations. Our exposure to foreign currencies comes from three main sources: (i) currency translation, when we translate results of our subsidiaries denominated in local functional currencies into U.S. Dollar, (ii) commercial transactions, such as when we contract purchases of our feedstock, which are mostly in U.S. Dollars, at non-U.S.-Dollar entities and (iii) financing transactions, as a large portion of our financial obligations are denominated in U.S. Dollars, some of which are hedged. In 2019, 40%, 27% and 16% of our net sales were generated by our subsidiaries whose functional currency is the Euro, the U.S. Dollar and the Korean Won, respectively, with the remainder in other currencies. Fluctuations in currency exchange rates could require us to reduce our prices to remain competitive in foreign regions. In each case, the relevant income or expense is reported in the respective local currency and translated into U.S. Dollar at the applicable currency exchange rate for inclusion in our consolidated financial information. Therefore, our financial results in any given period are materially affected by fluctuations in the value of the U.S. Dollar relative to other currencies, in particular the Euro and the Korean Won. Our foreign currency transaction exposure is partially offset by costs and expenses incurred by our subsidiaries in their local functional currencies. The pricing of carbon black oil, our main raw material, is linked to the price of heavy fuel oil and is generally benchmarked against Platts indices of three regions: the U.S. Gulf Coast, Rotterdam and Singapore. Most of our carbon black oil purchase contracts are denominated in U.S. Dollars. Generally, an appreciation of the U.S. Dollar has a negative impact on our results of operations and Net Working Capital, because our raw material purchases in U.S. Dollars may not be fully offset by our ability to pass-through changes in raw material costs to customers and by the translation effect of our results of operations outside the United States. We manage our foreign currency exchange exposure through the use of derivative instruments to economically hedge on balance sheet foreign currency denominated receivables and payables. In May 2018, we entered into a $235 million cross-currency swap to hedge interest rate risk and foreign currency exposure related to the U.S. Dollar-denominated Term Loan entered into by our German entity. In conjunction therewith we discontinued the use of the U.S. Dollar-denominated portion of our Term loan to hedge our U.S. operations. See “Item 8.-Financial Statements-Note K. Derivatives”. We use customary products to manage other foreign exchange risk, including forward exchange contracts and currency options. We do not generally use foreign exchange hedging for expected exposure, as our expected exposure from sales is largely offset by our expected exposure from purchases. Current and Future Environmental Regulations Our operations are subject to extensive environmental laws and regulations, which require us to invest significant financial and technical resources to maintain compliance with applicable requirements. If environmental harm is found to have occurred as a result of our current or historical operations, we may incur significant remediation costs at current or former production facilities or third-party sites and may have to pay fines and damages. Many of our facilities have a long history of operation and have never been the subject of comprehensive environmental investigations. As a result, our environmental compliance and remediation costs could increase. Future closure and decommissioning at any one of these facilities, or of process units at these facilities, could result in significant remediation costs. For instance, many of our facilities have onsite landfills, storage tanks, wastewater treatment systems, ponds and other units that have been in use for a number of years, and we may incur significant costs when closing these units in accordance with applicable laws and regulations and when addressing related contamination of soil and groundwater. For more information about information requests made by the EPA to, and alleged violations of the U.S. Clean Air Act by, certain of our facilities located in the United States, see “Item 1.-Business-Environmental, Health and Safety Matters-Environmental-Environmental Proceedings.” Changes to environmental regulations or laws that may affect previously unregulated aspects of our business may also require us to incur significant compliance costs. New regulations requiring further reductions of GHG and other emissions are being considered in Europe, the United States, China, Brazil and South Korea. Our carbon black operations may generate more CO2 than is permitted under current or future allocation schemes for GHG emissions, requiring us either to purchase emission credits or to modify our production processes to reduce emissions. Additionally, nano-scale materials, including carbon black, are under increased and ongoing scrutiny in multiple jurisdictions, including the European Union, and are likely to be subject to stricter regulation in the future, which may require us to incur significant costs in order to comply with new laws and requirements. Further, carbon black has been classified by certain national and international health organizations as a possible or suspected human carcinogen. A negative reclassification of carbon black by these organizations, or similar classifications of carbon black or other finished products, raw materials or intermediates by other organizations or governmental authorities could adversely affect our compliance costs, operations, sales and reputation. Environmental considerations can also affect the industries in which we operate, including our position with respect to our competitors. For example, new tire labeling regulatory requirements globally (particularly in Europe) are expected to reduce the threat of low-cost tire imports significantly and to favorably affect demand in developed regions. In connection with the Acquisition, Evonik agreed, subject to certain deductibles, caps, exclusions and procedural requirements, to indemnify us for certain historical environmental liabilities. See “Item 1A.-Risk Factors-Risks Related to Indebtedness, Currency Exposure and Other Financial Matters-Our Agreements with Evonik in connection with the Acquisition require us to indemnify Evonik with respect to certain aspects of our business and require Evonik to indemnify us for certain retained liabilities. We cannot offer assurance that we will be able to enforce claims under these indemnities as we expect.” Critical Accounting Policies The preparation of our financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses and related disclosure of contingent assets and liabilities. We consider an accounting estimate to be critical to the financial statements if (i) the estimate is complex in nature or requires a high degree of judgment and (ii) different estimates and assumptions were used, the results could have a material impact on the consolidated financial statements. We evaluate our estimates and application of our policies on an ongoing basis. We base our estimates on historical experience, current conditions and on various other assumptions 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. The policies that we believe are critical to the preparation of the consolidated financial statements are the following: •Revenue and expense recognition; •Goodwill; •Valuation of intangibles acquired in a business combination •Inventories; •Pension provisions; •Deferred taxes, current income taxes; •Derivative financial instruments; •Hedge accounting; and •Contingent liabilities and other financial obligations. These critical accounting policies and other significant accounting policies are discussed in Note A. Significant Accounting Policies to our audited consolidated financial statements included elsewhere in this report. See also Note L. Employee Benefit Plans to our audited consolidated financial statements for information about sensitivities of inputs used with respect to pension provisions. See also Note H. Business Combination, Goodwill and Intangible Assets to our audited consolidated financial statements with respect to goodwill. In particular, with regard to the assessment of the fair value of the reporting unit to which goodwill is allocated, management believes that no reasonably possible change in any of the key assumptions would cause the carrying value of the reporting units to materially exceed their recoverable amounts. Effective from January 1, 2018 ASC 606 with respect to revenue recognition became effective. The adoption of this standard did not result in a material difference in our revenue recognition. Effective from January 1, 2019 ASC 842 with respect to treatment and recognition of lease agreements became effective. We have adopted this standard and based on the lease portfolio as of January 1, 2019, the Company recorded additional operating lease ROU assets of approximately $30 million and operating lease liabilities of $31 million on its consolidated balance sheet, with no other adoption impacts to its consolidated statements of operations. One asset recorded under build-to-suit accounting as of December 31, 2018 and its associated liability of $29 million was derecognized upon adoption of the new standard. For our current lease obligation see also Note R. Commitments and Contingencies. Certain of the significant accounting policies include the use of estimates, but do not meet the definition of critical because they generally do not require estimates or judgments that are as difficult or subjective to measure. However, these policies are important to an understanding of the consolidated financial statements. Reconciliation of Non-GAAP Financial Measures We use Contribution Margin and Adjusted EBITDA as supplemental measures of our operating performance. Contribution Margin and Adjusted EBITDA presented in this Management Discussion and Analysis have not been prepared in accordance with GAAP or the accounting standards of any other jurisdiction. Other companies may use similar non-GAAP financial measures that are calculated differently from the way we calculate these measures. Accordingly, our Contribution Margin and Adjusted EBITDA may not be comparable to similar measures used by other companies and should not be considered in isolation, or construed as substitutes for, revenue, consolidated net income for the period, income from operations (EBIT), gross profit and other GAAP measures as indicators of our results of operations in accordance with GAAP. Contribution Margin and Contribution Margin per Metric Ton (Non-GAAP Financial Measures) We calculate Contribution Margin by subtracting variable costs (such as raw materials, packaging, utilities and distribution costs) from our revenue. We believe that Contribution Margin is useful because we see this measure as indicating the portion of revenue that is not consumed by such variable costs and therefore contributes to the coverage of all other costs and profits. The following table reconciles Contribution Margin and Contribution Margin per Metric Ton to gross profit: (1) Separate line item in audited Financial Statements. (2) Includes costs such as raw materials, packaging, utilities and distribution. (3) Includes costs such as depreciation, amortization and impairment of intangible assets and property, plant and equipment, personnel and other production related costs. Adjusted EBITDA (Non-GAAP Financial Measure) We define Adjusted EBITDA as income from operations (EBIT) before depreciation and amortization, adjusted for acquisition related expenses, restructuring expenses, consulting fees related to Company strategy, share of profit or loss of joint venture and certain other items. Adjusted EBITDA is defined similarly in our Credit Agreements. Adjusted EBITDA is used by our management to evaluate our operating performance and make decisions regarding allocation of capital because it excludes the effects of items that have less bearing on the performance of our underlying core business. Our use of Adjusted EBITDA has limitations as an analytical tool, and should not be considered in isolation or as a substitute for analysis of our financial results as reported under GAAP. Some of these limitations are: (a) although Adjusted EBITDA excludes the impact of depreciation and amortization, the assets being depreciated and amortized may have to be replaced in the future and thus the cost of replacing assets or acquiring new assets, which will affect our operating results over time, is not reflected; (b) Adjusted EBITDA does not reflect interest or certain other costs that we will continue to incur over time and will adversely affect our profit or loss, which is the ultimate measure of our financial performance and (c) other companies, including companies in our industry, may calculate Adjusted EBITDA or similarly titled measures differently. Because of these and other limitations, Adjusted EBITDA should be considered alongside our other GAAP-based financial performance measures, such as revenue, consolidated net income for the period or income from operations (EBIT). The following table presents a reconciliation of Adjusted EBITDA to consolidated net income for each of the periods indicated: (1) Restructuring expenses for the periods ended December 31, 2019 and December 31, 2017 are related to our strategic realignment of our worldwide Rubber footprint, and resulted in restructuring income in the period ended December 31, 2018 in particular as a result of the gain recognized in connection with the land sale in South Korea exceeding the associated cessation costs related to our worldwide Rubber footprint initiative. (2) Consulting fees related to the Orion strategy include external consulting for establishing and executing Company strategies relating to Rubber footprint realignment, conversion to U.S. dollar and U.S. GAAP, as well as costs relating to our assessment of feasibility for inclusion in certain U.S. indices. (3) Other adjustments (from items with less bearing on the underlying performance of the Company’s core business) in the period ended December 31, 2019 relate to an amount of $2.9 million in non-income tax expense incurred during the construction phase of an asset. The asset under construction is expected to qualify for certain non-income tax credits once operational, since such credits were applied to the predecessor machine. This tax disadvantage cannot be capitalized as part of the project’s capital expenditure. The remainder of other adjustments include in particular costs to meet the EPA requirements of $2.3 million. Other adjustments in the period December 31, 2018 related to license fees required for certain innovative technologies to meet the EPA requirements of $1.2 million and other EPA related costs of $1.4 million. Other adjustments in the period ended December 31, 2017 primarily relate to costs associated with our EPA enforcement action of $2.4 million, costs to remediate damages incurred by hurricane Harvey of $1.4 million and costs associate with the secondary offering of our shares, offset by $1.4 million of reimbursements of reassessed real estate transfer taxes. Operating Results 2019 Compared to 2018 The table below presents our historical results derived from our consolidated financial statements for the periods indicated. Net sales Net sales decreased overall by $101.9 million, or 6.5%, from $1,578.2 million in 2018 to $1,476.4 million in 2019. This net sales decrease was primarily due to lower volumes, foreign exchange translation effects and contractually indexed sales price decreases in our Rubber Carbon Black segment resulting from the pass through of lower feedstock costs to customers with agreements that link price to the cost of feedstock offset by certain base price increases. Volume decreased by 61.5 kmt, or 5.7%, from 1,084.7 kmt in 2018 to 1,023.2 kmt in 2019. This decrease largely reflected reduced Rubber volumes in South Korea due to the closure of the plant in Seoul and slowing demand Europe and China. The decrease in volume contributed a decrease of net sales of $86.8 million. In addition to the volume related decrease of net sales, unfavorable impacts from foreign exchange translation effects of $33.5 million were incurred. Oil price changes contributed a further reduction of net sales in 2019 compared to 2018 of $18.4 million. These unfavorable impacts were in part offset by increases of certain base prices of $40.8 million. Cost of sales and Gross profit Cost of sales decreased by $61.6 million, or 5.4%, from $1,148.2 million in 2018 to $1,086.6 million in 2019. The 5.7% decrease in volume in 2019 compared to 2018 resulted in a decrease of cost of sales of 4.9%, or $56.4 million in 2019 compared to 2018. Lower overall net sales as a result of the above mentioned impacts were not fully offset by lower cost of sales. As a result gross profit decreased by $40.3 million, or 9.4%, from $430.0 million in 2018 to $389.7 million in 2019 for reasons described above. Selling, general and administrative expenses Selling, general and administrative expenses decreased by $25.0 million, or 10.8%, from $231.9 million in 2018 to $206.9 million in 2019 mainly as a result of lower volume in 2019 compared to 2018 and lower personnel related expenses in fiscal year 2019 related to bonuses and long term incentive expenses as well as favorable impacts from foreign currency translation impacts. Research and development costs R&D expenses decreased by $0.4 million, from $20.3 million in 2018 to $19.9 million in 2019. This decrease is primarily related to the timing of expenditures for individual development of programs. Other expenses, net Other expenses, net which comprises other operating income and other operating expenses, amounted to $12.2 million in 2019 and $6.1 million in 2018. In 2019, other operating income amounted to $5.9 million and included, among other items, a gain related to an operating derivative of $1.3 million, a non-income tax related tax reimbursement $1.1 million and insurance claims of $0.8 million. Other operating expenses in 2019 amounted to $18.1 million, comprised primarily of $9.9 million treated as other adjustment items and consulting fees related to Company strategy, miscellaneous other third-party expenses of $4.3 million and an impairment charge of $1.3 million. In 2018, other operating income amounted to $5.0 million and included, among other items, $1.7 million income from the reversal of provisions. Other operating expenses in 2018 amounted to $11.1 million, comprised primarily of $4.8 million consulting fees related to Company strategy and license fees required for certain innovative technologies to meet the EPA requirements of $1.2 million and other EPA related costs of $1.9 million. Restructuring expenses/(income), net In 2019 restructuring expenses amounted to $3.6 million associated with our Rubber footprint restructuring costs. In 2018, restructuring expenses/(income), net, comprise restructuring income of $40.3 million and restructuring expenses of $15.6 million. As part of the strategic repositioning of the Rubber business footprint, we consolidated our two production network in South Korea, ceased production at our Seoul plant and sold the land. Proceeds from the land sale exceeded the associated closing and remediation costs and we recorded a restructuring gain of $24.6 million. Our Rubber footprint restructuring activities in the fiscal years 2016 to 2019 generated annualized savings of approximately $16 million per year on a consolidated basis since the end of fiscal year 2018 from the facility shutdown in Ambès, France, the facility consolidations in Seoul, South Korea, the related headcount reductions, as well as to a lesser extent, to operational efficiencies. These anticipated savings were expected to come essentially in full from our reportable Rubber segment. Besides the realized one-time gain recorded upon the sale of our land in Seoul, South Korea, a significant portion of the anticipated savings are expected to be reinvested in business development, research & development and capital improvements to help drive organic growth. Income from operations Income from operations decreased by $49.2 million, or 25.0%, from $196.3 million in 2018 to $147.2 million in 2019 mainly as a result of decreased gross profit and the absence of positive one-time proceeds from our land sale in South Korea in 2018. Interest and other financial expense, net Interest and other financial expense, net comprises interest and other financial income and interest and other financial expenses. Interest and other financial expense, net amounted to $27.6 million in 2019 compared to $28.6 million in 2018. Interest and other financial expense, net in 2019 includes, among others, $15.2 million of regular interest expenses for our term loan facilities, $2.1 million of amortization of capitalized transaction costs and $3.6 million net expenses of foreign currency revaluation effects. Interest and other financial expense, net in 2018 includes, $20.6 million of regular interest expenses for our term loan facilities, $2.2 million of amortization of capitalized transaction costs and $1.3 million net expenses of foreign currency revaluation effects. Income from operations before income tax expense and equity in earnings of affiliated companies Income from operations before income tax expense and equity in earnings of affiliated companies decreased by $48.1 million, or 28.7%, from $167.7 million in 2018 to $119.6 million in 2019, as a result of the effects described above. Income tax expense Income tax expense amounted to $33.2 million in 2019 compared to $46.9 million in 2018, as a result of decreased income before taxes. In 2019, the effective tax rate of 27.6% deviated from the expected Company rate of 32.0% in particular due to favorable impacts from tax rate differentials of $3.5 million and prior year taxes of $3.2 primarily associated with a conclusion of a tax audit. The amounts previously accrued for this purpose were released accordingly. For details regarding this deviation see Note Q. Income Taxes to the audited consolidated financial statements. In 2018, the effective tax rate of 27.9% deviated from the expected Company rate of 32.0% in particular due tax rate differentials of $6.7 million. For details regarding this deviation see Note Q. Income Taxes to the audited consolidated financial statements. Equity in earnings of affiliated companies, net of tax Equity in earnings of affiliated companies represents the equity income from our German JV, which was comparable in 2019 and 2018. Net income Our net income in 2019 amounted to $86.9 million, a decrease of $34.4 million, reflecting all the factors described above. Contribution Margin and Contribution Margin per Metric Ton (Non-GAAP Financial Measures) Contribution Margin decreased by $37.0 million, or 6.4%, from $577.6 million in 2018 to $540.7 million in 2019, primarily due to lower volumes, foreign exchange rate translation effects and unfavorable oil price differentials, partially offset by base price increases. Contribution Margin per Metric Ton decreased slightly by 0.8%, from $532.6 per Metric Ton in 2018 to $528.5 per Metric Ton in 2019. Adjusted EBITDA (Non-GAAP Financial Measure) Adjusted EBITDA decreased by $26.8 million, or 9.1%, from $294.1 million in 2018 to $267.3 million in 2019 mainly as a result of the decrease in Contribution Margin, somewhat offset by lower bonus expenses. 2018 Compared to 2017 The comparison of the fiscal years ended December 31, 2018 and 2017 can be found in our annual report on Form 20-F for the fiscal year ended December 31, 2018 located within Part I, Item 5. Operating and Financial Review and Prospects, which is incorporated by reference herein. Segment Discussion Our business operations are divided into two operating segments: the Specialty Carbon Black segment and the Rubber Carbon Black segment. We use segment revenue, segment gross profit, segment volume, Segment Adjusted EBITDA and Segment Adjusted EBITDA Margin as measures of segment performance and profitability. The table below presents our segment results derived from our audited consolidated financial statements for 2019, 2018 and 2017. (1) Unaudited. (2) Defined as Adjusted EBITDA divided by net sales. Specialty Carbon Black 2019 Compared to 2018 Net sales of the Specialty Carbon Black segment decreased by $36.9 million, or 6.8%, from $545.4 million in 2018 to $508.5 million in 2019, primarily due to lower volumes and foreign exchange rate translation effects, partially offset by base price increases. Volume of the Specialty Carbon Black segment decreased by 11.3 kmt, or 4.3%, from 262.4 kmt in 2018 to 251.0 kmt in 2019, as a result of lower demand in particular in North America, partially offset by increased volumes from our Chinese and European plants. Gross profit of the Specialty Carbon Black segment decreased by $28.9 million, or 14.5%, from $199.4 million in 2018 to $170.4 million in 2019, mainly as a result of unfavorable foreign exchange rate translation effects and lower volumes. Adjusted EBITDA of the Specialty Carbon Black segment decreased by $27.1 million, or 18.1%, from $149.3 million in 2018 to $122.2 million in 2019, primarily reflecting the decrease in gross profit. 2018 Compared to 2017 The comparison of the fiscal years ended December 31, 2018 and 2017 can be found in our annual report on Form 20-F for the fiscal year ended December 31, 2018 located within Part I, Item 5. Operating and Financial Review and Prospects, which is incorporated by reference herein. Rubber Carbon Black 2019 Compared to 2018 Net sales of the Rubber Carbon Black segment decreased by $64.9 million, or 6.3%, from $1,032.8 million in 2018 to $967.9 million in 2019, primarily due to lower volumes. Unfavorable impacts from contractually indexed sales prices resulting from the pass through changes in feedstock costs as well as unfavorable foreign exchange rate translation effects were almost in full offset by base price increases. Volume of the Rubber Carbon Black segment decreased by 50.2 kmt, or 6.1%, from 822.3 kmt in 2018 to 772.1 kmt in 2019 mainly due to lower demand in all our major regions except for North America. Gross profit of the Rubber Carbon Black segment decreased by $11.3 million, or 4.9%, from $230.6 million in 2018 to $219.3 million in 2019, mainly as a result of lower volumes, negative feedstock differentials and negative foreign exchange rate translation effects, in part offset by base price increases. Adjusted EBITDA of the Rubber Carbon Black segment increased by $0.3 million, or 0.2%, from $144.9 million in 2018 to $145.2 million in 2019, while the decrease in gross profit was offset in part by lower selling and general administrative charges, bonus expenses as well as compensating impacts for foreign exchange rates translation effects. 2018 Compared to 2017 We refer to our annual report 2018 filed with the SEC on From 20-F.The comparison of the fiscal years ended December 31, 2018 and 2017 can be found in our annual report on Form 20-F for the fiscal year ended December 31, 2018 located within Part I, Item 5. Operating and Financial Review and Prospects, which is incorporated by reference herein. Liquidity and Capital Resources Historical Cash Flows The tables below present our historical cash flows derived from our audited consolidated financial statements for 2019, 2018 and 2017. Net cash provided by operating activities in 2019 amounted to $231.5 million and consisted of a consolidated profit for the period of $86.9 million, adjustments primarily for depreciation of $96.7 million and cash inflows from changes in operating assets and liabilities of $17.7 million including changes in Net Working Capital of $49.8 million. Net cash used in investing activities in 2019 amounted to $155.8 million comprised of $100.2 million capital expenditure for maintenance and overhaul projects and expenditures associated as well as $50.6 million environmental improvements of our U.S. based facilities to address the EPA requirements. Net cash used in financing activities in 2019 amounted to $68.6 million. Cash inflows during the fiscal year of $97.0 million are related to local bank loan facilities while $101.3 million of cash outflows were used during the year for repayments of those and other current borrowings, $8.0 million regular debt repayment and $48.0 million dividend payments. Net cash provided by operating activities in 2018 amounted to $122.0 million and consisted of a consolidated profit for the period of $121.3 million, adjustments primarily for depreciation of $98.2 million and cash outflows from Net Working Capital of $65.6 million. Net cash used in investing activities in 2018 amounted to $88.1 million. It comprises proceeds from our land sale in Korea and $36.6 million were used in connection with the acquisition of the acetylene carbon black manufacturer Société du Noird'Acétylène de l'Aubette, SAS (“SN2A”), SN2A, now known as Orion Engineered Carbons SAS. The remaining capital expenditure for maintenance and overhaul projects, as well as expenditures associated with our efforts to consolidate our two productions plants in South Korea were approximately $103.8 million as well as expenditures of $12.6 million used in commencing the EPA related investments. Net cash used in financing activities in 2018 amounted to $43.8 million. $26.4 million was used for repayments of current borrowing, $8.3 million of regular debt repayments, $4.9 million used for share repurchases and $47.7 million for dividend payments. Cash inflows of $49.0 million is related to local bank loan facilities. Net cash provided by operating activities in 2017 amounted to $147.7 million and consisted of a consolidated profit for the period of $64.9 million, adjustments primarily for depreciation of $98.4 million, cash outflows from changes in operating assets and liabilities of $21.6 million including changes in Net Working Capital of $24.0 million. Net cash used in investing activities in 2017 amounted to $90.3 million for capital expenditure for maintenance and overhaul projects as well as expenditures associated with our efforts to consolidate our two production plants in South Korea. Cash outflows from financing activities in 2017 amounted to $68.5 million. $28.9 million reflecting repayments of borrowing, of which $20.7 million was paid as voluntary redemption of our Term Loan. In addition, $45.7 million was used for dividend payments. Cash inflows of $11.7 million is related to local ancillary bank loan facilities. Sources of Liquidity Our principal sources of liquidity are the net cash generated from our operating activities, the cash balances, amounts available under our multicurrency, senior secured Revolving Credit Facility and financing sources like the subsidiaries facilities with local financial institutions. We believe that our cash position and cash generated from operations will be adequate to support the further growth of our business. Net Working Capital (Non-GAAP Financial Measure) We define Net Working Capital as the total of inventories and current trade receivables, less trade payables. Net Working Capital is a non-GAAP financial measure, and other companies may use a similarly titled financial measure that is calculated differently from the way we calculate Net Working Capital. The following tables set forth the principal components of our Net Working Capital as of the dates indicated. Our Net Working Capital position can vary significantly from month to month, mainly due to fluctuations in oil prices and receipts of carbon black oil shipments. In general, increases in the cost of raw materials lead to an increase in our Net Working Capital requirements, as our inventories and trade receivables increase as a result of higher carbon black oil prices and related sales levels. These increases are partially offset by related increases in trade payables. Due to the quantity of carbon black oil that we typically keep in stock, such increases in Net Working Capital occur gradually over a period of two to three months. Conversely, decreases in the cost of raw materials lead to a decrease in our Net Working Capital requirements over the same period of time. Based on 2019 Net Working Capital requirements, we estimate that a $10 per barrel movement in the Brent crude oil price correlates to a movement in our Net Working Capital of approximately $27 million to $30 million within about a two to three month period. In times of relatively stable oil prices, the effects on our Net Working Capital levels are less significant and Net Working Capital swings increase in an environment of high price volatility. Our Net Working Capital decreased from $282.9 million as of December 31, 2018 to $221.1 million as of December 31, 2019 primarily due to the impact from lower feedstock costs and overall weaker volumes and thus lower receivables at year end. Capital Expenditures (Non-GAAP Financial Measure) We define Capital Expenditures as cash paid for the acquisition of intangible assets and property, plant and equipment as shown in the consolidated financial statements. Our Capital Expenditures amounted to $90.3 million in 2017, $116.2 million in 2018 and $155.8 million in 2019. We plan to finance our Capital Expenditures, including the increase seen in 2019 related to EPA related expenditure, with cash generated by our operating activities. With the exception of required expenditures in association with our settlement with the EPA we currently do not have any material commitments to make Capital Expenditures, and do not plan to make Capital Expenditures, outside the ordinary course of our business. See “Note R. Commitments and Contingencies” for further details regarding the EPA settlement. Capital Expenditures in 2019 amounted to $155.8 million and were mainly composed of maintenance and overhaul projects including 50.6 million expenditures associated with our efforts to commencing environmental investments required to address the EPA requirements in the United States. Capital Expenditures in 2018 amounted to $116.2 million and were mainly composed of maintenance and overhaul projects as well as expenditures associated with our efforts to consolidate our to productions plants in South Korea and commencing investments required to address the EPA requirements in the United States of $12.6 million. Capital Expenditures in 2017 amounted to $90.3 million and were mainly composed of maintenance and overhaul projects. Research and Development, Patents and Licenses, etc. Spending on innovation, including both applications technology and process development, amounted to $19.9 million in 2019, $20.3 million in 2018 and $18.2 million in 2017 and was mostly directed towards the development of new specialty carbon black products, new applications for carbon black products and the improvement of process efficiencies, and to a lesser extent towards research on installation of equipment to reduce emission levels in connection with the recent EPA consent decree. For further information see “Item 1. Business-Innovation.” Trend Information See “Item 1. Business.” Off-Balance Sheet Arrangements As of December 31, 2019, we did not have any off-balance sheet arrangements. Contractual Obligations The following table sets forth our contractual obligations as of December 31, 2019: (1)Sets forth obligations to repay principal and interest under our long-term debt obligations. (2)Represents the obligation under the Revolving Credit Facility. As of December 31, 2019, there were no cash amounts drawn under our Revolving Credit Facility of €175.0 million (USD equivalent: $196.6 million). (3)Represents the Term Loans and includes the outstanding principal amounts of $281.3 million (U.S. Dollar term loan) and $361.8 million (EUR term loan) which has been translated at an exchange rate at the reporting date of $1.1234 per €1.00. The borrowing costs on the principal of the Euro-denominated Term Loan have been translated applying the same exchange rate. (4)Represents interest expenses related to indebtedness from our Term Loans, assuming future interest based on a forward rate assumption. (5)Represents purchase commitments under long-term supply agreements for the supply of raw materials, mainly oil and gas. (6)This amount does not reflect the Company’s obligations under its existing pension arrangements, which as of December 31, 2019 amounted to $21.4 million (see “Note L. Employee Benefit Plans” with regard to pension provisions and post-retirement benefits included in the audited financial statements). The level of performance bonds, guarantees and letters of credit required for carbon black oil purchasing could increase as a result of increasing oil prices or other factors (such as our ownership structure). As at December 31, 2019 Orion Engineered Carbons GmbH has three guarantees issued by Euler Hermes S.A. with a total volume of $9.2 million (in prior year four guarantees by Euler Hermes S.A. of $15.2 million; one guarantee insurance issued by Deutsche Bank AG with a volume of $2.2 million (in prior year one guarantee issued by Deutsche Bank AG with a volume of $2.9 million). None of these guarantees reduce the possible utilization limit of the current RCF.

<s>[INST] Overview In 2019, we generated revenue of $1,476.4 million on a volume of 1,023.2 kmt, a net income of $86.9 million, and Adjusted EBITDA of $267.3 million. Adjusted EBITDA for our Specialty Carbon Black segment was $122.2 million, and the Segment Adjusted EBITDA Margin was 24.0%. This segment accounted for 34.4% of our total revenue, 45.7% of total Adjusted EBITDA and 24.3% of our total volume in kmt in 2019. Adjusted EBITDA for our Rubber Carbon Black segment was $145.2 million, and Segment Adjusted EBITDA Margin was 15.0%. This segment accounted for 65.6% of our total revenue, 54.3% of total Adjusted EBITDA and 75.7% of our total volume in kmt in 2019. Key Factors Affecting Our Results of Operations We believe that certain factors have had, and will continue to have, a material effect on our results of operations and financial condition. As many of these factors are beyond our control and certain of these factors have historically been volatile, past performance will not necessarily be indicative of future performance and it is difficult to predict future performance with any degree of certainty. In addition, important factors that could cause our actual results of operations or financial conditions to differ materially from those expressed or implied below, include, but are not limited to, factors indicated under “Item 1A. Risk Factors”, “Note Regarding ForwardLooking Statements” of this report. General Economic Conditions, Cyclicality and Seasonality Our results of operations are affected by worldwide economic conditions. Because carbon black is used in a diverse group of end products, demand for carbon black has historically been related to real GDP and general global economic conditions. In particular, a large part of our sales has direct exposure to the cyclical automotive industry and, to a lesser extent, the construction industry. As a result, our results of operations experience a level of inherent cyclicality. The nature of our business and our large fixed asset base make it difficult to rapidly adjust our fixed costs downward when demand for our products declines, which materially affects our results of operations. Our business is generally not seasonal in nature, although we may experience some regional seasonal declines during holiday periods and our results of operations are generally weaker in the last three months of the year. Drivers of Demand Besides general global economic conditions, certain specific drivers of demand for carbon black differ among our operating segments. Specialty carbon black has a wide variety of enduses and demand is largely driven by the development of the coatings, polymers and printing industries. Demand for specialty carbon black in the coatings and polymers industries is mainly influenced by the levels of industrialization, automobile OEM demand, infrastructure, consumer goods and construction. Demand for specialty carbon black in the printing industry is mainly influenced by developments in print media and packaging materials. Demand for rubber carbon black is largely driven by the development of the tire and mechanical rubber goods industries. Demand for rubber carbon black in tires is mainly influenced by the number of replacement and original equipment tires produced, which in turn is driven by (i) vehicle trends, including the number of vehicles produced and registered, and the number of miles driven, (ii) demand for highperformance tires, (iii) demand for larger vehicles, such as trucks and buses and (iv) changes in regulatory requirements. Demand for rubber carbon black in mechanical rubber goods is mainly influenced by vehicle trends, construction activity and general industrial production. Demand in the developed West European and North American regions is mainly driven by demographic changes, customers’ highquality requirements, stringent tire regulation standards and relatively stable tire replacement demand. Demand in emerging markets, such as China, Southeastern Asia, South America and Eastern Europe, is mainly driven by the growing middle class, rapid industrialization, new infrastructure spending and increasing car ownership trends. The growth in vehicle production in turn drives demand for both original equipment tire manufacturing and replacement tires in developing regions. Asset Utilization Margins in the carbon black industry, and the chemical industry generally, are strongly influenced by industry capacity [/INST] Positive. </s>

Kontoor Brands, Inc.

2020-03-11

2019-12-28

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following discussion and analysis includes forward-looking statements. These forward-looking statements are subject to risks, uncertainties and other factors that could cause our actual results to differ materially from those expressed or implied by the forward-looking statements. Factors that could cause or contribute to these differences include, but are not limited to, those discussed in “Special Note On Forward-Looking Statements” included in Part I of this Annual Report on Form 10-K. Description of Business Kontoor Brands, Inc. ("Kontoor," the "Company," "we," "us" or "our") is a global lifestyle apparel company headquartered in the United States ("U.S."). The Company designs, produces, procures, markets and distributes apparel primarily under the brand names Wrangler® and Lee®. The Company's products are sold in the U.S. through mass merchants, specialty stores, mid-tier and traditional department stores, company-operated stores and online. The Company's products are also sold internationally, primarily in Europe and Asia, through department, specialty, company-operated, concession retail and independently operated partnership stores and online. VF Outlet™ stores carry Wrangler® and Lee® branded products, as well as merchandise that is specifically purchased for sale in these stores. Spin-Off Transaction On May 22, 2019, VF Corporation ("VF" or "former parent") completed the spin-off of its Jeanswear business, which included the Wrangler®, Lee® and Rock & Republic® brands, as well as the VF OutletTM business. The spin-off transaction (the "Separation") was effected through a pro-rata distribution to VF shareholders of one share of Kontoor common stock for every seven shares of VF common stock held on the record date of May 10, 2019. Kontoor began to trade as a standalone public company (NYSE: KTB) on May 23, 2019. On May 17, 2019, the Company incurred $1.05 billion of indebtedness under a newly structured third-party debt issuance, the proceeds of which were used primarily to finance a cash transfer to VF in connection with the Separation. Fiscal Year The Company operates and reports using a 52/53 week fiscal year ending on the Saturday closest to December 31 of each year. For presentation purposes herein, all references to periods ended December 2019, December 2018 and December 2017 correspond to the 52-week fiscal years ended December 28, 2019, December 29, 2018 and December 30, 2017, respectively. Basis of Presentation The Company’s financial statements for periods through the Separation date of May 22, 2019 were combined financial statements prepared on a "carve-out" basis of accounting, which reflected the business as historically managed within VF. The balance sheets and cash flows included only those assets and liabilities directly related to the Jeanswear and VF OutletTM businesses, and the statements of income included the historically reported results of those businesses along with allocations of a portion of VF’s total corporate expenses. Refer to Note 1 to the Company's financial statements for additional information on the carve-out basis of accounting. The Company’s financial statements for the period from May 23, 2019 through December 28, 2019 were based on the reported results of Kontoor Brands, Inc. as a standalone company. This results in a lack of comparability between periods in the statements of income, primarily in selling, general and administrative expenses. Effective with the Separation, the Company began implementing business model changes, which included the exit of unprofitable markets in Europe, the transition of our former Central and South America Kontoor Brands, Inc 2019 Form 10-K 28 ("CASA") region to a licensed model and the discontinuation of certain transactions with VF. Thus, certain revenues and costs presented in the carve-out statements of income did not continue after the Separation. Additionally, the Company's balance sheet at December 2019 includes only the assets and liabilities associated with the entities that transferred at the Separation, some of which are different from those that were reported on a carve-out basis at December 2018. References to foreign currency amounts for the years ended December 2019 and December 2018 herein reflect the changes in foreign exchange rates from the years ended December 2018 and December 2017, respectively, and the corresponding impact on translating foreign currencies into U.S. dollars and on foreign currency-denominated transactions. The Company's most significant foreign currency translation exposure is typically driven by business conducted in euro-based countries. However, the Company conducts business in other developed and emerging markets around the world with exposure to other foreign currencies. Amounts herein may not recalculate due to the use of unrounded numbers. Business Overview As a newly formed standalone public company as of May 22, 2019, we have worked to stabilize, position and streamline our presence around the world, and our active, strategic brand management has positioned us favorably for long-term success. As part of a centralized approach to our global business, our management team is providing global oversight for their respective business functions, including supply chain, digital, direct-to-consumer and strategy, while seeking to ensure that we maintain our worldwide presence and regional approach. We have undergone transformational change to improve operational performance, address internal and external factors and set the stage for long-term profitable growth. We have launched significant cost-savings initiatives during 2019 as we began to refine a global go-to-market approach that will sustain our long-term commitment to total shareholder return. The Company is focused on growing our three strategic channels, with higher rates of growth anticipated in our Non-U.S. Wholesale channel as we pursue a broader set of products, channels and geographic opportunities for the Wrangler® and Lee® brands, and in the digital platforms of our global Branded Direct-to-Consumer channel. The U.S. Wholesale channel will continue to receive our full focus and commitment, but with slower anticipated rates of growth than the Non-U.S. Wholesale and global Branded Direct-to-Consumer channels. Additionally, we have made significant investments during 2019 to support the design and implementation of a global ERP system that will continue into 2020 and 2021. During 2019, both prior to and after the Separation we have pursued global initiatives related to business model changes, restructuring programs and costs incurred to effect the Separation and establish ourselves as a standalone public company ("Separation costs"), which have and will continue to result in improved profitability. These initiatives have included exiting unprofitable markets in Europe and South America, the transition of our former CASA region to a licensed model, streamlining and right-sizing supply chain operations including the closure of three owned manufacturing facilities in Mexico, streamlining our global organizational structure including a redesign of our commercial organization in the U.S. and Asia, and relocating the Lee® brand’s North American headquarters to Greensboro, North Carolina. Subsequent to the Separation, the Company has continued to service commercial arrangements with VF, which include sales of VF-branded products at VF Outlet™ stores, as well as sales to VF for products manufactured in our plants, use of our transportation fleet and fulfillment of a transition services agreement related to VF’s sale of its Nautica® brand business in mid-2018, none of which will continue in 2020. We will continue to implement proactive strategic quality-of-sales programs to improve efficiencies throughout the organization, such as exiting unprofitable points of distribution, including select channels in India, changing business models and rationalizing underperforming styles. Focusing on our near- to medium-term business strategy, we are focused on optimizing our business and accelerating our performance in fundamental areas, including margin expansion and cash flow generation. Longer term, we are focused on accelerating revenue generation and additional strategic actions to fuel and sustain long-term performance and our competitive advantage around the world. We anticipate opportunities to further enhance our value-creation ability through investment in our core business. Our primary areas of financial focus during 2020 will be to (i) continue aggressive pay-down of debt; (ii) provide for a superior dividend yield; and (iii) implement technology solutions to enable global efficiency. Additionally, we continue to monitor the COVID-19 coronavirus situation and the potential impact on our global operations. In terms of supply chain impacts, there are currently no material disruptions in either manufacturing or sourcing of materials. HIGHLIGHTS OF THE YEAR ENDED DECEMBER 2019 • Net revenues decreased 8% to $2,548.8 million compared to the year ended December 2018, driven by decreases in all segments and a 1% unfavorable impact from foreign currency. • U.S. Wholesale revenues decreased 4% compared to the year ended December 2018, primarily due to the negative impact of a major U.S. retailer bankruptcy in the fourth quarter of 2018, proactive quality-of-sales initiatives and reduced sales of certain lower margin lines of business. These declines were partially offset by growth in our U.S. digital wholesale business. The U.S. Wholesale net revenues represented 63% of total revenues in the current year. • International revenues decreased 15% compared to the year ended December 2018, due to a 5% unfavorable impact from foreign currency and declines in the Non-U.S. Wholesale channel primarily driven by strategies actioned by the Company in 2019, which included the exit of unprofitable points of distribution in India, strategic actions to exit direct operations in underperforming 29 Kontoor Brands, Inc. 2019 Form 10-K countries in Europe and South America and business model changes. International revenues represented 25% of total revenues in the current year. • Branded Direct-to-Consumer revenues decreased 5% on a global basis compared to the year ended December 2018, primarily due to business model changes actioned by the Company in 2019 and a 3% unfavorable impact from foreign currency. These declines were partially offset by 16% growth in the U.S. digital business through our owned e-commerce sites. The global Branded Direct-to-Consumer channel represented 11% of total revenues in the current year. • Gross margin decreased 90 basis points to 39.4% compared to the year ended December 2018. Gross margin was negatively impacted by approximately 140 basis points during the current year due to business model changes, restructuring programs and Separation costs, partially offset by favorable channel mix in the current year. • Selling, general & administrative expenses as a percentage of revenues increased 320 basis points. Business model changes, restructuring programs and Separation costs negatively impacted the current year by approximately 300 basis points. The remaining increase as a percentage of net revenues was primarily driven by deleverage of fixed costs on lower revenues. • Net income decreased 63% to $96.7 million compared to the year ended December 2018, primarily due to the business results discussed above and a $32.6 million ($25.2 million after-tax) non-cash impairment of the Rock & Republic® trademark intangible asset during the current year. ANALYSIS OF RESULTS OF OPERATIONS Consolidated and Combined Statements of Income The following table presents a summary of the changes in net revenues for the years ended December 2019 and December 2018: 2019 Compared to 2018 Net revenues decreased 8% due to declines in the Wrangler and Lee segments, as well as declines in the Other category. These declines were primarily due to proactive quality-of-sales initiatives including business model changes and exits of select markets, programs and points of distribution, the negative impact of a major U.S. retailer bankruptcy in the fourth quarter of 2018, reduced sales of certain lower margin lines of business, the discontinuation of manufacturing for VF and a 1% unfavorable impact from foreign currency. The declines were partially offset by growth in our U.S. digital wholesale partners and owned e-commerce sites. 2018 Compared to 2017 Net revenues decreased 2% primarily due to declines in the Wrangler and Lee segments. These declines were primarily due to a number of global macroeconomic challenges that primarily impacted our wholesale channels, which were partially offset by strength in our direct-to-consumer business. Both our U.S. Wholesale and Non-U.S. Wholesale channels declined in 2018 compared to 2017. The U.S. Wholesale channel was unfavorably impacted in 2018 by the continued effects of a key customer’s inventory de-stocking decision, along with door closures following the bankruptcy of a major U.S. retailer in the fourth quarter of 2018. This decline was partially offset by strong growth with our digital wholesale partners and growth in other key brick & mortar retail accounts. Our Non-U.S. Wholesale channel was adversely affected by foreign exchange impacts from the highly inflationary economy in Argentina, as well as inventory reduction decisions by certain retailers in the non-US Americas region and the ongoing effects of the economic demonetization in India. Our Branded Direct-to-Consumer channel continued to grow, driven by the performance of our own websites. Additional details on 2019, 2018 and 2017 revenues are provided in the section titled “information by reportable segment.” The following table presents components of the Company's statements of income as a percent of total net revenues: Kontoor Brands, Inc 2019 Form 10-K 30 2019 Compared to 2018 Gross margin decreased 90 basis points. Business model changes, restructuring programs and Separation costs negatively impacted the current year by approximately 140 basis points. This decrease was partially offset by the impact of favorable channel mix in the current year. Selling, general and administrative expenses as a percentage of revenues increased 320 basis points. Business model changes, restructuring programs and Separation costs negatively impacted the current year by approximately 300 basis points. The remaining increase as a percentage of net revenues was primarily driven by deleverage of fixed costs on lower revenues. Non-cash impairment of intangible asset reflects a $32.6 million impairment of the Rock & Republic® trademark recorded in August 2019. There were no intangible asset impairments in 2018. The effective income tax rate was 28.5% for the year ended December 2019 compared to 22.6% for the year ended December 2018. The 2019 effective income tax rate included a net discrete tax expense of $3.8 million, comprised of $3.5 million of tax expense primarily related to an increase in unrecognized tax benefits and interest, $2.1 million of net tax expense related to recording valuation allowances on beginning balance deferred tax assets at the date of Separation and the impact of a corresponding change in assertion on unremitted earnings, $1.9 million of tax expense related to adjustments to tax balances transferred from former parent at the Separation and $3.7 million of tax benefit related to stock compensation. The $3.8 million of net discrete tax expense in 2019 increased the effective income tax rate by 2.8% compared to an increase of 1.4% for discrete items in 2018. Without discrete items, the effective income tax rate for the year ended December 2019 increased 4.5%, primarily due to losses incurred in certain foreign jurisdictions and the tax impacts of GILTI, partially offset by favorable changes in our jurisdictional mix of earnings. Our effective income tax rate for foreign operations was 20.1% and 17.2% for the years ended December 2019 and December 2018, respectively. 2018 Compared to 2017 Gross margin decreased 110 basis points. Increased manufacturing labor, overhead and product costs negatively impacted the year ended December 2018, and was partially offset by favorable pricing, the benefit of facility closures and a mix shift toward higher margin products. Additionally, restructuring charges were higher in 2018 due to the exit of a manufacturing facility. Selling, general and administrative expenses as a percentage of revenues decreased 50 basis points. 2018 was impacted by lower advertising spend following the timing of strategic investments in late 2017 to improve our brand messaging, lower compensation-related costs associated with reduced headcount and a reduction in costs allocated to us by VF due to being a smaller portion of VF’s total operating results in 2018. These decreases were partially offset by higher restructuring charges for severance costs related to ongoing efforts to enhance our cost efficiency and profitability, Separation transaction costs to advisors, attorneys and other third parties that were not incurred in 2017, as well as an increase in the non-service components of net periodic pension costs. Income taxes decreased $166.0 million during the year ended December 2018 compared to the year ended December 2017 primarily due to the transitional impact of the Tax Act that resulted in a provisional net charge of $136.7 million during the fourth quarter of 2017. The effective income tax rate was 22.6% for the year ended December 2018 compared to 67.6% for the year ended December 2017. The effective income tax rate was substantially lower in 2018 when compared to 2017 primarily due to the discrete tax expense associated with the Tax Act recorded in 2017. The Tax Act reduced the federal tax rate on U.S. earnings to 21% and moved from a global taxation regime to a modified territorial regime. As part of the legislation, U.S. companies were required to pay a tax on historical earnings generated offshore that had not been repatriated to the U.S. Additionally, revaluation of deferred tax asset and liability positions at the lower federal base rate of 21% was required. The transitional impact of the Tax Act resulted in a provisional net charge of $136.7 million during the fourth quarter of 2017. This amount was primarily comprised of $110.6 million related to the transition tax and $19.4 million of tax expense related to revaluing U.S. deferred tax assets and liabilities using the new U.S. corporate tax rate of 21%. Other provisional charges of $6.7 million were primarily related to establishing a deferred tax liability for foreign withholding and state taxes on unremitted foreign earnings. The 2018 effective income tax rate included a net discrete tax expense of $4.8 million, comprised of $5.5 million of net tax expense related to the Tax Act, $2.4 million of net tax expense related to unrecognized tax benefits and interest and $3.1 million of tax benefit related to stock compensation. The $4.8 million net discrete tax expense in 2018 increased the effective income tax rate by 1.4% compared to an increase of 36.2% for discrete items in 2017. Without discrete items, the effective income tax rate for the year ended December 2018 decreased 10.2%, primarily due to the impact of the Tax Act, including a lower U.S. corporate income tax rate that was effective beginning January 1, 2018. Our effective income tax rate for foreign operations was 17.2% and 19.3% for the years ended December 2018 and December 2017, respectively. 31 Kontoor Brands, Inc. 2019 Form 10-K Information by Business Segment Management at each of the brands has direct control over and responsibility for corresponding net revenues and operating income, hereinafter termed "segment revenues" and "segment profit," respectively. Our management evaluates operating performance and makes investment and other decisions based on segment revenues and segment profit. Common costs for certain centralized functions are allocated to the segments as discussed in Note 3 to the Company's financial statements. The following tables present a summary of the changes in segment revenues and segment profit for the years ended December 2019 and December 2018: Segment Net Revenues Segment Profit The following sections discuss the changes in segment revenues and segment profit. Wrangler 2019 Compared to 2018 Global revenues for the Wrangler® brand decreased 5%, driven by declines in all channels. • Revenues in the Americas region decreased 4%, primarily due to a 2% decrease in U.S. wholesale revenues resulting from reduced sales of certain lower margin lines of business and the negative impact of a major U.S. retailer bankruptcy in the fourth quarter of 2018. Non-U.S. Americas wholesale revenues decreased 32%, primarily due to business model changes in the CASA region and a 5% unfavorable impact from foreign currency. • Revenues in the APAC region decreased 29%, primarily due to results in India which reflected the economic impact of demonetization and our exit of certain unprofitable points of distribution, as well as a 3% unfavorable impact from foreign currency. • Revenues in the EMEA region decreased 13%, primarily due to business model changes and a 5% unfavorable impact from foreign currency. Kontoor Brands, Inc 2019 Form 10-K 32 Operating margin decreased to 14.2% compared to 16.6% for 2018, primarily due to higher product costs, unfavorable mix driven by lower international sales, higher restructuring and Separation costs as well as business model changes in 2019. 2018 Compared to 2017 Global revenues for the Wrangler® brand decreased 1% due to declines in non-U.S. wholesale and branded direct-to-consumer revenues, offset by growth in U.S. wholesale revenues. • Revenues in the Americas region were flat due to declines in non-U.S. wholesale and branded direct-to-consumer revenues, offset by growth in U.S. wholesale revenues. Branded brick & mortar revenues in the Americas region decreased, primarily due to declines in sales through our VF OutletTM stores, offset by growth in our owned websites. The U.S. Wholesale channel increase was attributable to strong growth with our digital wholesale partners and growth in certain key brick & mortar retail accounts. Revenues in the non-U.S. Americas region decreased 16% due to declines in wholesale and branded brick & mortar revenues, primarily due to a 13% unfavorable impact from foreign currency related to the highly inflationary economy in Argentina. • Revenues in the APAC region decreased 4%, primarily due to declines in wholesale revenues associated with the ongoing effects of economic demonetization in India and a 3% unfavorable impact from foreign currency. • Revenues in the EMEA region decreased 2%, primarily due to declines in wholesale and branded direct-to-consumer revenues attributed to door closures and an unseasonably warm summer weather pattern, partially offset by a 4% favorable impact from foreign currency. Operating margin decreased to 16.6% compared to 17.3% for 2017, primarily due to higher restructuring costs related to severance, additional strategic investments in our direct-to-consumer business and product development costs, all of which resulted in reduced expense leverage on lower revenues in 2018. Lee 2019 Compared to 2018 Global revenues for the Lee® brand decreased 8%, driven by declines in all channels. • Revenues in the Americas region decreased 6%, primarily due to a 7% decrease in U.S. wholesale revenues resulting from the negative impact of a major U.S. retailer bankruptcy in the fourth quarter of 2018 and reduced sales in certain lower margin lines of business. Non-U.S. Americas revenues decreased 13%, primarily due to business model changes in the CASA region and a 2% unfavorable impact from foreign currency. • Revenues in the APAC region decreased 7%, primarily due to a 4% unfavorable impact from foreign currency and results in India which reflected the economic impact of demonetization and our exit of certain unprofitable points of distribution. • Revenues in the EMEA region decreased 16%, primarily due to business model changes, softer European demand and a 5% unfavorable impact from foreign currency. Operating margin decreased to 7.7% compared to 9.7% for 2018, primarily due to higher product costs, unfavorable mix driven by lower international sales, higher restructuring and Separation costs as well as business model changes in 2019. 2018 Compared to 2017 Global revenues for the Lee® brand decreased 5%, driven by declines in U.S. wholesale revenues, which were partially offset by growth in branded direct-to-consumer revenues. • Revenues in the Americas region decreased 9%, primarily due to declines in U.S. wholesale revenues. The U.S. Wholesale channel was adversely impacted by a key customer’s inventory destocking decision related to our Lee® Riders® brand, as well as door closures following bankruptcy filings by a limited number of key retailers. This decline was partially offset by strong growth in our sales through our VF OutletTM stores. Revenues in the non-U.S. Americas region decreased 14%, primarily due to declines in wholesale revenues related to inventory reductions at a key retailer and a 4% unfavorable impact from foreign currency, led by the highly inflationary economy in Argentina. 33 Kontoor Brands, Inc. 2019 Form 10-K • Revenues in the APAC region decreased 1%, primarily due to declines in wholesale revenues that were adversely affected by higher product returns related to a market transition in a key market, partially offset by growth in branded direct-to-consumer revenues led by our concessions business and a 1% favorable impact from foreign currency. • Revenues in the EMEA region were flat, primarily due to growth in wholesale revenues and a 4% favorable foreign currency impact, offset by declines in our branded direct-to-consumer revenues driven by door closures and an unseasonably warm summer weather pattern. Operating margin decreased to 9.7% compared to 10.7% for 2017, primarily due to higher manufacturing labor, overhead and product costs, while selling, general and administrative expenses remained flat on lower revenues in 2018. Other In addition, we report an "Other" category for purposes of a reconciliation of segment revenues and segment profit to the Company's operating results, but the Other category is not considered a reportable segment based on evaluation of the aggregation criteria. Other includes sales of third-party branded merchandise at VF Outlet™ stores, sales and licensing of Rock & Republic® branded apparel, and sales of products manufactured for third-parties. Sales of Wrangler® and Lee® branded products at VF Outlet™ stores are not included in Other and are reported in the respective segments discussed above. The Other category also includes transactions with VF for pre-Separation activities, none of which will continue going forward. These transactions include sales of VF-branded products at VF Outlet™ stores, as well as sales to VF for products manufactured in our plants, use of our transportation fleet and fulfillment of a transition services agreement related to VF’s sale of its Nautica® brand business in mid-2018. *Calculation not meaningful. 2019 Compared to 2018 Other revenues decreased 26% as transactions with VF for pre-Separation activities decreased to $22.6 million compared to $51.0 million during 2018. In addition, VF Outlet™ store revenues decreased 12% compared to 2018 as a result of a decrease in comparable store sales and total square footage. 2018 Compared to 2017 Other revenues decreased 2% primarily due to a 12% decrease in our VF OutletTM store revenues resulting from exiting unprofitable doors and underperforming categories, partially offset by revenues generated from fulfilling a transition services agreement related to VF’s sale of its Nautica® brand business in mid-2018 and increased sales to VF. Total sales to VF increased to $51.0 million compared to $45.5 million in 2017. Our profit and operating margin improvement was primarily due to the margin earned on fulfilling the Nautica® transition services agreement. Reconciliation of Segment Profit to Income Before Income Taxes For purposes of preparing these financial statements on a carve-out basis, corporate and other expenses included the Company's allocation of a portion of VF's total corporate expenses through the Separation date of May 22, 2019. For the period from May 23, 2019 through the end of 2019, the Company incurred corporate and other expenses as a standalone public company. Refer to Note 3 to the Company's financial statements for additional information on the Company's methodology for allocating these costs. Kontoor Brands, Inc 2019 Form 10-K 34 The costs below are necessary to reconcile total segment profit to income before taxes. These costs are excluded from segment profit as they are managed centrally and are not under control of brand management. (1) Represents an impairment charge in the third quarter of 2019 related to the Rock & Republic® trademark. See Note 7 to the Company's financial statements. * Calculation not meaningful. 2019 Compared to 2018 Non-cash impairment of intangible asset reflects a $32.6 million impairment of the Rock & Republic® trademark recorded in August 2019. There were no intangible asset impairments in 2018. Corporate and other expenses increased $59.2 million, due to Separation costs, an increase in general corporate costs required to operate as a standalone public company and expenses associated with implementation of the Company's global enterprise resource planning system. Interest income from former parent, net decreased $3.9 million as all notes to and from former parent were settled in connection with the Separation from VF. Interest expense increased $34.6 million, primarily due to borrowings on the Company's credit facilities established with the Separation. 2018 Compared to 2017 Corporate and other expenses declined slightly, due to the $3.9 million decrease in the allocation of VF’s corporate expenses to us being partially offset by $2.3 million in Separation transaction costs. Interest income from former parent, net increased $4.4 million primarily due to increased interest income from an approximate 110 basis point increase in the average interest rate in effect on our related party notes receivable balances, partially offset by increased interest expense due to an approximate 70 basis point increase in the average interest rate in effect on our related party notes payable balances in 2018 compared to 2017. ANALYSIS OF FINANCIAL CONDITION Liquidity and Capital Resources Prior to the Separation, we generated strong annual cash flows from operating activities. While part of VF, a substantial portion of the Company's cash was transferred to VF and managed at the corporate level. This cash was not specifically identifiable to the Company and therefore was not reflected within our balance sheets. VF's third-party long-term debt and the related interest expense were not allocated to the Company as we were not the legal obligor of the respective debt obligations. As a standalone public company, our ability to fund our operating needs is dependent upon our ability to continue to generate positive cash flow from operations and maintain our debt financing on acceptable terms. Based upon our history of generating positive cash flows from operations, we believe that we will be able to support our short-term liquidity needs as well as any future liquidity and capital requirements through the combination of cash flows from operations, available cash balances and borrowing capacity from our revolving credit facility. In the event that the aforementioned sources of liquidity need to be augmented, additional cash requirements would likely be financed through the additional issuance of debt or equity securities subject to any restrictions under the Tax Matters Agreement; however, there can be no assurances that we will be able to obtain additional debt or equity financing on acceptable terms, if required, in future periods. 35 Kontoor Brands, Inc. 2019 Form 10-K At December 2019, we had $106.8 million in cash and cash equivalents. We anticipate utilizing cash flows from operations to support continued investments in our brands, talent and capabilities, growth strategies, dividend payments to shareholders and repayment of our debt obligations over time. Management believes that our cash balances and funds provided by operating activities, along with existing borrowing capacity and access to capital markets, taken as a whole, provide (i) adequate liquidity to meet all of our current and long-term obligations when due, including third-party debt incurred in connection with the Separation, (ii) adequate liquidity to fund capital expenditures and planned dividend payouts and (iii) flexibility to meet investment opportunities that may arise. On May 17, 2019, we incurred $1.05 billion of indebtedness under a newly structured third-party debt issuance, the proceeds of which were used primarily to finance a cash transfer to VF in connection with the Separation. This debt obligation could restrict our future business strategies and could adversely impact our future results of operations, financial condition or cash flows. Additionally, the Separation increased our overall interest expense and decreased the overall debt capacity and commercial credit available to the Company. Refer to Note 10 to the Company's financial statements for additional information regarding the Company's credit facilities, including financial covenants and interest rates thereunder, and borrowing limits and availability as of December 2019. During 2019, the Company made $127.0 million of principal payments related to this debt obligation, including optional repayments. As a result of these optional repayments, the Company is not required to make mandatory principal payments on long-term debt until June 2021. At December 2019 and 2018, the Company had $47.8 million and $35.9 million, respectively, of international lines of credit with various banks, which are uncommitted and may be terminated at any time by either us or the banks. Total outstanding balances under these arrangements were $1.1 million and $3.2 million at December 2019 and 2018, respectively, all of which are letters of credit and non-interest bearing to the Company. During 2019, the Company paid $63.6 million of dividends to its shareholders. On February 18, 2020, the Board of Directors declared a regular quarterly cash dividend of $0.56 per share of the Company's Common Stock, payable on March 20, 2020, to shareholders of record at the close of business on March 10, 2020. The Company intends to continue to pay cash dividends in future periods. The declaration and amount of any future dividends will be determined and subject to authorization by our Board of Directors and will be dependent upon multiple factors including our financial condition, earnings, cash flows, capital requirements, covenants associated with our debt obligations, legal requirements, regulatory constraints, industry practice and any other factors or considerations that our Board of Directors deems relevant. We currently expect capital expenditures to range from $55.0 million to $70.0 million in 2020, primarily to support our implementation of a global ERP system. The following table presents our cash flows during the periods: Operating Activities Cash flow provided by operating activities is dependent on the level of our net income, adjustments to net income and changes in working capital. During 2019, cash provided by operating activities increased $874.1 million as compared to 2018, primarily due to the settlement of amounts due to and from former parent related to the Company's sale of trade accounts receivable arrangement with VF, partially offset by a decrease in net income attributable to operating results. During 2018, cash provided by operating activities decreased $264.9 million as compared to 2017, primarily due to $323.3 million lower cash proceeds from settlement of amounts due to and from former parent related to the Company's sale of trade accounts receivable with VF, partially offset by an increase in net income attributable to operating results and changes in other working capital. Refer to Note 4 to the Company's financial statements for additional information on sales of trade accounts receivable to VF. Investing Activities During 2019, cash provided by investing activities increased $472.6 million, primarily due to the collection of notes receivable from former parent in connection with the Separation. During 2018, cash provided by investing activities increased $68.9 million, primarily due to receipt of $29.8 million from VF for repayment of amounts advanced to VF in 2017, resulting in a $59.6 million cash flow improvement. Financing Activities During 2019, cash provided by financing activities decreased $1.4 billion, primarily due to net transfers to former parent and the repayment of notes payable to former parent in connection with the Separation. The Company also made principal payments of $127.0 million on long-term debt obligations and paid $63.6 million of dividends to our shareholders in 2019. These cash disbursements were partially offset by $1.05 billion in proceeds from the issuance of long-term debt in 2019. Kontoor Brands, Inc 2019 Form 10-K 36 During 2018, cash provided by financing activities increased $226.1 million, primarily due to a decrease in net transfers to VF. Contractual Obligations The following table presents our estimated material contractual obligations and other commercial commitments at December 2019, and the future periods in which such obligations are expected to be settled in cash: (1) Long-term debt consists of mandatory principal payments on long-term debt. (2) Other recorded liabilities represent payments due for other long-term liabilities in the balance sheet related to deferred compensation and other employee-related benefits and other liabilities. These amounts are based on historical and forecasted cash outflows. Amounts exclude liabilities for unrecognized income tax benefits and deferred income taxes. (3) Operating leases represent required minimum lease payments during the noncancelable lease term. Most real estate leases also require payments of related operating expenses such as taxes, insurance and utilities, which are not included above. (4) Interest payment obligations represent estimated future interest payments on floating rate long-term debt and are estimated based on interest rates in effect as of December 2019 and the remaining term of the debt. Amounts exclude amortization of debt issuance costs, debt discounts and acquisition costs that would be included in interest expense in the financial statements. (5) Minimum royalty payments represent obligations under license agreements to use trademarks owned by third parties and include required minimum advertising commitments. Actual payments could exceed related minimum royalty obligations. (6) Inventory obligations represent binding commitments to purchase raw materials, contract production and finished products that are payable upon delivery of the inventory. This obligation excludes the amount included in accounts payable at December 2019 related to inventory purchases. (7) Other obligations represent other binding commitments for the expenditure of funds, including (i) amounts related to contracts not involving the purchase of inventories, such as the noncancelable portion of service or maintenance agreements for management information systems, (ii) capital spending and (iii) advertising. The Company is party to a 10-year power purchase agreement to procure electricity generated from renewable energy sources to meet a portion of electricity needs for certain facilities in Mexico (including our manufacturing plants). Other obligations include total purchase commitments of $33.3 million over the contract term which is included in other obligations above. We had other financial commitments at December 2019 that are not included in the above table but may require the use of funds under certain circumstances: • $32.6 million of surety bonds, custom bonds, standby letters of credit and international bank guarantees are not included in the above table because they represent contingent guarantees of performance under self-insurance and other programs and would only be drawn upon if we were to fail to meet our other obligations. • Purchase orders for goods or services in the ordinary course of business are not included in the above table because they represent authorizations to purchase rather than binding commitments. 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, results of operations, liquidity, capital expenditures or capital resources. Critical Accounting Policies and Estimates We have chosen accounting policies that management believes are appropriate to accurately and fairly report our operating results and financial position in conformity with GAAP. We apply these accounting policies in a consistent manner. Significant accounting policies are summarized in Note 1 to the Company's financial statements included elsewhere in this Annual Report on Form 10-K. 37 Kontoor Brands, Inc. 2019 Form 10-K The application of these accounting policies requires that we make estimates and assumptions about future events and apply judgments that affect the reported amounts of assets, liabilities, net revenues, expenses, contingent assets and liabilities, and related disclosures. These estimates, assumptions and judgments are based on historical experience, current trends and other factors believed to be reasonable under the circumstances. Management evaluates these estimates and assumptions on an ongoing basis. Because our business cycle is relatively short (i.e., from the date that inventory is received until that inventory is sold and the trade accounts receivable is collected), actual results related to most estimates are known within a few months after any balance sheet date. In addition, we may retain outside specialists to assist in impairment testing of goodwill and intangible assets. Several of the estimates and assumptions we are required to make relate to future events and are therefore, inherently uncertain, especially as it relates to events outside of our control. If actual results ultimately differ from previous estimates, the revisions are included in results of operations when the actual amounts become known. We believe the following accounting policies involve the most significant management estimates, assumptions and judgments used in preparation of the financial statements or are the most sensitive to change from outside factors. The selection and application of the Company’s critical accounting policies and estimates are periodically discussed with the Audit Committee of the Board of Directors. Long-Lived Assets, Including Intangible Assets and Goodwill Testing of Property, Plant and Equipment for Impairment Our policy is to review property, plant and equipment assets for potential impairment whenever events or changes in circumstances indicate that the carrying value of an asset or asset group may not be recoverable. We test for potential impairment at the asset or asset group level, which is the lowest level for which there are identifiable cash flows that are largely independent, by comparing the carrying value to the estimated undiscounted cash flows expected to be generated by the asset. If the forecasted undiscounted cash flows to be generated by the asset are not expected to be adequate to recover the asset’s carrying value, a fair value analysis must be performed, and an impairment charge is recorded if there is an excess of the asset’s carrying value over its estimated fair value. When testing property, plant and equipment for potential impairment, management uses the income-based discounted cash flow method using the estimated cash flows of the respective asset or asset group. The estimated undiscounted cash flows of the asset or asset group through the end of its useful life are compared to its carrying value. If the undiscounted cash flows of the asset or asset group exceed its carrying value, there is no impairment charge. If the undiscounted cash flows of the asset or asset group are less than its carrying value, the estimated fair value of the asset or asset group is calculated based on the discounted cash flows using the reporting unit’s weighted average cost of capital (“WACC”), and an impairment charge is recognized for the difference between the estimated fair value of the asset or asset group and its carrying value. Testing of Indefinite-Lived Intangible Assets and Goodwill for Impairment Our policy is to evaluate indefinite-lived intangible assets and goodwill for possible impairment as of the beginning of the fourth quarter of each year, or whenever events or changes in circumstances indicate that the fair value of such assets may be below their carrying amount. As part of our annual impairment testing, we may elect to assess qualitative factors as a basis for determining whether it is necessary to perform quantitative impairment testing. If management’s assessment of these qualitative factors indicates that it is not more likely than not that the fair value of the intangible asset or reporting unit is less than its carrying value, then no further testing is required. Otherwise, the intangible asset or reporting unit must be quantitatively tested for impairment. •Indefinite-Lived Intangible Assets - An indefinite-lived intangible asset is quantitatively tested for possible impairment by comparing the estimated fair value of the asset to its carrying value. Fair value of an indefinite-lived trademark is based on an income approach using the relief-from-royalty method. Under this method, forecasted net revenues for products sold with the trademark are assigned a royalty rate that would be charged to license the trademark (in lieu of ownership), and the estimated fair value is calculated as the present value of those forecasted royalties avoided by owning the trademark. The discount rate is based on the reporting unit’s WACC that considers market participant assumptions, plus a spread that factors in the risk of the intangible asset. The royalty rate is selected based on consideration of (i) royalty rates included in active license agreements, if applicable, (ii) royalty rates received by market participants in the apparel industry and (iii) the current performance of the reporting unit. If the estimated fair value of the trademark intangible asset exceeds its carrying value, there is no impairment charge. If the estimated fair value of the trademark is less than its carrying value, an impairment charge would be recognized for the difference. •Rock & Republic® Trademark Intangible Asset Impairment Analysis - The Rock & Republic® brand has an exclusive wholesale distribution and licensing arrangement that covers all branded apparel, accessories and other merchandise. As of June 30, 2018, management performed a quantitative impairment analysis of the Rock & Republic® trademark intangible asset to determine if the carrying value was recoverable. This testing was determined to be necessary due to management's expectation that certain customer contract terms would be modified as it related to exclusivity of specific product lines to continue under the contract, which was considered a triggering event. Based on the analysis performed, management concluded that the trademark intangible asset did not require further testing as the undiscounted cash flows exceeded the carrying value of $49.0 million. During the third quarter of 2019, management determined that the exclusive domestic wholesale distribution and licensing agreement of the Rock & Republic® brand would not be extended as previously expected. This was considered a triggering event that required management to perform a quantitative impairment analysis of the Rock & Republic® trademark intangible asset as of August 2019. Based on this analysis, the Company recorded a $32.6 million non-cash impairment charge which was reflected within "non-cash impairment of intangible asset" in the Company's statement of income during the third quarter of 2019. The Company did not incur any Kontoor Brands, Inc 2019 Form 10-K 38 impairment charges during 2018. Refer to Note 13 to the Company's financial statements for additional information on the related fair value measurements. It is possible that management’s conclusion regarding the recoverability of the intangible asset could change in future periods as there can be no assurance that the estimates and assumptions used in the analysis as of August 2019 will prove to be accurate predictions of the future. •Goodwill - Goodwill is quantitatively evaluated for possible impairment by comparing the estimated fair value of a reporting unit to its carrying value. Reporting units are businesses with discrete financial information that is available and reviewed by segment management. For goodwill impairment testing, we estimate the fair value of a reporting unit using both income-based and market-based valuation methods. The income-based approach is based on the reporting unit’s forecasted future cash flows that are discounted to present value using the reporting unit’s WACC as discussed above. For the market-based approach, management uses both the guideline company and similar transaction methods. The guideline company method analyzes market multiples of net revenues and earnings before interest, taxes, depreciation and amortization (“EBITDA”) for a group of comparable public companies. The market multiples used in the valuation are based on the relative strengths and weaknesses of the reporting unit compared to the selected guideline companies. Under the similar transactions method, valuation multiples are calculated utilizing actual transaction prices and net revenue / EBITDA data from target companies deemed similar to the reporting unit. Based on the range of estimated fair values developed from the income and market-based methods, we determine the estimated fair value for the reporting unit. If the estimated fair value of the reporting unit exceeds its carrying value, the goodwill is not impaired and no further review is required. However, if the estimated fair value of the reporting unit is less than its carrying value, we calculate the impairment loss as the difference between the carrying value of the reporting unit and the estimated fair value. The income-based fair value methodology requires management’s assumptions and judgments regarding economic conditions in the markets in which we operate and conditions in the capital markets, many of which are outside of management’s control. At the reporting unit level, fair value estimation requires management’s assumptions and judgments regarding the effects of overall economic conditions on the specific reporting unit, along with assessment of the reporting unit’s strategies and forecasts of future cash flows. Forecasts of individual reporting unit cash flows involve management’s estimates and assumptions regarding: • Annual cash flows, on a debt-free basis, arising from future net revenues and profitability, changes in working capital, capital spending and income taxes for at least a ten-year forecast period. • A terminal growth rate for years beyond the forecast period. The terminal growth rate is selected based on consideration of growth rates used in the forecast period, historical performance of the reporting unit and economic conditions. • A discount rate that reflects the risks inherent in realizing the forecasted cash flows. A discount rate considers the risk-free rate of return on long-term treasury securities, the risk premium associated with investing in equity securities of comparable companies, the beta obtained from comparable companies and the cost of debt for investment grade issuers. In addition, the discount rate may consider any company-specific risk in achieving the prospective financial information. Under the market-based fair value methodology, judgment is required in evaluating market multiples and recent transactions. Management believes that the assumptions used for its impairment tests are representative of those that would be used by market participants performing similar valuations of our reporting units. Annual Impairment Testing Management performs its annual goodwill and indefinite-lived intangible asset impairment testing as of the fourth quarter of each fiscal year. Management performed a qualitative impairment assessment for all reporting units and indefinite-lived trademark intangible assets, as discussed below in the “Qualitative Impairment Assessment” section. We did not record any impairment charges in 2019 or 2018 related to results of our annual impairment testing. Refer to the Rock & Republic® Impairment Analysis section above for additional information on results of testing performed by management in response to a triggering event identified in the third quarter of 2019. Qualitative Impairment Assessment For all reporting units, we elected to perform a qualitative impairment assessment to determine whether it is more likely than not that the goodwill and indefinite-lived trademark intangible assets in those reporting units were impaired. We considered relevant events and circumstances for each reporting unit, including (i) current year results, (ii) financial performance versus management’s annual and five-year strategic plans, (iii) changes in the reporting unit carrying value since prior year, (iv) industry and market conditions in which the reporting unit and indefinite-lived trademark operates, (v) macroeconomic conditions, including discount rate changes and (vi) changes in products or services offered by the reporting unit. If applicable, performance in recent years was compared to forecasts included in prior valuations. Based on the results of the qualitative impairment assessment, we concluded that it was not more likely than not that the carrying values of the goodwill and indefinite-lived trademark intangible assets were greater than their fair values, and that further quantitative impairment testing was not necessary. 39 Kontoor Brands, Inc. 2019 Form 10-K Management’s Use Of Estimates and Assumptions Management made its estimates based on information available as of the date of our assessment, using assumptions we believe market participants would use in performing an independent valuation of the business. It is possible that our conclusions regarding impairment or recoverability of goodwill or intangible assets in any reporting unit could change in future periods. There can be no assurance that the estimates and assumptions used in our goodwill and intangible asset impairment testing will prove to be accurate predictions of the future, if, for example, (i) the businesses do not perform as projected, (ii) overall economic conditions in future years vary from current assumptions (including changes in discount rates), (iii) business conditions or strategies for a specific reporting unit change from current assumptions, including loss of major customers, (iv) investors require higher rates of return on equity investments in the marketplace or (v) enterprise values of comparable publicly traded companies, or actual sales transactions of comparable companies, were to decline, resulting in lower multiples of net revenues and EBITDA. A future impairment charge for goodwill or intangible assets could have a material effect on our financial position and results of operations. Income Taxes As a global company, Kontoor is subject to income taxes and files income tax returns in over 50 U.S. and foreign jurisdictions each year. The Company’s U.S. operations and certain of its non-U.S. operations historically have been included in the tax returns of VF or its subsidiaries that may not have been part of the spin-off transaction. Due to economic and political conditions, tax rates in various jurisdictions may be subject to significant change. The Company could be subject to changes in its tax rates, the adoption of new U.S. or international tax legislation or exposure to additional tax liabilities. The Company makes an ongoing assessment to identify any significant exposure related to increases in tax rates in the jurisdictions in which the Company operates. The calculation of income tax liabilities involves uncertainties in the application of complex tax laws and regulations, which are subject to legal interpretation and significant management judgment. The Company’s income tax returns are regularly examined by federal, state and foreign tax authorities, and those audits may result in proposed adjustments. The Company has reviewed all issues raised upon examination, as well as any exposure for issues that may be raised in future examinations. The Company has evaluated these potential issues under the “more-likely-than-not” standard of the accounting literature. A tax position is recognized if it meets this standard and is measured at the largest amount of benefit that has a greater than 50% likelihood of being realized. Such judgments and estimates may change based on audit settlements, court cases and interpretation of tax laws and regulations. Income tax expense could be materially affected to the extent Kontoor prevails in a tax position or when the statute of limitations expires for a tax position for which a liability for unrecognized tax benefits or valuation allowances have been established, or to the extent Kontoor is required to pay amounts greater than the established liability for unrecognized tax benefits. The Company does not currently anticipate any material impact on earnings from the ultimate resolution of income tax uncertainties. There are no accruals for general or unknown tax expenses. Kontoor has $9.6 million of gross deferred income tax assets related to operating loss carryforwards, and $9.3 million of valuation allowances against those assets. Realization of deferred tax assets related to operating loss carryforwards is dependent on future taxable income in specific jurisdictions, the amount and timing of which are uncertain, and on possible changes in tax laws. If management believes that the Company will not be able to generate sufficient taxable income to offset losses during the carryforward periods, the Company records valuation allowances to reduce those deferred tax assets to amounts expected to be ultimately realized. If in a future period management determines that the amount of deferred tax assets to be realized differs from the net recorded amount, the Company would record an adjustment to income tax expense in that future period. On December 22, 2017, the U.S. government enacted the Tax Act. The Tax Act included a broad range of complex provisions impacting the taxation of multi-national companies. Generally, accounting for the impacts of newly enacted tax legislation is required to be completed in the period of enactment; however, in response to the complexities and ambiguity surrounding the Tax Act, the SEC released Staff Accounting Bulletin No. 118 (“SAB 118”) to provide companies with relief around the initial accounting for the Tax Act. Pursuant to SAB 118, the SEC has provided a one-year measurement period for companies to analyze and finalize accounting for the Tax Act. During the one-year measurement period, SAB 118 allows companies to recognize provisional amounts when reasonable estimates can be made for the impacts resulting from the Tax Act. The Company has finalized accounting for the Tax Act during the one-year measurement period, as detailed below. During the fourth quarter of 2017, we recognized a provisional charge of $136.7 million primarily comprised of $110.6 million related to the transition tax and $19.4 million of tax expense related to revaluing U.S. deferred tax assets and liabilities using the new U.S. corporate tax rate of 21%. The transition tax was treated consistently with other taxes payable (i.e., deemed settled and reflected within former parent investment). Other provisional charges of $6.7 million were primarily related to establishing a deferred tax liability for foreign withholding and state taxes on unremitted earnings. Kontoor finalized its accounting for the Tax Act during the one-year measurement period under SAB 118, and recognized additional net charges of $5.5 million in 2018, primarily comprised of $5.7 million of charges related to the transition tax, additional tax benefits of $1.5 million related to revaluing U.S. deferred tax assets and liabilities using the new U.S. corporate tax rate of 21%, and other charges of $1.3 million related to establishing a deferred tax liability for foreign withholding taxes. The Tax Act also created a new minimum tax called the base erosion and anti-abuse tax (“BEAT”), a provision that taxes U.S. allocated expenses (e.g., interest and general administrative expenses), a tax on global intangible low-tax income (“GILTI”) from foreign operations, a general elimination of U.S. federal income taxes on dividends from foreign subsidiaries, a new limitation on deductible interest expense, and limitations on the deductibility of certain employee compensation. Under GAAP, companies may make an accounting policy election to either treat taxes resulting from GILTI as a current-period expense when they are incurred or factor such amounts into the measurement Kontoor Brands, Inc 2019 Form 10-K 40 of deferred taxes. The Company completed its analysis related to this accounting policy election and made the election to treat the taxes resulting from GILTI as a component of current income tax expense, consistent with the treatment prior to the accounting policy election. We presently do not expect to be subject to the minimum tax imposed by BEAT provisions. Recently Issued and Adopted Accounting Standards Refer to Note 1 to the Company's financial statements included elsewhere in this Annual Report on Form 10-K for discussion of recently issued and adopted accounting standards.

<s>[INST] Description of Business Kontoor Brands, Inc. ("Kontoor," the "Company," "we," "us" or "our") is a global lifestyle apparel company headquartered in the United States ("U.S."). The Company designs, produces, procures, markets and distributes apparel primarily under the brand names Wrangler® and Lee®. The Company's products are sold in the U.S. through mass merchants, specialty stores, midtier and traditional department stores, companyoperated stores and online. The Company's products are also sold internationally, primarily in Europe and Asia, through department, specialty, companyoperated, concession retail and independently operated partnership stores and online. VF Outlet™ stores carry Wrangler® and Lee® branded products, as well as merchandise that is specifically purchased for sale in these stores. SpinOff Transaction On May 22, 2019, VF Corporation ("VF" or "former parent") completed the spinoff of its Jeanswear business, which included the Wrangler®, Lee® and Rock & Republic® brands, as well as the VF OutletTM business. The spinoff transaction (the "Separation") was effected through a prorata distribution to VF shareholders of one share of Kontoor common stock for every seven shares of VF common stock held on the record date of May 10, 2019. Kontoor began to trade as a standalone public company (NYSE: KTB) on May 23, 2019. On May 17, 2019, the Company incurred $1.05 billion of indebtedness under a newly structured thirdparty debt issuance, the proceeds of which were used primarily to finance a cash transfer to VF in connection with the Separation. Fiscal Year The Company operates and reports using a 52/53 week fiscal year ending on the Saturday closest to December 31 of each year. For presentation purposes herein, all references to periods ended December 2019, December 2018 and December 2017 correspond to the 52week fiscal years ended December 28, 2019, December 29, 2018 and December 30, 2017, respectively. Basis of Presentation The Company’s financial statements for periods through the Separation date of May 22, 2019 were combined financial statements prepared on a "carveout" basis of accounting, which reflected the business as historically managed within VF. The balance sheets and cash flows included only those assets and liabilities directly related to the Jeanswear and VF OutletTM businesses, and the statements of income included the historically reported results of those businesses along with allocations of a portion of VF’s total corporate expenses. Refer to Note 1 to the Company's financial statements for additional information on the carveout basis of accounting. The Company’s financial statements for the period from May 23, 2019 through December 28, 2019 were based on the reported results of Kontoor Brands, Inc. as a standalone company. This results in a lack of comparability between periods in the statements of income, primarily in selling, general and administrative expenses. Effective with the Separation, the Company began implementing business model changes, which included the exit of unprofitable markets in Europe, the transition of our former Central and South America Kontoor Brands, Inc 2019 Form 10K 28 ("CASA") region to a licensed model and the discontinuation of certain transactions with VF. Thus, certain revenues and costs presented in the carveout statements of income did not continue after the Separation. Additionally, the Company's balance sheet at December 2019 includes only the assets and liabilities associated with the entities that transferred at the Separation, some of which are different from those that were reported on a carveout basis at December 2018. References to foreign currency amounts for the years ended December 2019 and December 2018 herein reflect the changes in foreign exchange rates from the years ended December 2018 and December 2017, respectively, and the corresponding impact on translating foreign currencies into [/INST] Negative. </s>

Elastic N.V.

2019-06-28

2019-04-30

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 section titled “Selected Consolidated Financial Data” and our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such difference include, but are not limited to, those identified below and those discussed in the section titled “Risk Factors” included elsewhere in this Annual Report on Form 10-K. Our fiscal year end is April 30. Overview Elastic is a search company. We deliver technology that enables users to search through massive amounts of structured and unstructured data for a wide range of consumer and enterprise applications. Our primary offering is the Elastic Stack, a powerful set of software products that ingest and store data from any source, and in any format, and perform search, analysis, and visualization in milliseconds or less. The Elastic Stack is designed for direct use by developers to power a variety of use cases. We have also built software solutions on the Elastic Stack that address a wide variety of use cases, including app search, site search, enterprise search, logging, metrics, APM, business analytics, and security analytics. Our products are used by individual developers and organizations of all sizes across a wide range of industries. Elasticsearch is the heart of the Elastic Stack. It is a distributed, real-time search and analytics engine and datastore for exploring all types of data including textual, numerical, geospatial, structured, and unstructured. The first public release of Elasticsearch was in 2010 by our co-founder Shay Banon as an open source project. The Company was formed in 2012. Since then, we have added new products, released new features, acquired companies, and created new solutions to expand the functionality of our products. Our business model is based on a combination of open source and proprietary software. We market and distribute the Elastic Stack and our solutions using an open source distribution strategy. Developers are able to download our software directly from our website. Many features of our software can be used free of charge. Some are only available through paid subscriptions, which include access to specific proprietary features and also include support. These paid features can be unlocked without the need to re-deploy the software. We believe that open source drives a number of benefits for our users, our customers, and our company. It facilitates rapid and efficient developer adoption, particularly by empowering individual developers to download and use our software without payment, registration, or the friction of a formal sales interaction. Our use of open source licensing fosters a vibrant developer community around our products and solutions, which drives adoption of our products and increased interaction among users. Further, this approach enables community review of our code and products, which allows us to improve the reliability and security of our software. We generate revenue primarily from sales of subscriptions for our software. We offer various subscription tiers that provide different levels of access to paid proprietary features and support. We do not sell support separately. Our subscription agreements for self-managed deployments typically have terms of one to three years and we bill for them annually in advance. Elastic Cloud customers may purchase subscriptions either on a month-to-month basis or on a committed contract of at least one year in duration. Subscriptions accounted for 91%, 93% and 90% of total revenue in the years ended April 30, 2019, 2018 and 2017, respectively. We also generate revenue from consulting and training services. We had over 8,100 customers, over 5,000 customers and over 2,800 customers as of April 30, 2019, 2018, and 2017, respectively. We define a customer as an entity that generated revenue in the quarter ending on the measurement date from an annual or month-to-month subscription. All affiliated entities are typically counted as a single customer. The annual contract value, or ACV, of a customer’s commitments is calculated based on the terms of that customer’s subscriptions, and represents the total committed annual subscription amount as of the measurement date. Month-to-month subscriptions are not included in the calculation of ACV. The number of customers who represented greater than $100,000 in ACV was over 440, over 275, and over 150 as of April 30, 2019, 2018 and 2017, respectively. We engage in various sales and marketing efforts to extend our open source distribution model. We employ multi-touch marketing campaigns to nurture our users and customers and keep them engaged after they download our software. Additionally, we maintain direct sales efforts focused on users and customers who have adopted our software, as well as departmental decision-makers and senior executives who have broad purchasing power in their organizations. Our sales teams are primarily segmented by geographies and secondarily by the employee count of our customers. They focus on both initial conversion of users into customers and additional sales to existing customers. In addition to our direct sales efforts, we also maintain partnerships to further extend our reach and awareness of our products around the world. We continue to make substantial investments in developing the Elastic Stack and the solutions we address and expanding our global sales and marketing footprint. With a distributed team spanning over 35 countries, we are able to recruit, hire, and retain high-quality, experienced developers, tech leads, product managers and sales personnel and operate at a rapid pace to drive product releases, fix bugs, and create and market new products. We had 1,442 employees as of April 30, 2019. We have experienced significant growth, with revenue increasing to $271.7 million in the year ended April 30, 2019 from $159.9 million in the year ended April 30, 2018 and $88.2 million in the year ended April 30, 2017, representing year-over-year growth of 70% for the year ended April 30, 2019 and 81% for the year ended April 30, 2018. In the year ended April 30, 2019, revenue from outside the United States accounted for 43% of our total revenue. For our non-U.S. operations, the majority of our revenue and expenses are denominated in currencies such as the Euro and British Pound Sterling. No customer represented more than 10% of our revenue in the years ended April 30, 2019, 2018 or 2017. We have not been profitable to date. In the years ended April 30, 2019, 2018 and 2017, we incurred net losses of $102.3 million, $52.7 million and $52.0 million, respectively, and our net cash used in operating activities was $23.9 million, $20.8 million and $16.1 million, respectively. We have experienced losses in each year since our incorporation and as of April 30, 2019, had an accumulated deficit of $317.1 million. We expect we will continue to incur net losses for the foreseeable future. There can be no assurance as to when we may become profitable. Initial Public Offering In October 2018, we completed our IPO in which we issued and sold 8,050,000 ordinary shares at an offering price of $36.00 per share, including 1,050,000 ordinary shares pursuant to the exercise in full of the underwriters’ option to purchase additional shares. We received net proceeds of $263.8 million, after deducting underwriting discounts and commissions of $20.3 million and offering expenses of $5.7 million. Immediately prior to the closing of the IPO, all 28,939,466 shares of our then-outstanding redeemable convertible preference shares automatically converted into 28,939,466 ordinary shares at their respective conversion ratios and the we reclassified $200.6 million from temporary equity to additional paid-in capital and $0.3 million to ordinary shares on our consolidated balance sheet. Key Factors Affecting Our Performance We believe that the growth and future success of our business depends on many factors, including those described below. While each of these factors presents significant opportunities for our business, they also pose important challenges that we must successfully address in order to sustain our growth and improve our results of operations. Growing the Elastic community. Our open source strategy consists of providing a combination of open source, free proprietary and paid proprietary software and fostering a community of users and developers. Our strategy is designed to pursue what we believe to be significant untapped potential for the use of our technology. After developers begin to use our software and start to participate in our developer community, they become more likely to apply our technology to additional use cases and evangelize our technology within their organizations. This reduces the time required for our sales force to educate potential leads on our solutions, increasing their efficiency and shortening the sales process. In order to capitalize on our opportunity, we intend to make further investments to keep the Elastic Stack accessible and well known to software developers around the world. We intend to continue to invest in our products and support and engage our user base and developer community through content, events, and conferences in the U.S. and internationally. Our results of operations may fluctuate as we make these investments. Developing new features and solutions to expand the use cases to which the Elastic Stack can be applied. The Elastic Stack is applied to various use cases both directly by developers and through the solutions we offer. Our revenue is derived primarily from subscriptions of the Elastic Stack and our solutions. We believe that releasing additional open source and proprietary features of the Elastic Stack and additional solutions on top of the stack drives usage of our products and ultimately drives our growth. To that end, we plan to continue to invest in building new features and solutions that expand the capabilities of the Elastic Stack and make it easier to apply to additional use cases. These investments may adversely affect our operating results prior to generating benefits, to the extent that they ultimately generate benefits at all. Growing our customer base by converting users of our software to paid subscribers. Our financial performance depends on growing our paid customer base by converting free users of our software into paid subscribers. Our open source distribution model has resulted in rapid adoption by developers around the world. We have invested, and expect to continue to invest, heavily in sales and marketing efforts to convert additional free users to paid subscribers. Our investment in sales and marketing is significant given our large and diverse user base. The investments are likely to occur in advance of the anticipated benefits resulting from such investments, such that they may adversely affect our operating results in the near term. Expanding within our current customer base. Our future growth and profitability depend on our ability to drive additional sales to existing customers. Customers often expand the use of our software within their organizations by increasing the number of developers using our products, increasing the utilization of our products for a particular use case, and expanding use of our products to additional use cases. We focus some of our direct sales efforts on encouraging these types of expansion within our customer base. An indication of how our customer relationships have expanded over time is through our Net Expansion Rate, which is based upon trends in the ACV of customers that have entered into annual subscription agreements. To calculate an expansion rate as of the end of a given month, we start with the ACV from all such customers as of twelve months prior to that month end, or Prior Period Value. We then calculate the ACV from these same customers as of the given month end, or Current Period Value, which includes any growth in the value of their subscriptions and is net of contraction or attrition over the prior twelve months. We then divide the Current Period Value by the Prior Period Value to arrive at an expansion rate. The Net Expansion Rate at the end of any period is the weighted average of the expansion rates as of the end of each of the trailing twelve months. We believe that our Net Expansion Rate provides useful information about the evolution of our business’ existing customers. The Net Expansion Rate includes the dollar-weighted value of our subscriptions that expand, renew, contract, or attrit. For instance, if each customer had a one-year subscription and renewed its subscription for the exact same amount, then the Net Expansion Rate would be 100%. Customers who reduced their annual subscription dollar value (contraction) or did not renew their annual subscription (attrition) would adversely affect the Net Expansion Rate. Our Net Expansion Rate was over 130% at the end of each of our last ten fiscal quarters. As large organizations expand their use of the Elastic Stack across multiple use cases, projects, divisions and users, they often begin to require centralized provisioning, management and monitoring across multiple deployments. To satisfy these requirements, we offer Elastic Cloud Enterprise, a proprietary product. We will continue to focus some of our direct sales efforts on driving adoption of our Elastic Cloud Enterprise offering. Increasing adoption of Elastic Cloud. Elastic Cloud, our family of SaaS products that includes Elasticsearch Service, Site Search Service, and App Search Service, is an important growth opportunity for our business. Organizations are increasingly looking for SaaS deployment alternatives with reduced administrative burdens. In some cases, open source users that have been self-managing deployments of the Elastic Stack subsequently become paying subscribers of Elastic Cloud. In the years ended April 30, 2019, 2018 and 2017, Elastic Cloud contributed 17%, 16% and 11% of our total revenue, respectively. We believe that offering a SaaS deployment alternative is important for achieving our long-term growth potential, and we expect Elastic Cloud’s contribution to our subscription revenue to increase over time. However, an increase in the relative contribution of Elastic Cloud to our business could adversely impact our gross margin as a result of the associated hosting and managing costs. Non-GAAP Financial Measures In addition to our results determined in accordance with U.S. GAAP, we believe the following non-GAAP measures are useful in evaluating our operating performance. We use the following non-GAAP financial information to evaluate our ongoing operations and for internal planning and forecasting purposes. We believe that non-GAAP financial information, when taken collectively, may be helpful to investors because it provides consistency and comparability with past financial performance. However, non-GAAP financial information is presented for supplemental informational purposes only, has limitations as an analytical tool and should not be considered in isolation or as a substitute for financial information presented in accordance with U.S. GAAP. In particular, free cash flow is not a substitute for cash used in operating activities. Additionally, the utility of free cash flow as a measure of our financial performance and liquidity is further limited as it does not represent the total increase or decrease in our cash balance for a given period. In addition, other companies, including companies in our industry, may calculate similarly-titled non-GAAP measures differently or may use other measures to evaluate their performance, all of which could reduce the usefulness of our non-GAAP financial measures as tools for comparison. A reconciliation is provided below for each non-GAAP financial measure to the most directly comparable financial measure stated in accordance with U.S. GAAP. Investors are encouraged to review the related GAAP financial measures and the reconciliation of these non-GAAP financial measures to their most directly comparable GAAP financial measures, and not to rely on any single financial measure to evaluate our business. We believe that these non-GAAP financial measures, when taken together with the corresponding GAAP financial measures, provide meaningful supplemental information regarding our performance by excluding certain items that may not be indicative of our business, operating results or future outlook. Non-GAAP Gross Profit and Non-GAAP Gross Margin We define non-GAAP gross profit and non-GAAP gross margin as GAAP gross profit and GAAP gross margin, respectively, excluding stock-based compensation expense, employer payroll taxes on employee stock transactions, and amortization of acquired intangible assets. We believe non-GAAP gross profit and non-GAAP gross margin provide our management and investors consistency and comparability with our past financial performance and facilitate period-to-period comparisons of operations, as these metrics generally eliminate the effects of certain variables from period to period for reasons unrelated to overall operating performance. Non-GAAP Operating Loss and Non-GAAP Operating Margin We define non-GAAP operating loss and non-GAAP operating margin as GAAP operating loss and GAAP operating margin, respectively, excluding stock-based compensation expense, employer payroll taxes on employee stock transactions, amortization of acquired intangible assets, and acquisition-related expenses. We believe non-GAAP operating loss and non-GAAP operating margin provide our management and investors consistency and comparability with our past financial performance and facilitate period-to-period comparisons of operations, as these metrics generally eliminate the effects of certain variables from period to period for reasons unrelated to overall operating performance. Free Cash Flow and Free Cash Flow Margin Free cash flow is a non-GAAP financial measure that we define as net cash (used in) provided by operating activities less purchases of property and equipment. Free cash flow margin is calculated as free cash flow divided by total revenue. We believe that free cash flow and free cash flow margin are useful indicators of liquidity that provide information to management and investors about the amount of cash generated from our core operations that, after the purchases of property and equipment, can be used for strategic initiatives, including investing in our business and selectively pursuing acquisitions and strategic investments. We further believe that historical and future trends in free cash flow and free cash flow margin, even if negative, provide useful information about the amount of cash generated (or consumed) by our operating activities that is available (or not available) to be used for strategic initiatives. For example, if free cash flow is negative, we may need to access cash reserves or other sources of capital to invest in strategic initiatives. One limitation of free cash flow and free cash flow margin is that they do not reflect our future contractual commitments. Additionally, free cash flow does not represent the total increase or decrease in our cash balance for a given period. The following table presents our cash flows for the periods presented and a reconciliation of free cash flow and free cash flow margin to net cash used in operating activities, the most directly comparable financial measure calculated in accordance with GAAP: Calculated Billings We define calculated billings as total revenue plus the increase in total deferred revenue as presented on or derived from our consolidated statements of cash flows less the (increase) decrease in total unbilled accounts receivable in a given period. For annual contracts, we generally invoice customers at the time of entering into the contract. For multi-year contracts, we generally invoice customers for the first year at the time of entering into the contract, and then annually prior to each anniversary of the contract start date. Some Elastic Cloud customers purchase subscriptions on a month-to-month basis, which are usually invoiced monthly in arrears. Training and consulting services are invoiced either at the time of contract or at the time of delivery, based on the arrangement with the customer. Our management uses calculated billings to understand and evaluate our near term cash flows and operating results. The following table presents our calculated billings for the periods presented and a reconciliation of calculated billings to total revenue, the most directly comparable financial measure calculated in accordance with GAAP: Components of Results of Operations Revenue Subscription. Our revenue is primarily generated through the sale of time-based subscriptions to software which is either self-managed by the user or hosted and managed by us in the cloud. Subscriptions provide access to paid proprietary software features and access to support for our paid and unpaid software. A portion of the revenue from self-managed subscriptions is generally recognized up front at the point in time when the license is delivered. This revenue is presented as License - self-managed in our consolidated statements of operations. The remainder of revenue from self-managed subscriptions, and revenue from subscriptions that require access to the cloud or that are hosted and managed by us in the cloud, is recognized ratably over the subscription term and is presented within Subscription - self-managed and SaaS in our consolidated statements of operations. Professional services. Professional services revenue comprises consulting services as well as public and private training. Professional services revenue is typically recognized at the point in time the services are delivered. Cost of Revenue Subscription. Cost of license - self-managed consists of amortization of certain intangible assets. Cost of subscription - self-managed and SaaS consists primarily of personnel and related costs for employees associated with supporting our subscription arrangements, certain third-party expenses, and amortization of certain intangible and other assets. Personnel and related costs, or personnel costs, comprise cash compensation, benefits and stock-based compensation to employees, costs of third-party contractors, and allocated overhead costs. Third-party expenses consist of cloud infrastructure costs and other expenses directly associated with our customer support. We expect our cost of subscription - self-managed and SaaS to increase in absolute dollars as our subscription revenue increases. Professional services. Cost of professional services revenue consists primarily of personnel costs directly associated with delivery of training, implementation and other professional services, costs of third-party contractors, facility rental charges and allocated overhead costs. We expect our cost of professional services revenue to increase in absolute dollars as we invest in our business and as professional services revenue increases. Gross profit and gross margin. Gross profit represents revenue less cost of revenue. Gross margin, or gross profit as a percentage of revenue, has been and will continue to be affected by a variety of factors, including the timing of our acquisition of new customers and our renewals with existing customers, the average sales price of our subscriptions and professional services, the amount of our revenue represented by hosted services, the mix of subscriptions sold, the mix of revenue between subscriptions and professional services, the mix of professional services between consulting and training, transaction volume growth and support case volume growth. We expect our gross margin to fluctuate over time depending on the factors described above. We expect our revenue from Elastic Cloud to increase as a percentage of total revenue, which could adversely impact our gross margin as a result of the associated hosting and managing costs. Operating Expenses Research and development. Research and development expense mainly consists of personnel costs and allocated overhead costs for employees and contractors. We expect our research and development expense to increase in absolute dollars for the foreseeable future as we continue to develop new technology and invest further in our existing products. Sales and marketing. Sales and marketing expense mainly consists of personnel costs, commissions, allocated overhead costs and costs related to marketing programs and user events. Marketing programs consist of advertising, events, brand-building and customer acquisition and retention activities. We expect our sales and marketing expense to increase in absolute dollars as we expand our salesforce and increase our investments in marketing resources. We capitalize sales commissions and associated payroll taxes paid to internal sales personnel that are related to the acquisition of customer contracts. Sales commissions costs are amortized over the period that the performance obligation they relate to are satisfied. These performance obligations primarily relate to our subscription contracts, which are typically sold for a one to three year duration. General and administrative. General and administrative expense mainly consists of personnel costs for our management, finance, legal, human resources, and other administrative employees. Our general and administrative expense also includes professional fees, accounting fees, audit fees, tax services and legal fees, as well as insurance, allocated overhead costs, and other corporate expenses. We expect our general and administrative expense to increase in absolute dollars as we increase the size of our general and administrative functions to support the growth of our business. We also anticipate that we will continue to incur additional costs for employees and third-party consulting services related to operating as a public company. Other Income (Expense), Net Other income (expense), net primarily consists of gains and losses from transactions denominated in a currency other than the functional currency and interest income (expense). Provision for Income Taxes Provision for income taxes consists primarily of income taxes related to the Netherlands, U.S. federal, state and foreign jurisdictions in which we conduct business. Our effective tax rate is affected by recurring items, such as tax rates in jurisdictions outside the Netherlands and the relative amounts of income we earn in those jurisdictions. In addition, non-deductible stock-based compensation and changes in our valuation allowance had the most significant impact on the difference between the statutory Dutch tax rate and our effective tax rate. Results of Operations The following tables set forth our results of operations for the periods presented in dollars and as a percentage of our total revenue. For a discussion of our consolidated statement of operations data for the fiscal year ended April 30, 2018 compared to the year ended April 30, 2017 and as a percentage of revenue for that period, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” the Company’s final prospectus for its IPO filed with the SEC pursuant to Rule 424(b)(4) under the Securities Act of 1933, as amended (File No. 333-227191) on October 5, 2018. Comparison of Fiscal Years Ended April 30, 2019 and 2018 Revenue Total revenue increased by $111.7 million, or 70%, in the year ended April 30, 2019 compared to the prior year. Total subscription revenue increased $98.9 million, or 66%, in the year ended April 30, 2019 compared to the prior year. Approximately 25% of the increase was due to sales to new customers added during the year ended April 30, 2019, and the remaining increase resulted from an increase in sales to existing customers. Professional services revenue increased by $12.8 million, or 122%, in the year ended April 30, 2019 compared to the prior year. The increase in professional services revenue was attributable to increased adoption of our professional services offerings. Cost of Revenue and Gross Margin Total cost of subscription revenue increased by $25.6 million, or 91%, in the year ended April 30, 2019 compared to the prior year. This increase was primarily due to an increase of $12.9 million in cloud infrastructure costs and increases of $9.4 million in personnel and related charges together with $1.0 million in software and equipment expense from growth in headcount in our support organization. In addition, amortization of acquired intangible assets increased $0.9 million. Stock-based compensation expense, included within personnel and related costs, increased by $2.7 million. Total subscription margin decreased to 78% in the year ended April 30, 2019 from 81% in the prior year. This decrease is due to growth and related investment in our SaaS offerings which incur costs related to cloud infrastructure and the increased costs associated with scaling our support organization. Cost of professional services revenue increased by $11.6 million, or 94%, in the year ended April 30, 2019 compared to the prior year. This increase was primarily due to an increase of $6.9 million in personnel and related costs and an increase of $1.1 million in travel expenses driven by an increase in headcount in our consulting and training organizations. In addition, subcontractor costs increased by $1.8 million to supplement our internal resources providing services to our customers and charges for training facility rentals increased by $0.9 million. Stock-based compensation expense, included within personnel and related costs, increased by $0.9 million. Gross margin for professional services revenue was (3)% in the year ended April 30, 2019 compared to (18)% for the prior year. Historically, our professional services offerings have primarily consisted of training, however we have recently experienced increased demand for consulting services. In the year ended April 30, 2019, we have invested in headcount for our professional services organization that we believe will be needed as we continue to grow. Our gross margin for professional services may fluctuate or decline in the near-term as we seek to expand our professional services business. Operating Expenses Research and development Research and development expense increased by $45.5 million, or 82%, in the year ended April 30, 2019 compared to the prior year as we continued to invest in the development of new and existing offerings. Personnel and related costs increased by $35.6 million and software and equipment expense increased by $1.8 million, primarily as a result of growth in headcount. In addition, cloud infrastructure costs related to our research and development activities increased $4.7 million. Stock-based compensation expense, included within personnel and related costs, increased by $11.1 million. Sales and marketing Sales and marketing expense increased by $64.7 million, or 78%, in year ended April 30, 2019 compared to the prior year. This increase was primarily due to an increase of $51.4 million in personnel and related costs as we continue to increase our sales and marketing headcount as well as an increase of $9.4 million in commissions expense related to the amortization of contract acquisition costs, together with an increase of $8.4 million in stock-based compensation expense. The increased headcount also resulted in an increase of $4.9 million in travel expenses and $3.7 million in software and equipment expense. In addition, marketing expenses increased $3.3 million primarily due to our expanded user conference program in year ended April 30, 2019. General and administrative General and administrative expense increased by $17.6 million, or 61%, in the year ended April 30, 2019 compared to the prior year. As a result of our continued investment in headcount, personnel and related costs increased by $14.9 million and travel expense increased $2.3 million. Legal and professional advisory expenses increased by $1.6 million as we invested in transitioning to a public company environment as well as due to our continued increase in international expansion. These increases were partially offset by a decrease in bad debt expense of $0.8 million. Stock-based compensation expense, included within personnel and related costs, increased by $4.1 million year over year. Other Income (Expense), Net NM - Not meaningful Other income was $3.4 million for the year ended April 30, 2019 compared to other expense of $1.4 million in the prior year. This increase was primarily due to a $3.4 million increase in interest income on money market funds as a result of proceeds generated from our IPO, a net increase of $1.1 million in realized gain from foreign currency fluctuations and an increase of $0.3 million in miscellaneous income. Provision for Income Taxes The provision for income taxes increased by $1.0 million, or 30%, for the year ended April 30, 2019 compared to the prior year. The increase in tax expense is primarily due to the establishment of a valuation allowance for deferred tax assets in the United States and United Kingdom as well as additional expense due to enacted legislation in the Netherlands, offset by a tax benefit for stock-based compensation. Our effective tax rate was (4)% and (7)% of our net loss before taxes for the year ended April 30, 2019 and 2018, respectively. Quarterly Results of Operations The following tables set forth our unaudited quarterly consolidated statements of operations data for each of the quarters indicated, as well as the percentage that each line item represents of our total revenue for each quarter presented. 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 reflect, in the opinion of management, all adjustments of a normal, recurring nature that are necessary for a fair statement of the financial information contained in those financial statements. Our historical results are not necessarily indicative of the results that may be expected in the future. The following quarterly financial data should be read in conjunction with our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. The following table sets forth selected consolidated statements of operations data for each of the periods indicated as a percentage of total revenue: Quarterly Trends in Revenue and Expense Our quarterly total subscription revenue increased sequentially in each of the periods presented due to the expansion of our existing customer subscription footprint and an increase in the number of new customers. Revenue trends are impacted by seasonality in our sales cycle which generally reflects a trend to greater revenue in our second and fourth quarters and lower revenue in our first and third quarters, though we believe this trend has been somewhat masked by our overall revenue growth. Because we generally invoice annually in advance for subscription agreements at least one year in duration, but we recognize the majority of the revenue ratably over the term of those agreements, a substantial portion of the revenue that we report in each period is attributable to the recognition of deferred revenue relating to subscriptions invoiced during previous periods. Consequently, increases or decreases in subscriptions in any one period typically will not be fully reflected in our revenue for that period and will positively or negatively affect our revenue in future periods. Accordingly, the effect of downturns in sales and market acceptance of our products may not be fully reflected in our results of operations until future periods. The increase in professional services revenue in the second half of the year ended April 30, 2018 and through the year ended April 30, 2019 was a result of an increase in standalone consulting and training services due to increased adoption of our offerings. Our cost of revenue increased sequentially in each of the quarters presented, primarily driven by expanded adoption of Elastic Cloud by existing and new customers, which resulted in increased hosting costs, as well as growth in personnel costs as we grew our support team. Our total gross margin remained relatively flat during the first half of the year ended April 30, 2018. The slight decline in gross margin in the second half of the year ended April 30, 2018 and through the year ended April 30, 2019 was a result of changing mix between self-managed and Elastic Cloud subscriptions and an increase in investment in our consulting organization. We expect our revenue from Elastic Cloud to increase as a percentage of total revenue, which may adversely impact our gross margin as a result of the associated hosting costs. Our research and development and general and administrative expenses generally increased sequentially over the periods presented as we grew the associated headcount and other costs. Prior to the year ended April 30, 2019, we have seen seasonality in sales and marketing costs associated with the timing of our largest user conference, Elastic{ON}, which we have held in the fourth quarter. Beginning in the year ended April 30, 2019, we held regional Elastic{ON} events throughout the year, thereby spreading the costs more evenly over the course of the year. We are subject to income taxes in the Netherlands, the United States, and numerous other jurisdictions. Our tax expense fluctuates between quarters primarily as a result of seasonally higher earnings in the second and fourth quarters and due to the impact of tax rates in foreign jurisdictions, and the relative amounts of income we earn in those jurisdictions. Liquidity and Capital Resources As of April 30, 2019, we had cash and cash equivalents and restricted cash of $298.0 million and $2.3 million, respectively, and working capital of $226.1 million. Our restricted cash constitutes cash deposits with financial institutions in support of letters of credit in favor of landlords for non-cancelable lease agreements. In October 2018, we completed our IPO in which we issued and sold 8,050,000 ordinary shares at an offering price of $36.00 per share, including 1,050,000 ordinary shares pursuant to the exercise in full of the underwriters’ option to purchase additional shares. We received net proceeds of $263.8 million, after deducting underwriting discounts and commissions of $20.3 million and offering expenses of $5.7 million. Previously, we financed our operations principally through private placements of our equity securities, as well as payments received from customers. We have generated significant operating losses from our operations as reflected in our accumulated deficit of $317.1 million as of April 30, 2019. We have historically incurred, and expect to continue to incur, operating losses and generate negative cash flows from operations on an annual basis for the foreseeable future due to the investments we intend to make as described above, and as a result we may require additional capital resources to execute on our strategic initiatives to grow our business. We believe that our existing cash and cash equivalents will be sufficient to fund our operating and capital needs for at least the next 12 months. Our assessment of the period of time through which our financial resources will be adequate to support our operations is a forward-looking statement and involves risks and uncertainties. Our actual results could vary as a result of, and our future capital requirements, both near-term and long-term, will depend on, many factors, including our growth rate, the timing and extent of spending to support our research and development efforts, the expansion of sales and marketing activities, the timing of new introductions of solutions or features, and the continuing market acceptance of our solutions and services. We may in the future enter into arrangements to acquire or invest in complementary businesses, services and technologies, including intellectual property rights. We have based this estimate on assumptions that may prove to be wrong, and we could use our available capital resources sooner than we currently expect. 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, or if we cannot expand our operations or otherwise capitalize on our business opportunities because we lack sufficient capital, our business, operating results and financial condition would be adversely affected. The following table summarizes our cash flows for the periods presented: Net Cash Used in Operating Activities Net cash used in operating activities during the year ended April 30, 2019 was $23.9 million, which resulted from a net loss of $102.3 million adjusted for non-cash charges of $70.7 million and net cash inflow of $7.7 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of $39.9 million for stock-based compensation expense, $21.4 million for amortization of deferred contract acquisition costs, $5.7 million of depreciation and intangible asset amortization expense and a $3.6 million decrease in deferred income taxes. The net cash inflow from changes in operating assets and liabilities was the result of a $71.9 million increase in deferred revenue due to higher billings and a net increase of $16.9 million in accounts payable, accrued expenses and accrued compensation and benefits due to growth in our business and higher headcount. These inflows were partially offset by an increase in deferred contract acquisition costs of $30.0 million as our sales commissions increased due to the addition of new customers and expansion of our existing customer subscriptions, a $29.8 million increase in accounts receivable due to higher billings and timing of collections from our customers and a $21.3 million increase in prepaid expenses and other assets primarily related to an increase in prepaid hosting costs and prepaid software subscription costs driven by the growth in our business. Net cash used in operating activities during the year ended April 30, 2018 was $20.8 million, which resulted from a net loss of $52.7 million adjusted for non-cash charges of $30.2 million and net cash inflow of $1.7 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of $12.7 million for stock-based compensation expense, $12.7 million for amortization of deferred contract acquisition costs, $5.1 million of depreciation and intangible asset amortization expense which were partially offset by a $0.3 million increase in deferred income taxes . The net cash inflow from changes in operating assets and liabilities was the result of a $45.8 million increase in deferred revenue due to higher billings and a net increase of $13.4 million in accounts payable, accrued expenses and accrued compensation and benefits due to growth in our business and higher headcount. These inflows were partially offset by a $21.6 million increase in accounts receivable due to higher billings and timing of collections from our customers, an increase in deferred contract acquisition costs of $20.5 million as our sales commissions increased due to the addition of new customers and expansion of our existing customer subscriptions, and a $15.4 million increase in prepaid expenses and other assets primarily related to an increase in prepaid hosting costs and prepaid software subscription costs driven by the growth in our business. Net cash used in operating activities during the year ended April 30, 2017 was $16.1 million, which resulted from a net loss of $52.0 million, adjusted for non-cash charges of $31.1 million and net cash inflow of $4.7 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of $3.2 million for depreciation and amortization expense, $8.4 million for amortization of deferred contract acquisition costs, and $18.9 million for stock-based compensation expense and a $0.7 million decrease in deferred income taxes. The net cash inflow from changes in operating assets and liabilities was the result of a $27.0 million increase in deferred revenue and a net increase of $4.3 million in accounts payable, accrued expenses and other liabilities, and accrued compensation and benefits, partially offset by an $11.1 million increase in accounts receivable due to higher billings and timing of collections from our customers, an increase in deferred contract acquisition costs of $12.3 million as our sales commission payments increased due to addition of new customers and expansion of our existing customer subscriptions, and a $3.1 million increase in prepaid expenses and other assets. Net Cash (Used in) Provided by Investing Activities Net cash used in investing activities during the year ended April 30, 2019 of $8.3 million resulted from cash used for capital expenditures of $3.4 million, other investing activities of $2.9 million and business acquisitions, net of cash acquired, of $2.0 million. Net cash provided by investing activities during the year ended April 30, 2018 of $8.3 million resulted from the maturity of short-term investments of $15.0 million, which was partially offset by cash used for business acquisitions, net of cash acquired, of $3.7 million and capital expenditures of $3.0 million. Net cash used in investing activities during the year ended April 30, 2017 of $20.3 million resulted from the purchase of short-term investments of $15.0 million, cash used for a business acquisition net of cash acquired of $4.5 million, and net capital expenditures of $0.8 million. Net Cash Provided by Financing Activities Net cash provided by financing activities of $281.8 million during 2019 was due to net proceeds to us of $269.5 million, after deducting underwriting discounts and commissions of $20.3 million as a result of our IPO and $18.6 million in proceeds from the exercise of stock options. These were partially offset by $5.7 million of payment of offering costs, a repurchase of unvested early exercised options and $0.6 million of other financing payments. Net cash provided by financing activities of $3.4 million during the year ended April 30, 2018 was due to $3.8 million of proceeds from the exercise of stock options, which was partially offset by $0.4 million of other financing payments. Net cash provided by financing activities of $59.8 million during the year ended April 30, 2017 was due to $57.8 million in proceeds from issuance of Series D redeemable convertible preference shares, and $2.1 million in proceeds from the exercise of stock options offset in part by $0.1 million of other financing payments. Off Balance Sheet Arrangements As of April 30, 2019, we did not have any relationships with any entities or financial partnerships, such as structured finance or special purpose entities, that would have been established for the purpose of facilitating off balance sheet arrangements or other purposes. Contractual Obligations and Commitments Our principal commitments consist of obligations under operating leases for office space and hosting infrastructure commitments. The following table summarizes our contractual obligations as of April 30, 2019: (1) Consists of future non-cancelable minimum rental payments under operating leases for our offices, excluding rent payments from our sub-tenants and variable operating expenses. Non-cancelable rent payments from our sub-tenants as of April 30, 2019 for the next five years are expected to be an aggregate of $0.1 million. (2) In December 2018, we entered into non-cancelable capacity commitments with a hosting infrastructure vendor for total minimum commitments of $17.0 million for calendar year 2019, $20.0 million for calendar year 2020 and $23.0 million for calendar year 2021. Furthermore, actual payments under these capacity commitments may be higher than the total minimum commitment depending on services used. (3) Consists of a note payable related to financing of our infrastructure. In addition to the contractual obligations set forth above, as of April 30, 2019, we had $2.3 million in letters of credit outstanding in favor of certain landlords for office space. These letters of credit renew annually and expire on various dates through 2023. The table above does not reflect obligations pursuant to cash-settled restricted stock units issued to certain employees. Refer to Note 11 to our consolidated financial statements elsewhere in this Annual Report on Form 10-K. The contractual commitment amounts in the table above are associated with agreements that are enforceable and legally binding. Obligations under contracts that we can cancel without a significant penalty are not included in the table above. Purchase orders issued in the ordinary course of business are not included in the table above, as our purchase orders represent authorizations to purchase rather than binding agreements. Critical Accounting Policies We prepare our financial statements in conformity with generally accepted accounting principles in the United States, or GAAP. The preparation of financial statements in accordance with GAAP requires certain estimates, assumptions and judgments to be made that may affect our consolidated financial statements. Accounting policies that have a significant impact on our results are described in Note 2 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. The accounting policies discussed in this section are those that we consider to be the most critical. We consider an accounting policy to be critical if the policy is subject to a material level of judgment and if changes in those judgments are reasonably likely to materially impact our results. Revenue Recognition We generate our revenue primarily from the sale of self-managed subscriptions (which include licenses for proprietary features, support, and maintenance) and SaaS subscriptions. We also generate revenue from professional services, which consist of consulting and training. The consolidated financial statements reflect our accounting for revenue in accordance with ASC Topic 606, Revenue from Contracts with Customers, or ASC 606, which we early adopted on May 1, 2017. We have presented the consolidated financial statements for the year ended April 30, 2017 as if ASC 606 had been effective for this period. Under ASC 606, we recognize revenue when our customer obtains control of promised products or services in an amount that reflects the consideration that we expect to receive in exchange for those goods or services. In determining the appropriate amount of revenue to be recognized as we fulfill our obligations under each of our agreements, we perform the following steps: (i) identification of the contract with a customer; We contract with customers through order forms, which in some cases are governed by master sales agreements. We determine that we have a contract with a customer when the order form has been approved, each party’s rights regarding the products or services to be transferred can be identified, the payment terms for the services can be identified, we have determined the customer has the ability and intent to pay, and the contract has commercial substance. We apply judgment in determining the customer’s ability and intent to pay, which is based on a variety of factors, including the customer’s historical payment experience or, in the case of a new customer, credit, reputation, and financial or other information pertaining to the customer. At contract inception we evaluate whether two or more contracts should be combined and accounted for as a single contract and whether the combined or single contract includes more than one performance obligation. We have concluded that our contracts with customers do not contain warranties that give rise to a separate performance obligation. (ii) determination of whether the promised goods or services are performance obligations; Performance obligations promised in a contract are identified based on the products and services that will be transferred to the customer that are both capable of being distinct, whereby the customer can benefit from the products or services either on their own or together with other resources that are readily available from third parties or from us, and are distinct in the context of the contract, whereby the transfer of the products and services is separately identifiable from other promises in the contract. Our self-managed subscriptions include both an obligation to provide access to proprietary features in our software, as well as an obligation to provide support (on both open source and proprietary features) and maintenance. Our SaaS products provide access to hosted software as well as support, which we consider to be a single performance obligation. Services-related performance obligations relate to the provision of consulting and training services. These services are distinct from subscriptions and do not result in significant customization of the software. (iii) measurement of the transaction price; We measure the transaction price with reference to the standalone selling price, or SSP, of the various performance obligations inherent within a contract. The SSP is determined based on the prices at which we separately sell these products assuming the majority of these fall within a pricing range. In instances where SSP is not directly observable, such as when we do not sell the software license separately, we derive the SSP using information that may include market conditions and other observable inputs which can require significant judgment. There is typically more than one SSP for individual products and services due to the stratification of those products and services by quantity, term of the subscription, sales channel and other circumstances. 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. None of our contracts contain a significant financing component. (iv) allocation of the transaction price to the performance obligations; If the contract contains a single performance obligation, the entire transaction price is allocated to the single performance obligation. For contracts that contain multiple performance obligations, we allocate the transaction price to each performance obligation based on a relative SSP. If one of the performance obligations is outside of the SSP range, we allocate SSP considering the midpoint of the range. We also consider if there are any additional material rights inherent in a contract, and if so, we allocate a portion of the transaction price to such rights based on SSP. (v) recognition of revenue when we satisfy each performance obligation; Revenue is recognized at the time the related performance obligation is satisfied by transferring the promised product or service to the customer. Our self-managed subscriptions include both upfront revenue recognition when the license is delivered as well as revenue recognized ratably over the contract period for support and maintenance based on the stand-ready nature of these subscription elements. Revenue from our SaaS products is recognized ratably over the contract period when we satisfy the performance obligation. Consulting services are time-based arrangements and revenue is recognized as these services are performed. Revenue from training services is recognized on the dates these services are complete. We generate sales directly through our sales team and through our channel partners. Sales to channel partners are made at a discount and revenues are recorded at this discounted price once all the revenue recognition criteria above are met. To the extent that we offer rebates, incentives, or joint marketing funds to such channel partners, recorded revenues are reduced by this amount. Channel partners generally receive an order from an end-customer prior to placing an order with us. Payment from channel partners is not contingent on the partner’s collection from end-customers. Contract Balances The timing of revenue recognition may differ from the timing of invoicing to customers. For annual contracts, we typically invoice customers at the time of entering into the contract. For multi-year agreements, we generally invoice customers on an annual basis prior to each anniversary of the contract start date. We record unbilled accounts receivable related to revenue recognized in excess of amounts invoiced as we have an unconditional right to invoice and receive payment in the future related to those fulfilled obligations. Contract liabilities consist of deferred revenue which is recognized over the contractual period. Deferred Contract Acquisition Costs Deferred contract acquisition costs represent costs that are incremental to the acquisition of customer contracts, which consist mainly of sales commissions and associated payroll taxes. We determine whether costs should be deferred based on sales compensation plans, if the commissions are in fact incremental and would not have occurred absent the customer contract. Sales commissions for renewal of a contract are considered commensurate with the commissions paid for the acquisition of the initial contract given there is no substantive difference in commission rates. Deferred contract acquisition costs are expensed commensurate with the recognition of revenue as performance obligations are satisfied. These performance obligations primarily relate to our subscription contracts which are typically sold for a one to three year duration. Amortization of deferred contract acquisition costs is recognized in sales and marketing expense in the consolidated statement of operations. We periodically review the carrying amount of deferred contract acquisition costs to determine whether events or changes in circumstances have occurred that could impact the period of benefit of these deferred costs. We did not recognize any impairment of deferred contract acquisition costs during the years ended April 30, 2019, 2018 and 2017. Stock-Based Compensation Expense Compensation expense related to stock-based awards granted to employees is calculated based on the fair value of such awards on the date of grant. We determine the grant date fair value of the awards using the Black-Scholes option-pricing model. The related stock-based compensation expense is recognized on a straight-line basis over the period in which an employee is required to provide service in exchange for the stock-based award, which is generally four years. Our use of the Black-Scholes option pricing model requires the input of highly subjective assumptions, including the fair value of the underlying ordinary shares, the expected term of the option, the expected volatility of the price of our ordinary shares, risk-free interest rates and the expected dividend yield of our ordinary shares. The assumptions used to determine the fair value of the awards represent management’s best estimates. These estimates involve inherent uncertainties and the application of management’s judgment. These assumptions and estimates are as follows: • Fair value of ordinary shares. See “Ordinary Share Valuations” below. • Expected term. The expected term represents the period that our stock-based awards are expected to be outstanding. The expected term assumptions were determined based on the vesting terms, exercise terms and contractual lives of the options. For option grants that are considered “plain vanilla,” the expected term was estimated using the simplified method. The simplified method calculates the expected term as the midpoint between the vesting date and the contractual expiration date of the award. • Expected volatility. Since the Company has limited trading history of its ordinary shares, the expected volatility is derived from the average historical stock volatilities of several unrelated public companies within the Company’s industry that the Company considers to be comparable to its own business over a period equivalent to the option’s expected term. • Risk-free interest rate. We base the risk-free interest rate used in the Black-Scholes option pricing model on the implied yield available on U.S. Treasury zero-coupon issues with a remaining term equivalent to that of the options for each expected term. • Dividend yield. The expected dividend assumption is based on our current expectations about our anticipated dividend policy. As we have no history of paying any dividends, we used an expected dividend yield of zero. The following table summarizes the assumptions used in the Black-Scholes option pricing model to determine the fair value of our stock options: 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 ordinary shares, we may refine our estimation process, which could materially impact our future stock-based compensation expense. Prior to our IPO, we also assessed the need to record stock-based compensation expense when certain of our affiliated shareholders purchased shares from our employees and founders in excess of fair value of such shares. We recognized any such excess value as stock-based compensation expense in our consolidated statements of operations. During the year ended April 30, 2017, we recorded $13.8 million in stock-based compensation expense from a secondary stock purchase transaction that was executed among certain of our employees, founders, and certain of our affiliated shareholders. Ordinary Share Valuations For valuations after the completion of the IPO, our board of directors determines the fair value of each share of underlying ordinary shares based on the closing price of our ordinary shares as reported on the date of the grant. Our ordinary shares are publicly traded and are therefore subject to potentially significant fluctuations in the market price. Increases and decreases in the market price of our ordinary shares will also increase and decrease the fair value of our stock-based awards granted in future periods. Prior to the completion of our IPO, the fair value of the ordinary shares underlying our equity awards was determined by our board of directors, after considering contemporaneous third-party valuations and input from management. The valuations of our ordinary shares were determined in accordance with the guidelines outlined in the American Institute of Certified Public Accountants Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. In the absence of a public trading market, our board of directors, with input from management, exercised significant judgment and considered numerous objective and subjective factors to determine the fair value of our ordinary shares as of the date of each option grant, including the following factors: • contemporaneous valuations performed at periodic intervals by unrelated third-party valuation firms; • the prices, rights, preferences and privileges of our redeemable convertible preference shares relative to those of our ordinary shares; • the lack of marketability of our ordinary shares; • our actual and expected operating and financial performance; • current business conditions and projections; • our hiring of key personnel and the experience of our management; • our history and the timing of the introduction of new products; • our stage of development; • the likelihood of achieving a liquidity event, such as an initial public offering or a merger or acquisition of our business given prevailing market conditions; • the illiquidity of stock-based awards involving securities in a private company; • the market performance of comparable publicly traded companies; • secondary stock transactions, including a secondary stock purchase transaction that included certain of our employees, founders and certain of our affiliated shareholders; and • U.S. and global capital markets conditions. In valuing our ordinary shares, the fair value of our business, or enterprise value, was determined using both the income approach and market approach. The income approach estimates value based on the expectation of future cash flows that a company will generate. These future cash flows are discounted to their present values using a discount rate based on the capital rates of return for venture-backed early stage companies and is adjusted to reflect the risks inherent in our cash flows. The market approach estimates value based on a comparison of the company to comparable public companies in a similar line of business. From the comparable companies, a representative market value multiple is determined and then applied to the company’s financial results to estimate the value of the subject company. The resulting equity value was then allocated to each class of stock using an option pricing methodology and Probability Weighted Expected Return Method, or PWERM. The option pricing method is based on a binomial lattice model, which allows for the identification for a range of possible future outcomes, each with an associated probability. The option pricing method is appropriate to use when the range of possible future outcomes is difficult to predict and thus creates highly speculative forecasts. PWERM involves a forward-looking analysis of the possible future outcomes of the enterprise. This method is particularly useful when discrete future outcomes can be predicted at a relatively high confidence level with a probability distribution. Discrete future outcomes considered under the PWERM include an IPO, as well as non-IPO market based outcomes. Determining the fair value of the enterprise using the PWERM requires us to develop assumptions and estimates for both the probability of an IPO liquidity event and stay private outcomes, as well as the values we expect those outcomes could yield. We apply significant judgment in developing these assumptions and estimates, primarily based upon the enterprise value we determined using the income approach and market approach, our knowledge of the business and our reasonable expectations of discrete outcomes occurring. After the equity value is determined and allocated to the various classes of shares, a discount for lack of marketability, or DLOM, is applied to arrive at the fair value of ordinary shares. A DLOM is applied based on the theory that as an owner of a private company stock, the stockholder has limited opportunities to sell this stock and any such sale would involve significant transaction costs, thereby reducing overall fair market value. Our assessments of the fair value of ordinary shares for grant dates between the dates of the valuations were based in part on the current available financial and operational information and the ordinary share value provided in the most recent valuation as compared to the timing of each grant. For financial reporting purposes, we considered the amount of time between the valuation date and the grant date to determine whether to use the latest ordinary share valuation. This determination included an evaluation of whether the subsequent valuation indicated that any significant change in valuation had occurred between the previous valuation and the grant date. Business Combinations, Goodwill and Intangible Assets We allocate the fair value of purchase consideration in a business combination to tangible assets, liabilities assumed and intangible assets acquired based on their estimated fair values. The excess of the fair value of purchase consideration over the fair values of these identifiable assets and liabilities is allocated to goodwill. The allocation of the purchase consideration requires management to make significant estimates and assumptions, especially with respect to intangible assets. These estimates can include, but are not limited to, future expected cash flows from acquired customers and acquired technology from a market participant perspective, useful lives and discount rates. Management’s 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 up to 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. We assess goodwill for impairment at least annually, in the fourth quarter, and whenever events or changes in circumstances indicate that the carrying value of the asset may not be recoverable. For the purposes of impairment testing, we have determined that we have one operating segment and one reporting unit. Our test of goodwill impairment starts with a qualitative assessment to determine whether it is necessary to perform a quantitative goodwill impairment test. If qualitative factors indicate that the fair value of the reporting unit is more likely than not less than its carrying amount, then a quantitative goodwill impairment test is performed. For the quantitative analysis, we compare the fair value of our reporting unit to its carrying value. If the estimated fair value exceeds book value, goodwill is considered not to be impaired and no additional steps are necessary. However, if the fair value of the reporting unit is less than book value, then under the second step the carrying amount of the goodwill is compared to its implied fair value. Acquired intangible assets are amortized over their estimated useful lives. We evaluate the recoverability of our intangible assets for possible 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 intangible assets are expected to generate. If such review indicates that the carrying amount of our intangible assets is not recoverable, the carrying amount of such assets is reduced to fair value. Income Taxes We are subject to income taxes in the Netherlands and numerous other jurisdictions including federal, state, and local jurisdictions in the United States and all other tax jurisdictions or countries in which we conduct business. Earnings from our non-Dutch activities are subject to local country income tax. We follow the asset and liability method of accounting for income taxes. This method requires recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax basis of assets and liabilities. We assess whether it is more likely than not that some portion or all of the deferred tax assets will be realized. We record a valuation allowance to our deferred tax assets to the extent we believe they are not more likely than not to be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income. We recognize the tax benefit from uncertain tax positions only if it is more likely than not that the tax position will be sustained on examination by the tax authorities, based on the technical merits of the position. The tax benefit is measured based on the largest benefit that is more likely than not of being realized upon ultimate settlement. We adjust reserves for our uncertain tax positions due to changing facts and circumstances. We recognize interest and penalties due to taxing authorities as a component of provision for income taxes. We make estimates and judgments about our future taxable income based on assumptions that are consistent with our plans and estimates. Should the actual amounts differ from estimates, the amount of valuation allowance could be materially impacted. Any adjustment to the deferred tax asset valuation allowance would be recorded in the consolidated statement of operations for the periods in which the adjustment is determined to be required. JOBS Act Extended Transition Period We are an emerging growth company, as defined in 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 irrevocably elected not to avail ourselves of this exemption from 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 Elastic is a search company. We deliver technology that enables users to search through massive amounts of structured and unstructured data for a wide range of consumer and enterprise applications. Our primary offering is the Elastic Stack, a powerful set of software products that ingest and store data from any source, and in any format, and perform search, analysis, and visualization in milliseconds or less. The Elastic Stack is designed for direct use by developers to power a variety of use cases. We have also built software solutions on the Elastic Stack that address a wide variety of use cases, including app search, site search, enterprise search, logging, metrics, APM, business analytics, and security analytics. Our products are used by individual developers and organizations of all sizes across a wide range of industries. Elasticsearch is the heart of the Elastic Stack. It is a distributed, realtime search and analytics engine and datastore for exploring all types of data including textual, numerical, geospatial, structured, and unstructured. The first public release of Elasticsearch was in 2010 by our cofounder Shay Banon as an open source project. The Company was formed in 2012. Since then, we have added new products, released new features, acquired companies, and created new solutions to expand the functionality of our products. Our business model is based on a combination of open source and proprietary software. We market and distribute the Elastic Stack and our solutions using an open source distribution strategy. Developers are able to download our software directly from our website. Many features of our software can be used free of charge. Some are only available through paid subscriptions, which include access to specific proprietary features and also include support. These paid features can be unlocked without the need to redeploy the software. We believe that open source drives a number of benefits for our users, our customers, and our company. It facilitates rapid and efficient developer adoption, particularly by empowering individual developers to download and use our software without payment, registration, or the friction of a formal sales interaction. Our use of open source licensing fosters a vibrant developer community around our products and solutions, which drives adoption of our products and increased interaction among users. Further, this approach enables community review of our code and products, which allows us to improve the reliability and security of our software. We generate revenue primarily from sales of subscriptions for our software. We offer various subscription tiers that provide different levels of access to paid proprietary features and support. We do not sell support separately. Our subscription agreements for selfmanaged deployments typically have terms of one to three years and we bill for them annually in advance. Elastic Cloud customers may purchase subscriptions either on a monthtomonth basis or on a committed contract of at least one year in duration. Subscriptions accounted for 91%, 93% and 90% of total revenue in the years ended April 30, 2019, 2018 and 2017, respectively. We also generate revenue from consulting and training services. We had over 8,100 customers, over 5,000 customers and over 2,800 customers as of April 30, 2019, 2018, and 2017, respectively. We define a customer as an entity that generated revenue in the quarter ending on the measurement date from an annual or monthtomonth subscription. All affiliated entities are typically counted as a single customer. The annual contract value, or ACV, of a customer’s commitments is calculated based on the terms of that customer’s subscriptions, and represents the total committed annual subscription amount as of the measurement date. Monthtomonth subscriptions are not included in the calculation of ACV. The number of customers who represented greater than $100,000 in ACV was over 440, over 275, and over 150 as of April 30, 2019, 2018 and 2017, respectively. We engage in various sales and marketing efforts to extend our open source distribution model. We employ multitouch marketing campaigns to nurture our users and customers and keep them engaged after they download our software. Additionally, we maintain direct sales efforts focused on users and customers who have adopted our software, as well as departmental decisionmakers and senior executives who have broad purchasing power in their organizations. Our sales teams are primarily segmented by geographies and secondarily by the employee count of [/INST] Positive. </s>

BEYOND MEAT, INC.

2020-03-19

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those discussed in the forward-looking statements as a result of various factors, including those set forth in Part I, Item 1A, “Risk Factors,” and “Note Regarding Forward-Looking Statements” included elsewhere in this report. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our audited financial statements and related notes included elsewhere in this report, as well as the information presented under “Selected Financial Data.” Overview Beyond Meat is one of the fastest growing food companies in the United States, offering a portfolio of revolutionary plant-based meats. We build meat directly from plants, an innovation that enables consumers to experience the taste, texture and other sensory attributes of popular animal-based meat products while enjoying the nutritional and environmental benefits of eating our plant-based meat products. Our brand commitment, “Eat What You Love,” represents a strong belief that by eating our plant-based meats, consumers can enjoy more, not less, of their favorite meals, and by doing so help address concerns related to human health, climate change, resource conservation, and animal welfare. The success of our breakthrough innovation model and products has allowed us to appeal to a broad range of consumers, including those who typically eat animal-based meats, positioning us to compete directly in the $1.4 trillion global meat industry. We sell a range of plant-based products across the three main meat platforms of beef, pork and poultry. They are offered in ready-to-cook formats (generally merchandised at retail in the meat case), which we refer to as our “fresh” platform, and ready-to-heat formats (merchandised at retail in the freezer), which we refer to as our “frozen” platform. As of December 31, 2019, our products were available in approximately 77,000 retail and restaurant and foodservice outlets in more than 65 countries, across mainstream grocery, mass merchandiser, club and convenience store, and natural retailer channels, direct to consumer, and various food-away-from-home channels, including restaurants, foodservice outlets and schools. On May 6, 2019, we completed our IPO, in which we sold 11,068,750 shares of our common stock. The shares began trading on the Nasdaq Global Select Market on May 2, 2019. The shares were sold at a public offering price of $25.00 per share for net proceeds of approximately $252.4 million, after deducting underwriting discounts and commissions of $19.4 million and issuance costs of approximately $4.9 million payable by us. Upon the closing of the IPO, all outstanding shares of our convertible preferred stock automatically converted into 41,562,111 shares of common stock on a one-for-one basis, and warrants exercisable for convertible preferred stock were automatically converted into warrants exercisable for 160,767 shares of common stock. On August 5, 2019, we completed our Secondary Offering, in which we sold 250,000 shares. The shares were sold at a public offering price of $160.00 per share for net proceeds to the Company of approximately $37.4 million, after deducting underwriting discounts and commissions of $1.5 million and issuance costs of approximately $1.1 million payable by us. Total Secondary Offering costs paid in 2019 were approximately $2.2 million, of which approximately $1.1 million was capitalized to reflect the costs associated with the issuance of new shares and offset against proceeds from the Secondary Offering. We did not receive any proceeds from the sale of common stock by the selling stockholders in the Secondary Offering. We continue to experience strong sales growth over prior periods. Net revenues increased to $297.9 million in 2019 from $87.9 million in 2018 and $32.6 million in 2017, representing a 202% compound annual growth rate. The Beyond Burger accounted for approximately 64%, 70% and 48% of our gross revenues in 2019, 2018 and 2017, respectively. We believe that sales of the Beyond Burger will continue to constitute a significant portion of our revenues, income and cash flow for the foreseeable future. We have generated losses from inception. Net loss in 2019, 2018, and 2017 was $12.4 million, $29.9 million, and $30.4 million, respectively, as we invested in innovation and growth of our business. We operate on a fiscal calendar year, and each interim quarter is comprised of one 5-week period and two 4-week periods, with each week ending on a Saturday. Our fiscal year always begins on January 1 and ends on December 31. As a result, our first and fourth fiscal quarters may have more or fewer days included than a traditional 91-day fiscal quarter. Components of Our Results of Operations and Trends and Other Factors Affecting Our Business Net Revenues We generate net revenues primarily from sales of our products to our customers across mainstream grocery, mass merchandiser, club and convenience store, and natural retailer channels, direct to consumer, and various food-away-from-home channels, including restaurants, foodservice outlets and schools, mainly in the United States. We continue to experience strong sales growth over prior periods. The following factors and trends in our business have driven net revenue growth over prior periods and are expected to be key drivers of our net revenue growth for the foreseeable future: • increased penetration across our restaurant and foodservice channel, including increased desire by restaurant and foodservice establishments, including large FSR and/or global QSR customers, to add plant-based products to their menus and to highlight these offerings, and our retail channel, including mainstream grocery, mass merchandiser, club and convenience store, and natural retailer customers; • distribution expansion and increased velocity of our fresh product sales across our channels, by which we mean that the volume of our products sold per outlet has generally increased period-over-period due to greater adoption of and demand for our products; • increased international sales of our products across geographies, markets and channels as we continue to grow our numbers of international customers; • our continued innovation, including enhancing existing products and introducing new products across our plant-based beef, pork and poultry platforms that appeal to a broad range of consumers, including those who typically eat animal-based meat; • enhanced marketing efforts as we continue to build our brand and drive consumer adoption of our products, including scaling our GO BEYOND marketing campaign launched in February 2019, which seeks to mobilize our ambassadors to help raise brand awareness, define the category and remain its leader; • overall market trends, including growing consumer awareness and demand for nutritious, convenient and high protein plant-based foods; and • increased production levels as we scale production to meet demand for our products across our distribution channels both domestically and internationally. In addition to the factors and trends above, we expect the following to positively impact net revenues going forward: • expansion of our own internal production facilities domestically and abroad to produce our woven proteins, blends of flavor systems and binding systems, and potentially convert our woven proteins into packaged products, while forming additional strategic relationships with co-manufacturers; and • localized production to increase the availability and speed with which we can get our products to customers internationally. Net revenues from sales in our retail channel increased by 185.2% in 2019 to $144.8 million from $50.8 million in 2018, and by 99.2% in 2018 from $25.5 million in 2017. Net revenues from sales in our restaurant and foodservice channel increased by 312.0% in 2019 to $153.1 million from $37.1 million in 2018, and by 424.0% in 2018 from $7.1 million in 2017. We expect further growth in both channels as we increase our production capacity in response to demand, scale internationally, add new customers and increase sales velocities at existing customers. We distribute our products internationally, using distributors in more than 65 countries worldwide as of December 31, 2019. In 2019, we commenced co-manufacturing in Canada and also expanded our partnership with one of our distributors to co-manufacture our innovative plant-based meats at a new co-manufacturing facility built by our distributor in the Netherlands, construction of which was completed in the first quarter of 2020. Our international net revenues (which exclude revenues from Canada) are included in our retail and restaurant and foodservice channels and were approximately 16%, 8% and 1%, respectively, of our net revenues in 2019, 2018 and 2017. Substantially all of our long-lived assets are in the United States. Net revenues from sales to the Canadian market are included with net revenues from sales to the United States market. As the Company accelerates international expansion initiatives, net revenues from international sales are expected to continue to grow. Over the next few years, the main driver of growth in our net revenues is expected to be sales of our fresh products, primarily the Beyond Burger, in both our retail channel and our restaurant and foodservice channel, including strategic and global customers both in the United States and Canada, and in other international locations. As we seek to continue to rapidly grow our net revenues, we face several challenges. In 2017, continuing into 2018, demand for our products exceeded our expectations and production capacity, significantly constraining our net revenue growth relative to our total demand opportunity. While we have significantly expanded our production capacity to address production shortfall, we may experience a lag in production relative to customer demand if our growth rate exceeds our expectations. We routinely offer sales discounts and promotions through various programs to customers and consumers. These programs include rebates, temporary on-shelf price reductions, off-invoice discounts, retailer advertisements, product coupons and other trade activities. We anticipate needing to offer more trade and promotion discounting, primarily within the retail channel, to match competition pricing and promotions. The expense associated with these discounts and promotions is estimated and recorded as a reduction in total gross revenues in order to arrive at reported net revenues. We anticipate that these promotional activities could impact our net revenues and that changes in such activities could impact period-over-period results. In addition, because we do not have any purchase commitments from our distributors or customers, the amount of net revenues we recognize will vary from period to period depending on the volume and the channels through which our products are sold, causing variability in our results. We expect to face increasing competition across all channels, especially as additional plant-based protein product brands continue to enter the marketplace. In December 2019, a novel strain of coronavirus (“COVID-19”) was reported in Wuhan, China. The COVID-19 pandemic has continued to spread and has already caused severe global disruptions. The extent of COVID-19’s effect on our operational and financial performance will depend on future developments, including the duration, spread and intensity of the pandemic, all of which are uncertain and difficult to predict considering the rapidly evolving landscape. For example, the impact of COVID-19 on any of our suppliers, co-manufacturers, distributors or transportation or logistics providers may negatively affect the price and availability of our ingredients and/or packaging materials and impact our supply chain. Additionally, if we are forced to scale back hours of production or close our production facilities or our Manhattan Beach Project Innovation Center in response to the pandemic, we expect our business, financial condition and results of operations would be materially adversely affected. In addition, our growth strategy to expand our operations internationally may be impeded. We may also be impacted by decreased customer and consumer demand as a result of event cancellations and social distancing, government-imposed restrictions on public gatherings and businesses, shelter-in place orders and temporary restaurant, retail and grocery store closures. If the pandemic continues to evolve into a severe worldwide health crisis, the disease could have a material adverse effect on our business, results of operations, financial condition and cash flows and adversely impact the trading price of our common stock. Gross Profit (Loss) Gross profit (loss) consists of our net revenues less cost of goods sold. Our cost of goods sold primarily consists of the cost of raw materials and ingredients for our products, direct labor and certain supply costs, co-manufacturing fees, in-bound and internal shipping and handling costs incurred in manufacturing our products, plant and equipment overhead, depreciation and amortization expense, as well as the cost of packaging our products. In order to keep pace with demand, we have had to very quickly scale production and we have not always been able to meet all demand for our products. As a result, we have had to quickly expand our sources of supply for our core protein inputs such as pea protein. Our growth has also significantly increased facility and warehouse utilization rates. We intend to continue to increase our production capabilities at our two in-house manufacturing facilities in Columbia, Missouri, while expanding our co-manufacturing capacity and exploring additional production facilities domestically and abroad. As a result, we expect our cost of goods sold in absolute dollars to increase to support our growth. However, we expect such expenses to decrease as a percentage of net revenues over time as we continue to scale our business. Over the next several years, we continue to expect that gross profit improvements will be delivered primarily through improved volume leverage and throughput, greater internalization and geographic localization of our manufacturing footprint, materials and packaging input cost reductions, tolling fee efficiencies, and improved supply chain logistics and distribution costs. We intend to pass some of these cost savings on to the consumer as we pursue our goal to achieve price parity with animal protein in at least one of our product categories by 2024. Gross margin improved by 1,350 basis points to 33.5% in 2019 from 20.0% in 2018 and by 26.7 basis points in 2018 from (6.7)% in 2017. Gross margin benefited from an increase in the amount of products sold, improved production efficiencies and from a greater proportion of revenues from products in our fresh platform which have a higher net selling price per pound. We are also working to improve gross margin through ingredient cost savings achieved through scale of purchasing and through expanding our co-manufacturing network and negotiating lower tolling fees. However, in the near term, margin improvements may be impacted by our focus on growing our customer base, expanding into new geographies and markets, enhancing our production infrastructure, improving our innovation capabilities, enhancing our product offerings and increasing consumer engagement. Operating Expenses Research and Development Expenses Research and development expenses consist primarily of personnel and related expenses for our research and development staff, including salaries, benefits, bonuses, and share-based compensation, scale-up expenses, and depreciation and amortization expense on research and development assets. Our research and development efforts are focused on enhancements to our product formulations and production processes in addition to the development of new products. We expect to continue to invest substantial amounts in research and development, as evidenced in the build-out of our state-of-the-art Manhattan Beach Project Innovation Center in 2018. Research and development and innovation are core elements of our business strategy, as we believe they represent a critical competitive advantage for us. We believe that we need to continue to rapidly innovate in order to be able to continue to capture a larger market share of consumers who typically eat animal-based meats. We expect these expenses to increase in absolute dollars, but to decrease as a percentage of net revenues as we continue to scale production. Selling, General and Administrative (“SG&A”) Expenses SG&A expenses consist primarily of selling, marketing and administrative expenses, including personnel and related expenses, share-based compensation, outbound shipping and handling costs, non-manufacturing rent expense, depreciation and amortization expense on non-manufacturing assets and other non-production operating expenses. Marketing and selling expenses include share-based compensation awards to brand ambassadors, advertising costs, costs associated with consumer promotions, product samples and sales aids incurred to acquire new customers, retain existing customers and build our brand awareness. Administrative expenses include the expenses related to management, accounting, legal, IT, and other office functions. We expect SG&A expenses in absolute dollars to increase as we increase our domestic and international expansion efforts to meet our product demand and incur costs related to our status as a public company. Our selling and marketing expenses are expected to significantly increase, both through a greater focus on marketing and through additions to our sales and marketing organizations domestically and abroad. We expect to continue to significantly expand our marketing efforts to achieve greater brand awareness, accelerate our international expansion initiatives, attract new customers, drive consumer adoption of our products, and increase market penetration, including through the expansion of our GO BEYOND ambassador program, as well as the creation of an advisory board of leading experts in health and medicine to ensure that we have access to the latest thinking on peer-reviewed research on health, nutrition and ingredients. We have historically had a very small sales force, with only nine full-time sales employees as of December 31, 2017 growing to 33 full-time sales employees as of December 31, 2019. As we continue to grow, including internationally, we expect to expand our sales force to address additional opportunities, which would substantially increase our selling expense. Our administrative expenses are expected to increase as a public company with increased personnel cost in accounting, legal, IT and compliance-related functions. Restructuring Expenses In May 2017, management approved a plan to terminate an exclusive supply agreement with one of our co-manufacturers. For a discussion of these expenses, see Note 3, Restructuring, to the Notes to Financial Statements, and Part I, Item 3, Legal Proceedings, included elsewhere in this report. Seasonality Generally, we expect to experience greater demand for certain of our products during the summer grilling season. In each of 2019, 2018 and 2017, we experienced strong net revenue growth compared to the previous year, which masked this seasonal impact. As our business continues to grow, we expect to see additional seasonality effects, especially within our retail channel, with revenue contribution from this channel tending to be greater in the second and third quarters of the year. Results of Operations The following table sets forth selected items in our statements of operations for the periods presented: The following table presents selected items in our statements of operations as a percentage of net revenues for the respective periods presented: Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 Net Revenues Net revenues increased by $210.0 million, or 238.8%, in 2019, as compared to the prior year primarily due to strong growth in sales volumes of products in our fresh platform across both our retail and our restaurant and foodservice channels, driven by expansion in the number of retail and restaurant and foodservice outlets, including new strategic customers, new international customers, higher sales velocities from our existing customers and contribution from new products introduced in 2019. Net revenues from international customers (excluding the Canadian market) are included in our retail and restaurant and foodservice channels and were approximately 16% of net revenues in 2019, as compared to approximately 8% of net revenues in the prior year. Gross revenues from sales of products in our fresh platform in 2019 increased $224.9 million, or 275.3%, as compared to the prior year primarily due to increases in sales of all of our fresh platform products. Gross revenues from sales of products in our frozen platform in 2019 increased primarily from sales of Beyond Beef Crumbles, partially offset by the decline in sales of our frozen chicken strip product line which was discontinued in the first quarter of 2019. In 2019, gross revenues from the Beyond Burger, all Beyond Sausage flavors, Beyond Beef and Beyond Beef Crumbles were approximately 64%, 23%, 8% and 5%, respectively, compared to approximately 70%,12%, 0% and 9%, respectively, in 2018. Net revenues from sales through our retail channel in 2019 increased $94.0 million, or 185.2%, primarily due to expansion in the number of retail outlets, increased sales of the Beyond Burger and Beyond Sausage, as well as the introduction of Beyond Beef. Net revenues from sales through our restaurant and foodservice channel in 2019 increased $115.9 million, or 312.0%, primarily due to expansion in the number of restaurant and foodservice outlets, including new strategic customers and international customers, increases in sales of the Beyond Burger, as well as due to increased sales of Beyond Sausage and the introduction of Beyond Beef. The following tables present volume of our products sold in pounds: Cost of Goods Sold Cost of goods sold increased by $127.8 million, or 181.6%, in 2019 as compared to the prior year, primarily due to the increase in the sales volume of our products. Cost of goods sold in 2019 and 2018 included $6.4 million and $0.8 million, respectively, in write off of excess and obsolete inventories. Gross Profit and Gross Margin Gross profit in 2019 was $99.8 million, or 33.5% of net revenues, as compared to gross profit of $17.6 million, or 20% of net revenues, in the prior year, an improvement of $82.2 million. The improvement in gross profit and gross margin was primarily due to an increase in the volume of products sold, with resulting operating leverage, and improved production efficiencies. The greater proportion of product revenues from our fresh platform also contributed to the improvement in gross margin, due to a higher net selling price per pound of products in our fresh versus frozen platform. The increase in gross margin was partially offset by temporary disruptions related to capacity expansion projects at two co-manufacturing partners’ plants in the fourth quarter of 2019. As disclosed in Note 2, Summary of Significant Accounting Policies-Shipping and Handling Costs, in the Notes to Financial Statements included elsewhere in this report, we include outbound shipping and handling costs within SG&A expenses. As a result, our gross profit and gross margin may not be comparable to other entities that present all shipping and handling costs as a component of cost of goods sold. Research and Development Expenses Research and development expenses increased $11.1 million, or 115.4%, in 2019, as compared to the prior year. Research and development expenses increased primarily due to higher headcount, higher scale-up expenses and higher depreciation and amortization expense compared to the prior year. SG&A Expenses SG&A expenses increased by $40.3 million, or 116.8%, in 2019, as compared to the prior year. The increase was primarily due to $12.4 million in higher salaries, bonuses and related expenses due to higher headcount, $10.4 million in higher share-based compensation expense, including $3.2 million relating to equity awards made to brand ambassadors, $4.8 million in higher outbound shipping and handling expenses, $3.1 million in higher broker and distributor commissions, $2.4 million in higher legal expenses primarily due to the Secondary Offering and costs associated with being a public company, $1.9 million in higher insurance costs, and continued investment in marketing capabilities. Restructuring Expenses As a result of the termination in May 2017 of an exclusive supply agreement with one of our co- manufacturers due to non-performance under the agreement, we recorded restructuring expenses of $4.9 million and $1.5 million in 2019 and 2018, respectively, primarily related to legal and other expenses associated with the dispute. As of December 31, 2019 and 2018, there were $1.1 million and $0, respectively, in accrued unpaid liabilities associated with this contract termination representing legal fees. We continue to incur legal fees in connection with our ongoing efforts to resolve this dispute. See Note 3, Restructuring, to the Notes to Financial Statements, and Part I, Item 3, Legal Proceedings, included elsewhere in this report. Total Other Expense, Net Total other expense, net primarily includes interest expense on the Company’s debt balances and expense associated with the remeasurement of our preferred stock warrant liability and common stock warrant liability, partially offset by interest income. On May 6, 2019, in connection with the IPO, our then outstanding warrants exercisable for convertible preferred stock were automatically converted into warrants exercisable for common stock. We remeasured and reclassified the common stock warrant liability to additional-paid-in-capital in connection with the IPO and recorded $12.5 million in expense associated with the remeasurement of warrant liability in 2019. Interest income in 2019 increased due to interest income from invested proceeds from the IPO and Secondary Offering. Subsequent to the closing of the IPO, all outstanding warrants to purchase shares of common stock were cashless exercised. No warrants were outstanding as of December 31, 2019. Other, net was $3.6 million in 2019 as compared to $0.4 million in 2018 primarily due to increased interest income resulting from investment of proceeds from the IPO and Secondary Offering. Loss from Operations Loss from operations in 2019 was $0.5 million compared to loss from operations of $28.0 million in the prior year. This improvement was driven entirely by the year-over-year increase in gross profit, partially offset by higher operating expenses to support our expanded manufacturing and supply chain operations, higher share-based compensation expense, higher administrative costs associated with being a public company, higher restructuring expenses, and continued investment in innovation and marketing capabilities. Income Tax Expense For 2019 and 2018, we recorded income tax expense of $9,000 and $1,000, respectively. These amounts primarily consist of income taxes for state jurisdictions which have minimum tax requirements. No tax benefit was provided for losses incurred because those losses were offset by a full valuation allowance. Net Loss Net loss was $12.4 million in 2019 compared to a net loss of $29.9 million in the prior year. The decrease in net loss was primarily the result of the higher gross profit in 2019 and interest income, partially offset by higher operating expenses, higher share-based compensation expense, expenses associated with the remeasurement of our preferred stock warrant liability and common stock warrant liability in connection with the IPO, and higher interest expense. Year Ended December 31, 2018 Compared to Year Ended December 31, 2017 Net Revenues Net revenues increased by $55.4 million, or 169.9%, in 2018 as compared to 2017 primarily due to strong growth in sales volumes of products in our fresh platform across both our retail and our restaurant and foodservice channels, partially offset by a decrease in net revenues from the frozen platform. Gross revenues from sales of products in our fresh platform increased $63.6 million, or 351.1%, primarily due to increases in sales of the Beyond Burger and Beyond Sausage. Net revenues from retail sales increased $25.3 million, or 99.2%, primarily due to increase in sales of the Beyond Burger. Net revenues from sales through our restaurant and foodservice channel increased $30.1 million, or 424.0%, primarily due to increased sales of the Beyond Burger, which was being served in approximately 11,000 restaurant and foodservice outlets at the end of 2018, and due to increased sales of Beyond Sausage in 2018. The following tables present volume of our products sold in pounds: Cost of Goods Sold Cost of goods sold increased by $35.6 million, or 102.3%, in 2018 as compared to the prior year, primarily due to the increase in the sales volume of our products and from a 103% increase in manufacturing-related headcount to handle increased demand for our products. Cost of goods sold in 2017 includes $2.4 million in write-off of unrecoverable inventory related to the termination of an exclusive agreement with our co-manufacturer at the time. See Note 3, Restructuring, to the Notes to Financial Statements, and Part I, Item 3, Legal Proceedings, included elsewhere in this report. Gross Profit (Loss) and Gross Margin Gross profit in 2018 was $17.6 million compared to gross loss of $2.2 million in 2017, an improvement of $19.8 million. The improvement in gross profit and gross margin was primarily due to an increase in the amount of products sold, resulting in the ability to leverage our fixed costs across a greater amount of revenue. The greater proportion of product revenues from our fresh platform also contributed to the improvement in margin, due to a higher net selling price per pound of products in our fresh versus frozen platform. As disclosed in Note 2, Summary of Significant Accounting Policies-Shipping and Handling Costs, in the Notes to Financial Statements included elsewhere in this report, we include outbound shipping and handling costs within selling, general and administrative expense. As a result, our gross profit and gross margin may not be comparable to other entities that present all shipping and handling costs as a component of cost of goods sold. Research and Development Expenses Research and development expenses increased $3.9 million, or 67.5%, in 2018 as compared to the prior year. Research and development expenses increased primarily due to higher scale-up expenses and depreciation and amortization expense. SG&A Expenses SG&A expenses increased by $17.3 million, or 101.0%, in 2018 as compared to the prior year. The increase was primarily due to $6.8 million in higher salaries and related expenses due to a 224% increase in headcount, $2.7 million in higher outbound freight expenses, $1.9 million in higher supply chain expenses, $1.8 million in higher consulting and professional fees, $1.3 million in higher marketing services, $0.9 million in higher travel expenses, and $0.7 million in higher broker commissions in 2018 as compared to the prior year. SG&A expenses in 2017 include $1.2 million primarily related to disputed fees resulting from the co-manufacturer’s failure to meet agreed upon minimum production and expedited outbound freight expenses we incurred for alternative arrangements after we terminated the exclusive supply agreement with this co-manufacturer. Restructuring Expenses As a result of the termination in May 2017 of an exclusive supply agreement with one of our co- manufacturers due to non-performance under the agreement, we recorded restructuring expenses of $3.5 million in 2017, of which $2.3 million were related to the impairment write-off of long-lived assets, comprised of certain unrecoverable equipment located at the co-manufacturer’s site and company-paid leasehold improvements to the co-manufacturer’s facility pursuant to the agreement, and $1.2 million primarily related to legal and other expenses associated with the dispute. See Note 9, Commitments and Contingencies-Litigation, to the Notes to Financial Statements included elsewhere in this report. In addition, we recorded $2.4 million in write-off of unrecoverable inventory held at the co-manufacturer’s site, which is included in cost of goods sold, and $1.2 million primarily related to disputed fees for not meeting the agreed upon minimum production and expedited outbound freight expenses, which are included in selling, general and administrative expenses in our statement of operations for 2017. In 2018, we recorded $1.5 million in restructuring expenses related to this dispute, which consisted primarily of legal and other expenses. See Note 3, Restructuring, to the Notes to Financial Statements included elsewhere in this report. As of December 31, 2018 and 2017, there were no accrued unpaid liabilities associated with this contract termination, although we continue to incur legal fees in connection with our ongoing efforts to resolve this dispute. See Part I, Item 3, Legal Proceedings, included elsewhere in this report. Income Tax Expense For 2018 and 2017, we recorded income tax expense of $1,000 and $5,000, respectively. These amounts primarily consist of income taxes for state jurisdictions which have minimum tax requirements. No tax benefit was provided for losses incurred because those losses are offset by a full valuation allowance. Non-GAAP Financial Measures We use the following non-GAAP financial measures in assessing our operating performance and in our financial communications: “Adjusted EBITDA” is defined as net income (loss) adjusted to exclude, when applicable, income tax expense, interest expense, depreciation and amortization expense, restructuring expenses, share-based compensation expense, inventory losses from termination of an exclusive supply agreement with a co-manufacturer, costs of termination of an exclusive supply agreement with the same co-manufacturer, and expenses primarily associated with the conversion of our convertible notes and remeasurement of our preferred stock warrant liability and common stock warrant liability. “Adjusted EBITDA as a % of net revenues” is defined as Adjusted EBITDA divided by net revenues. We use Adjusted EBITDA and Adjusted EBITDA as a % of net revenues because they are important measures upon which our management assesses our operating performance. We use Adjusted EBITDA and Adjusted EBITDA as a % of net revenues as key performance measures because we believe these measures facilitate operating performance comparison from period-to-period by excluding potential differences primarily caused by the impact of restructuring, asset depreciation and amortization, non-cash share-based compensation and non-operational charges including the impact to cost of goods sold and SG&A expenses related to the termination of an exclusive co-manufacturing agreement, early extinguishment of convertible notes and remeasurement of warrant liability. Because Adjusted EBITDA and Adjusted EBITDA as a % of net revenues facilitate internal comparisons of our historical operating performance on a more consistent basis, we also use these measures for our business planning purposes. In addition, we believe Adjusted EBITDA and Adjusted EBITDA as a % of net revenues are widely used by investors, securities analysts, ratings agencies and other parties in evaluating companies in our industry as a measure of our operational performance. There are a number of limitations related to the use of Adjusted EBITDA rather than net income (loss), which is the most directly comparable measure prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”). Some of these limitations are: • Adjusted EBITDA excludes depreciation and amortization expense and, although these are non-cash expenses, the assets being depreciated may have to be replaced in the future increasing our cash requirements; • Adjusted EBITDA does not reflect interest expense, or the cash required to service our debt, which reduces cash available to us; • Adjusted EBITDA does not reflect income tax payments that reduce cash available to us; • Adjusted EBITDA does not reflect restructuring expenses that reduce cash available to us; • Adjusted EBITDA does not reflect share-based compensation expense and therefore does not include all of our compensation costs; • Adjusted EBITDA does not reflect other income (expense) that may increase or decrease cash available to us; and • other companies, including companies in our industry, may calculate Adjusted EBITDA differently, which reduces its usefulness as a comparative measure. These non-GAAP financial measures should not be considered in isolation or as a substitute for financial information provided in accordance with GAAP. These non-GAAP financial measures may not be computed in the same manner as similarly titled measures used by other companies. The following table presents the reconciliation of Adjusted EBITDA to its most comparable GAAP measure, net loss, as reported (unaudited): _____________ (1) In connection with the termination of an exclusive supply agreement with a co-manufacturer in May 2017, we recorded restructuring expenses related to the impairment write-off of long-lived assets, primarily comprised of certain unrecoverable equipment located at the co-manufacturer’s site and company-paid leasehold improvements to the co-manufacturer’s facility, and legal and other expenses associated with the dispute with the co-manufacturer. Amounts recorded in 2019 and 2018 primarily comprised of legal and other expenses associated with this dispute. See Note 3, Restructuring, to the Notes to Financial Statements, and Part I, Item 3, Litigation, included elsewhere in this report. (2) Consists of additional charges related to inventory losses incurred as a result of termination of an exclusive supply agreement with a co-manufacturer and is recorded in cost of goods sold. (3) Consists of additional charges incurred as a result of termination of an exclusive supply agreement with a co-manufacturer and is recorded in selling, general and administrative expenses. (4) In 2017, includes expenses associated with the conversion of our convertible notes. Liquidity and Capital Resources Our primary cash needs are for operating expenses, working capital and capital expenditures to support the growth in our business. Prior to our IPO, we financed our operations through private sales of equity securities and through sales of our products. Since our inception and through our IPO, we raised a total of $199.5 million from the sale of convertible preferred stock, including through sales of convertible notes which were converted into preferred stock, net of costs associated with such financings. In connection with our IPO, we sold an aggregate of 11,068,750 shares of our common stock at a public offering price of $25.00 per share and received approximately $252.4 million in net proceeds. In connection with the Secondary Offering we sold 250,000 shares of our common stock. The shares were sold at a public offering price of $160.00 per share and we received net proceeds of approximately $37.4 million. We did not receive any proceeds from the sale of common stock by the selling stockholders in the Secondary Offering. We have also entered into the credit facilities described below with Silicon Valley Bank (“SVB”). As of December 31, 2019, we had $276.0 million in cash and cash equivalents. We believe that our cash and cash equivalents, cash flow from operating activities and available borrowings under our credit facilities will be sufficient to fund our working capital and meet our anticipated capital requirements for the next 12 months. Our future capital requirements may vary materially from those currently planned and will depend on many factors, including the number and characteristics of any additional products or manufacturing processes we develop or acquire to serve new or existing markets; the expenses associated with our marketing initiatives; our investment in manufacturing to expand our manufacturing and production capacity; the costs required to fund domestic and international growth; the scope, progress, results and costs of researching and developing future products or improvements to existing products or manufacturing processes; any lawsuits related to our products or commenced against us, including the costs associated with our current litigation with a former co-manufacturer and the securities case recently brought against us; the expenses needed to attract and retain skilled personnel; the costs associated with being a public company; the costs involved in preparing, filing, prosecuting, maintaining, defending and enforcing intellectual property claims, including litigation costs and the outcome of such litigation; the impact of the COVID-19 pandemic; and the timing, receipt and amount of sales of, or royalties on, any future approved products, if any. Amended and Restated Loan and Security Agreement In June 2018, we refinanced our then existing revolving credit facility and term loan facility under a loan and security agreement with SVB (the “Amended LSA”). The Amended LSA includes a $6.0 million revolving credit facility (the “2018 Revolving Credit Facility”) and a term loan facility (the “2018 Term Loan Facility”) comprised of (i) a $10.0 million term loan advance at closing, (ii) a conditional $5.0 million term loan advance, if no event of default has occurred and is continuing through the borrowing date, and (iii) an additional conditional term loan advance of $5.0 million if no event of default has occurred and is continuing based upon a minimum level of gross profit for the trailing 12-month period. The 2018 Term Loan Facility has a floating interest rate that is equal to 4.0% above the prime rate, with interest payable monthly and principal amortizing commencing on July 1, 2020, and will mature in June 2022. Borrowings under the 2018 Revolving Credit Facility carry a variable annual interest rate of prime rate plus 0.75% to 1.25% with an additional 5% on the outstanding balances in the event of a default. The 2018 Revolving Credit Facility matures in June 2020. The 2018 Term Loan Facility and the 2018 Revolving Credit Facility (collectively, the “SVB Credit Facilities”) contain customary negative financial covenants that limit our ability to, among other things, incur additional indebtedness, grant liens, make investments, repurchase stock, pay dividends, transfer assets and merge or consolidate. The SVB Credit Facilities also contain customary affirmative financial covenants, including delivery of audited financial statements. We were in compliance with the financial covenants in the SVB Credit Facilities as of December 31, 2019. The SVB Credit Facilities are secured by an interest in our assets including manufacturing equipment, inventory, contract rights or rights to payment of money, leases, license agreements, general intangibles, and cash. In conjunction with the execution of the Amended LSA, we issued two common stock warrants one each to SVB and its affiliate to provide the ability to purchase an aggregate of 60,002 shares of our common stock at an exercise price of $3.00 per share. The common stock warrants were fully exercisable on the date of the grant and had a term of 10 years. We also paid a commitment fee of $30,000 to SVB in connection with the execution of the Amended LSA. Subsequent to the closing of the IPO, all outstanding warrants to purchase shares of common stock were cashless exercised and no warrants were outstanding as of December 31, 2019. As of December 31, 2019 and 2018, we had $6.0 million and $20.0 million in borrowings on the 2018 Revolving Credit Facility and 2018 Term Loan Facility, respectively, and had no availability to borrow under either of these loan facilities. In 2019 and 2018, we incurred $2.2 million and $0.9 million, respectively, in interest expense related to the SVB Credit Facilities. The interest rates on the 2018 Revolving Credit Facility and the 2018 Term Loan Facility at December 31, 2019 were 5.5% and 8.75%, respectively. Equipment Loan Facility In September 2018, we entered into an Equipment Loan and Security Agreement with Structural Capital Investments II, LP (“Structural Capital”) and Ocean II PLO, LLC, as administrative and collateral agent, pursuant to which Structural Capital agreed to provide an equipment loan facility to us in the amount of $5.0 million for the purpose of purchasing equipment. Subject to Structural Capital’s approval, we may request that they advance an additional $5.0 million or an aggregate of $10.0 million. The equipment loan facility matures on May 1, 2022, carries an interest rate of 6.25% plus the greater of 4.75% or the prime rate and is secured by the financed equipment. Principal repayments begin six months or 18 months after loan draw depending on us achieving certain financial milestones, and therefore, are paid over a period of 37 months or 25 months, respectively. As of June 30, 2019, we achieved all of the milestones and, therefore, monthly installment repayments of principal are expected to begin on December 31, 2020. We are also required to offer Structural Capital the right to purchase up to an aggregate of $1.0 million of our capital stock or any other equity interest in any transaction where we receive gross proceeds of at least $10.0 million. The equipment loan facility has a prepayment penalty of 2% during the first two years of the term and 1% thereafter. We must also pay a final payment fee of 13% of the facility commitment amount on the maturity date and such other date as the advances become due and such fee will increase by 1% if certain milestones are achieved. We had $5.0 million in borrowings outstanding as of December 31, 2019 and 2018 under the equipment loan facility. The interest rate on the equipment loan facility at December 31, 2019 and 2018 was 11.0% and 11.5%, respectively. For 2019, 2018 and 2017, we recorded $0.6 million, $0.2 million and $0, respectively, in interest expense related to the equipment loan facility. Cash Flows The following table presents the major components of net cash flows used in and provided by operating, investing and financing activities for the periods indicated. Net Cash Used in Operating Activities For the year ended December 31, 2019, we incurred a net loss of $12.4 million. The primary reason for net cash used in operating activities of $47.0 million was the $68.2 million in net cash outflows from changes in our operating assets and liabilities, primarily due to increases in inventory to meet growth in anticipated sales and to accommodate longer lead times for international shipments and increases in accounts receivable, partially offset by an increase in accounts payable. Net loss for the year ended December 31, 2019, included $33.7 million in non-cash expenses primarily comprised of share-based compensation expense, change in warrant liability, and depreciation and amortization expense. For the year ended December 31, 2018, we incurred a net loss of $29.9 million, which was the primary reason for net cash used in operating activities of $37.7 million. Net cash used in operating activities also included $16.3 million in net cash outflows from changes in our operating assets and liabilities, partially offset by $8.5 million in non-cash expenses primarily comprised of depreciation and amortization expense, share-based compensation expense and change in warrant liability. For the year ended December 31, 2017, we incurred a net loss of $30.4 million, which was the primary reason for net cash used in operating activities of $25.3 million. Net cash used in operating activities also included $2.6 million in net cash outflows from changes in our operating assets and liabilities, fully offset by $5.4 million in non-cash expenses primarily comprised of depreciation and amortization expense, share-based compensation expense, convertible note-related expense and change in warrant liability. For the year ended December 31, 2017, net loss included a non-cash restructuring loss of $2.3 million on the write-off of fixed assets related to our termination of an exclusive supply agreement with a co-manufacturer. Depreciation and amortization expense was $8.1 million, $4.9 million and $3.2 million, in 2019, 2018 and 2017, respectively. We anticipate our depreciation and amortization expense will increase in 2020 based on our existing fixed assets and anticipated capital expenditures as we further invest in R&D infrastructure and expand our production capabilities to meet increased demand for our products. Net Cash Used in Investing Activities Net cash used in investing activities primarily relates to capital expenditures to support our growth and investment in property, plant and equipment. For the year ended December 31, 2019, net cash used in investing activities was $26.2 million and consisted of $23.8 million in cash outflows for purchases of property, plant and equipment, primarily for manufacturing facility improvements and manufacturing equipment, $2.1 million in cash outflows related to property, plant and equipment purchased for sale to co-manufacturers which we expect will be sold by the end of 2020, and security deposits, partially offset by proceeds from sale of assets held for sale. For the year ended December 31, 2018, net cash used in investing activities was $23.2 million and consisted of $22.2 million in cash outflows for purchases of property, plant and equipment, primarily for manufacturing facility improvements and manufacturing equipment, $1.0 million in cash outflows related to property, plant and equipment purchased for sale to co-manufacturers, and security deposits, partially offset by proceeds from sale of fixed assets. For the year ended December 31, 2017, net cash used in investing activities was $8.1 million and primarily consisted of cash outflows for the purchases of property, plant and equipment, principally for the build-out and equipping of our Manhattan Beach Project Innovation Center. Net Cash Provided by Financing Activities For the year ended December 31, 2019, net cash provided by financing activities was $294.9 million primarily as a result of $254.9 million in net proceeds from our IPO, net of issuance costs, $37.4 million in net proceeds to us from the Secondary Offering, net of issuance costs, and $2.7 million in proceeds from stock option exercises, partially offset by $55,000 in payments of capital lease obligations. For the year ended December 31, 2018, net cash provided by financing activities was $76.2 million primarily as a result of $51.3 million in proceeds from the issuance of our Series G and Series H preferred stock, net of issuance costs, $20.0 million in borrowings under our 2018 Term Loan Facility, $6.0 million in borrowings under our 2018 Revolving Credit Facility, $5.0 million in borrowings under an equipment loan facility, and $1.4 million in proceeds from stock option exercises, partially offset by cash outflows for repayment of a note with the Missouri Department of Economic Development, and borrowings under our 2016 Revolving Credit Facility and 2016 Term Loan Facility. The proceeds from the borrowings were used to finance our operations. For the year ended December 31, 2017, financing activities provided $55.4 million in cash as a result of $43.3 million of proceeds from the issuance of our Series F and G preferred stock, net of issuance costs, $10.0 million in proceeds from the issuance of convertible notes that were eventually converted into Series G preferred stock, $2.5 million in revolving credit facility borrowings and $0.4 million in proceeds from stock option exercises, partially offset by payments towards our revolving credit facility borrowings and capital lease obligations. The proceeds from the borrowings were used to finance our operations. As of December 31, 2019, we had borrowed the entire availability of $20.0 million under the 2018 Term Loan Facility and $6.0 million under the 2018 Revolving Credit Facility. Contractual Obligations and Commitments Effective March 16, 2020, we entered into an agreement to extend the lease for one of our facilities in Columbia, Missouri, for an additional term of two years ending in June 2022. The aggregate lease amount for the additional two-year term is $0.5 million, which is not included in the table below. See Note 12, Subsequent Events, of the Notes to Financial Statements included elsewhere herein. The following table summarizes our significant contractual obligations as of December 31, 2019: ___________________ (1) Includes lease payments for our Manhattan Beach Project Innovation Center and corporate offices in El Segundo, California, and our manufacturing facilities in Columbia, Missouri. (2) Consists of payments under various capital leases for certain equipment. (3) Includes principal and interest accrued at a floating rate under the 2018 Revolving Credit Facility. (4) Includes principal and interest under the 2018 Term Loan Facility. (5) Includes principal and interest on an equipment loan. (6) Consists of commitments to purchase pea protein inventory. Excludes amounts under the multi-year sales agreement with Roquette Frères entered into subsequent to the year ended December 31, 2019. See Note 12, Subsequent Events, to the Notes to Financial Statements included elsewhere herein. In addition to the amounts shown in the table above, as of December 31, 2019, we had approximately $12.7 million in purchase order commitments for capital expenditures primarily to purchase machinery and equipment. Payments for these purchases will be due within twelve months. Segment Information We have one operating segment and one reportable segment, as our CODM, who is our Chief Executive Officer, reviews financial information on an aggregate basis for purposes of allocating resources and evaluating financial performance. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements or any holdings in variable interest entities. Critical Accounting Policies In preparing our financial statements in accordance with GAAP, we are required to make estimates and assumptions that affect the amounts of assets, liabilities, revenue, costs and expenses, and disclosure of contingent assets and liabilities that are reported in the financial statements and accompanying 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. Our actual results may differ from these estimates and assumptions. To the extent that there are differences between our estimates and actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected. We believe that the estimates, assumptions and judgments involved in the accounting policies described below have the greatest potential impact on our financial statements because they involve the most difficult, subjective or complex judgments about the effect of matters that are inherently uncertain. Therefore, we consider these to be our critical accounting policies. Accordingly, we evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ from these estimates and assumptions. See Note 2, Summary of Significant Accounting Policies, to the Notes to Financial Statements included elsewhere in this report for information about these critical accounting policies as well as a description of our other accounting policies. Revenue Recognition While our revenue recognition does not involve significant judgment, it represents an important accounting policy. Our revenues are generated through sales of our products to distributors or customers. Revenue is recognized at the point in which the performance obligation under the terms of a contract with the customer have been satisfied and control has transferred. The Company’s performance obligation is typically defined as the accepted purchase order, or the contract, with the customer which requires the Company to deliver the requested products at agreed upon prices at the time and location of the customer’s choice. The Company does not offer warranties or a right to return on the products it sells except in the instance of a product recall. Revenue is measured as the amount of consideration the Company expects to receive in exchange for fulfilling the performance obligation. Sales and other taxes the Company collects concurrent with the sale of products are excluded from revenue. The Company's normal payment terms vary by the type and location of its customers and the products offered. The time between invoicing and when payment is due is not significant. None of the Company's customer contracts as of December 31, 2019 contains a significant financing component. The Company routinely offers sales discounts and promotions through various programs to its customers and consumers. These programs include rebates, temporary on shelf price reductions, off invoice discounts, retailer advertisements, product coupons and other trade activities. Provision for discounts and incentives are recorded in the same period in which the related revenues are recognized. At the end of each accounting period, the Company recognizes a liability for estimated sales discounts that have been incurred but not paid. The offsetting charge is recorded as a reduction of revenues in the same period when the expense is incurred. The Company recognizes the incremental costs of obtaining contracts as an expense when incurred if the amortization period of the assets that the Company otherwise would have recognized is one year or less. The incremental cost to obtain contracts was not material. Share-Based Compensation The 2018 Equity Incentive Plan (the “2018 Plan”) provides for the grant of incentive stock options, within the meaning of Section 422 of the Code, to our employees and the employees of our subsidiaries, and for the grant of nonstatutory stock options, stock appreciation rights, restricted stock, restricted stock units, performance units, and performance shares to our employees, directors, and consultants and the employees and consultants of any subsidiary. Stock options. The administrator may grant incentive and/or non-statutory stock options under our 2018 Plan, provided that incentive stock options may only be granted to employees. The exercise price of such options must generally be equal to at least the fair market value of our common stock on the date of grant. The term of an option may not exceed 10 years, subject to certain exceptions. Stock appreciation rights. Stock appreciation rights may be granted under our 2018 Plan. Stock appreciation rights allow the recipient to receive the appreciation in the fair market value of our common stock between the date of grant and the exercise date. Restricted stock. Restricted stock may be granted under our 2018 Plan. Restricted stock awards are grants of shares of our common stock that are subject to various restrictions, including restrictions on transferability and forfeiture provisions. Shares of restricted stock will vest and the restrictions on such shares will lapse, in accordance with terms and conditions established by the administrator. Restricted stock units. Restricted stock units may be granted under our 2018 Plan, and may include the right to dividend equivalents, as determined in the discretion of the administrator. Each restricted stock unit granted is a bookkeeping entry representing an amount equal to the fair market value of one share of our common stock. Vesting criteria may include achievement of specified performance criteria and/or continued service, and the form and timing of payment. Performance units/performance shares. Performance units and performance shares may be granted under our 2018 Plan. Performance units and performance shares are awards that will result in a payment to a participant if performance goals established by the administrator are achieved and any other applicable vesting provisions are satisfied. We account for all shared-based compensation awards using a fair-value method. Options are recorded at their estimated fair value using the Black-Scholes option pricing model. We recognize the fair value of each award as an expense over the requisite service period, generally the vesting period of the equity grant. Determining the fair value of share-based awards at the grant date requires significant judgment. The determination of the grant date fair value of stock options using the Black-Scholes option-pricing model is affected by our estimated common stock fair value as well as other highly subjective assumptions including, the expected term of the awards, our expected volatility over the expected term of the awards, expected dividend yield, risk-free interest rates. The assumptions used in our option-pricing model represent management’s best estimates. These assumptions and estimates are as follows: Fair Value of Common Stock: We estimate the fair value of stock options using the Black-Scholes option pricing model. We use the value of our common stock to determine the fair value of restricted shares. Expected Term: As we do not have sufficient historical experience for determining the expected term of the stock option awards granted, our expected term is based on the simplified method, generally calculated as the mid-point between the vesting date and the end of the contractual term. Expected Volatility: As the Company has only been a public entity since May 2, 2019, there is not a substantive share price history to calculate volatility and, as such, we have elected to use an approximation based on the volatility of other comparable public companies, which compete directly with the Company, over the expected term of the options. Expected Dividend Yield: We have never declared or paid any cash dividends and do not presently intend to pay cash dividends in the foreseeable future. As a result, we used an expected dividend yield of zero. Risk-Free Interest Rates: We determine the average risk-free interest rate using the yield on actively traded U.S. Treasury notes with the same maturity as the expected term of the underlying options. If any assumptions used in the Black-Scholes option-pricing model change significantly, share-based compensation for future awards may differ materially compared with the awards granted previously. 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 share-based compensation expense could be materially different. Emerging Growth Company Status We are an “emerging growth company” (“EGC”) as defined in the JOBS Act. As an EGC, the JOBS Act, allows us to delay adoption of new or revised accounting pronouncements applicable to public companies until such pronouncements are made applicable to private companies. We expect to lose our EGC status upon the filing of the Form 10-K for the year ending December 31, 2020, when we expect to qualify as a Large Accelerated Filer based upon the current market capitalization of the Company according to Rule 12b-2 of the Exchange Act. Therefore, we have elected to use the adoption dates applicable to public companies beginning in the first quarter of 2020. For as long as we continue to be an emerging growth company, we intend to take advantage of certain other exemptions from various reporting requirements that are 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 and exemptions from the requirements of holding non-binding advisory votes on executive compensation and stockholder approval of any golden parachute payments not previously approved. Recently Adopted Accounting Pronouncements Please refer to Note 2, Summary of Significant Accounting Policies, to the Notes to Financial Statements included elsewhere in this report for a discussion of recently adopted accounting pronouncements and new accounting pronouncements that may impact us.

<s>[INST] Overview Beyond Meat is one of the fastest growing food companies in the United States, offering a portfolio of revolutionary plantbased meats. We build meat directly from plants, an innovation that enables consumers to experience the taste, texture and other sensory attributes of popular animalbased meat products while enjoying the nutritional and environmental benefits of eating our plantbased meat products. Our brand commitment, “Eat What You Love,” represents a strong belief that by eating our plantbased meats, consumers can enjoy more, not less, of their favorite meals, and by doing so help address concerns related to human health, climate change, resource conservation, and animal welfare. The success of our breakthrough innovation model and products has allowed us to appeal to a broad range of consumers, including those who typically eat animalbased meats, positioning us to compete directly in the $1.4 trillion global meat industry. We sell a range of plantbased products across the three main meat platforms of beef, pork and poultry. They are offered in readytocook formats (generally merchandised at retail in the meat case), which we refer to as our “fresh” platform, and readytoheat formats (merchandised at retail in the freezer), which we refer to as our “frozen” platform. As of December 31, 2019, our products were available in approximately 77,000 retail and restaurant and foodservice outlets in more than 65 countries, across mainstream grocery, mass merchandiser, club and convenience store, and natural retailer channels, direct to consumer, and various foodawayfromhome channels, including restaurants, foodservice outlets and schools. On May 6, 2019, we completed our IPO, in which we sold 11,068,750 shares of our common stock. The shares began trading on the Nasdaq Global Select Market on May 2, 2019. The shares were sold at a public offering price of $25.00 per share for net proceeds of approximately $252.4 million, after deducting underwriting discounts and commissions of $19.4 million and issuance costs of approximately $4.9 million payable by us. Upon the closing of the IPO, all outstanding shares of our convertible preferred stock automatically converted into 41,562,111 shares of common stock on a oneforone basis, and warrants exercisable for convertible preferred stock were automatically converted into warrants exercisable for 160,767 shares of common stock. On August 5, 2019, we completed our Secondary Offering, in which we sold 250,000 shares. The shares were sold at a public offering price of $160.00 per share for net proceeds to the Company of approximately $37.4 million, after deducting underwriting discounts and commissions of $1.5 million and issuance costs of approximately $1.1 million payable by us. Total Secondary Offering costs paid in 2019 were approximately $2.2 million, of which approximately $1.1 million was capitalized to reflect the costs associated with the issuance of new shares and offset against proceeds from the Secondary Offering. We did not receive any proceeds from the sale of common stock by the selling stockholders in the Secondary Offering. We continue to experience strong sales growth over prior periods. Net revenues increased to $297.9 million in 2019 from $87.9 million in 2018 and $32.6 million in 2017, representing a 202% compound annual growth rate. The Beyond Burger accounted for approximately 64%, 70% and 48% of our gross revenues in 2019, 2018 and 2017, respectively. We believe that sales of the Beyond Burger will continue to constitute a significant portion of our revenues, income and cash flow for the foreseeable future. We have generated losses from inception. Net loss in 2019, 2018, and 2017 was $12.4 million, $29.9 million, and $30.4 million, respectively, as we invested in innovation and growth of our business. We [/INST] Positive. </s>

SMARTSHEET INC

2019-04-01

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 together with 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 contains forward-looking statements based upon current expectations that involve risks and uncertainties. These statements are often identified by the use of words such as “may,” “will,” “expect,” “believe,” “anticipate,” “intend,” “could,” “estimate,” or “continue,” and similar expressions or variations. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including but not limited to those discussed in the section titled “Risk Factors” and in other parts of this Annual Report on Form 10-K. Our fiscal year ends January 31. Overview We empower everyone to improve how they work. We are a leading cloud-based platform for work execution, enabling teams and organizations to plan, capture, manage, automate, and report on work at scale, resulting in more efficient processes and better business outcomes. We were founded in 2005 with a vision to build a universal application for work management that does not require coding capabilities. Unstructured or dynamic work is work that has historically been managed using a combination of email, spreadsheets, whiteboards, phone calls, and in-person meetings to communicate with team members and complete projects and processes. It is frequently changing, often ad-hoc, and highly reactive to new information. Our platform helps manage this kind of unstructured work and serves as a single source of truth across work processes, fostering accountability and engagement within teams, leading to more efficient decision-making and better business outcomes. We generate revenue primarily from the sale of subscriptions to our cloud-based platform. For subscriptions, customers select the plan that meets their needs and can begin using Smartsheet within minutes. We offer four subscription levels: Individual, Business, Enterprise, and Premier, the pricing for which varies by the capabilities provided. Customers can also purchase Connectors, which provide data integration and automation to third-party applications. We also offer Control Center and Accelerators, which enable customers to implement solutions for a specific use case for large scale projects, initiatives, or processes. Professional services are offered to help customers create and administer solutions for specific use cases and for training purposes. Customers can begin using our platform by purchasing a subscription directly from our website or through our sales force, starting a free trial, or working as a collaborator on a project. Key Business Metrics We review the following key business metrics to evaluate our business, measure our performance, identify trends affecting our business, formulate business plans, and make strategic decisions. Number of domain-based customers We define domain-based customers as organizations with a unique email domain name such as @cisco. All other customers, which we designate as ISP customers, are typically small teams or individuals who register for our services with an email address hosted on a widely used domain such as @gmail, @outlook, or @yahoo. We believe that the number of customers, particularly our domain-based customers, using our platform is an indicator of our market penetration, the growth of our business, and our potential future business opportunities. Increasing awareness of our platform and its broad range of capabilities, coupled with the mainstream adoption of cloud-based technology, has expanded the diversity of our customer base to include organizations of all sizes across virtually all industries. Average ACV per domain-based customer We use average annualized contract value (“ACV”) per domain-based customer to measure customer commitment to our platform and sales force productivity. We define average ACV per domain-based customer as total outstanding ACV for domain-based subscriptions as of the end of the reporting period divided by the number of domain-based customers as of the same date. Dollar-based net retention rate We calculate dollar-based net retention rate as of a period end by starting with the ACV from the cohort of all customers as of the 12 months prior to such period end (“Prior Period ACV”). We then calculate the ACV from these same customers as of the current period end (“Current Period ACV”). Current Period ACV includes any upsells and is net of contraction or attrition over the trailing 12 months, but excludes subscription revenue from new customers in the current period. We then divide the total Current Period ACV by the total Prior Period ACV to arrive at the dollar-based net retention rate. The dollar-based net retention rate is used by us to evaluate the long-term value of our customer relationships and is driven by our ability to retain and expand the subscription revenue generated from our existing customers. Components of Results of Operations Revenue Subscription revenue Subscription revenue primarily consists of fees from customers for access to our cloud-based platform. We recognize subscription revenue ratably over the term of the subscription period beginning on the date access to our platform is provided, as no implementation work is required, assuming all other revenue recognition criteria have been met. Professional services revenue Professional services revenue includes primarily fees for consulting and training services. Our consulting services consist of platform configuration and use case optimization, and are primarily invoiced on a time and materials basis, with some smaller engagements being provided for a fixed fee. We recognize revenue for our consulting services as those services are delivered. Our training services are delivered either remotely or at the customer site. Training services are charged for on a fixed-fee basis and we recognize revenue as the training program is delivered. Our consulting and training services are generally considered to be distinct, for accounting purposes, and we recognize revenue as services are performed or upon completion of work. Cost of revenue and gross margin Cost of subscription revenue Cost of subscription revenue primarily consists of expenses related to hosting our services and providing support, including third-party hosting fees and payment processing fees, employee-related costs such as salaries, wages, and related benefits, allocated overhead, software and maintenance costs, amortization of acquisition-related intangibles, and costs of Connectors between Smartsheet and third-party applications. We intend to continue to invest in our platform infrastructure and our support organization. We currently utilize a combination of third-party co-location data centers and public cloud service providers. As our platform scales, we may require additional investments in infrastructure to host our platform and support our customers, which may negatively impact our subscription gross margin. Cost of professional services revenue Cost of professional services revenue consists primarily of employee-related costs for our consulting and training teams, allocated overhead, travel costs, and billable expenses. Gross margin Gross margin is calculated as gross profit expressed as a percentage of total revenue. Our gross margin may fluctuate from period to period as our revenue mix fluctuates, and as a result of the timing and amount of investments to expand our hosting capacity, our continued building of application support and professional services teams, increased share-based compensation expense, as well as the relative proportions of total revenue provided by subscriptions or professional services in a given time period. As we continue to expand our professional services offerings in the future, we expect our total gross margin percentage to gradually decline. Operating expenses Research and development Research and development expenses consist primarily of employee-related costs, hardware- and software-related costs, overhead allocations, costs of outside services used to supplement our internal staff, and recruiting expenses. We consider continued investment in our development talent and our platform to be important for our growth. We expect our research and development expenses to increase in absolute dollars as our business grows and to gradually decrease over the long-term as a percentage of total revenue due to economies of scale. Sales and marketing Sales and marketing expenses consist primarily of employee-related costs, costs of general marketing and promotional activities, travel-related expenses, third-party software-related expenses, recruiting expenses, and allocated overhead. Commissions earned by our sales force that are incremental to each customer contract, along with related fringe benefits and taxes, are capitalized and amortized over an estimated useful life of three years. We expect that sales and marketing expenses will increase in absolute dollars as we expect more of our future revenue to come from our inside and direct sales models, rather than through digital self-service sales. General and administrative General and administrative expenses consist primarily of employee-related costs for accounting, finance, legal, IT, and human resources personnel. In addition, general and administrative expenses include non-personnel costs, such as legal, accounting, and other professional fees, hardware and software costs, certain tax, license and insurance-related expenses, and allocated overhead. We are incurring additional expenses as a result of operating as a public company, including costs to comply with the rules and regulations applicable to companies listed on a national securities exchange, costs related to compliance and reporting obligations pursuant to the rules and regulations of the SEC, and increased expenses for insurance, investor relations, and professional services. We expect our general and administrative expenses to increase in absolute dollars as our business grows, and to gradually decrease over the long term as a percentage of total revenue due to economies of scale. Interest income (expense) and other, net Interest income (expense) and other, net consists of interest income from our investment holdings, expenses resulting from the revaluation of our convertible preferred stock warrant liability, interest expense associated with our capital leases, and foreign exchange gains and losses. Income tax provision (benefit) Our income tax provision has not been historically significant to our business as we have incurred operating losses to date. We maintain a valuation allowance on our U.S. federal and state deferred tax assets as we have concluded that it is not more likely than not that the deferred assets will be realized. 2017 Tender Offer During the three months ended July 31, 2017, we facilitated a tender offer (“2017 Tender Offer”), in which our current and former employees and directors were able to sell a portion of their vested shares of common stock to certain existing investors. We recorded share-based compensation expense for the amount paid by our existing investors to our current and former employees and directors in excess of the estimated fair value of our common stock. That total amount resulted in $15.5 million incremental expense for the three months ended July 31, 2017, of which $0.1 million was recorded to cost of revenue, $5.1 million was recorded to research and development expense, $0.6 million was recorded to sales and marketing expense, and $9.7 million was recorded to general and administrative expense. In addition, the excess over the estimated fair value of the sale price of the common and convertible preferred stock sold by non-employees, totaling $4.6 million, was recorded as a deemed dividend within additional paid-in capital. Our quarterly trends in total operating expenses, operating loss, and net loss, were significantly impacted by this transaction, which took place and was completed during the three months ended July 31, 2017. Results of Operations The following tables set forth our results of operations for the periods presented and as a percentage of our total revenue for those periods: (1) Amounts include share-based compensation expense as follows: Share-based compensation expense related to the 2017 Tender Offer, which is included in the table above, was as follows: The following table sets forth the components of our statements of operations data, for each of the periods presented, as a percentage of total revenue. Comparison of the years ended January 31, 2019 and 2018 Revenue The increase in subscription revenue between periods was driven by increased contributions from existing customers, as evidenced by our dollar-based net retention rate of 134% for the trailing 12-month period ended January 31, 2019, followed by contributions from new customers, as evidenced by the 7% increase in the number of domain-based customers. The increase in professional services revenue was primarily driven by increasing demand for our consulting and training services. Cost of revenue, gross profit, and gross margin Cost of subscription revenue increased $6.3 million, or 48%, for the year ended January 31, 2019 compared to the year ended January 31, 2018. The increase was primarily due to an increase of $3.4 million in employee-related expenses due to increased headcount, of which $0.3 million was related to share-based compensation expenses other than those related to the 2017 Tender Offer, and net of a $0.1 million decrease as a result of the 2017 Tender Offer. In addition, there was an increase of $0.9 million in data center and hosting costs, an increase of $0.5 million in credit card processing fees, an increase of $0.4 million in each of software-related costs, allocated overhead, and amortization of acquisition-related intangibles, an increase of $0.2 million in travel-related costs, and an increase of $0.1 million in professional services and fees. Our gross margin for subscription revenue was 88% and 87% for the year ended January 31, 2019 and 2018, respectively. Our gross margin for subscription revenue increased as we continued to realize gains from economies of scale. As we add new functionality, expand internationally, migrate more of our infrastructure to cloud-based hosting providers, and serve more regulated markets, our gross margin for subscription revenue may decline. Cost of professional services increased $5.9 million, or 68%, for the year ended January 31, 2019 compared to the year ended January 31, 2018. The increase was primarily due to an increase of $5.0 million in employee-related expenses, of which $0.4 million was related to share-based compensation, as we continued to grow our professional services offerings and workforce, an increase of $0.5 million in allocated overhead costs, an increase of $0.2 million in fees paid to outside resources to supplement internal employees, and an increase of $0.1 million in software-related costs. Our gross margin for professional services was 28% and 20% for the year ended January 31, 2019 and 2018, respectively. We expect our gross margin for professional services to decline in the future as we expand our team to support increasing demand. Operating expenses Research and development expenses Research and development expenses increased $21.3 million, or 57%, for the year ended January 31, 2019 as compared to the year ended January 31, 2018. The increase was primarily due to an increase of $16.2 million in employee-related expenses due to increased headcount, of which $5.0 million related to increased share-based compensation expenses other than those related to the 2017 Tender Offer, and net of a $5.1 million decrease as a result of the 2017 Tender Offer. In addition, there was an increase of $2.5 million in software-related costs, an increase of $1.3 million in allocated overhead expense, an increase of $1.1 million in costs of outside services used to supplement our internal staff, and an increase of $0.2 million in travel-related costs. Sales and marketing expenses Sales and marketing expenses increased $33.1 million, or 45%, for the year ended January 31, 2019 as compared to the year ended January 31, 2018. The increase was primarily due to an increase of $25.4 million in employee-related expenses due to increased headcount, of which $4.0 million related to increased share-based compensation other than that related to the 2017 Tender Offer, and net of a $0.6 million decrease as a result of the 2017 Tender Offer. In addition, there was an increase in marketing costs of $5.4 million, primarily due to a larger ENGAGE customer conference, investment in brand marketing, and pay-per-click advertising, an increase of $2.0 million in allocated overhead costs, an increase of $1.1 million in travel-related costs, and an increase of $0.4 million in software-related costs. These were partially offset by a decrease of $1.2 million in costs of outside services used to supplement our internal staff. General and administrative expenses General and administrative expenses increased $6.0 million, or 21%, for the year ended January 31, 2019 as compared to the year ended January 31, 2018. The increase was primarily due to an increase in employee-related expenses of $2.0 million, of which $3.2 million related to increased share-based compensation expenses other than those related to the 2017 Tender Offer, and net of a $9.7 million decrease as a result of the 2017 Tender Offer. In addition, there was an increase of $1.4 million in costs of outside services used to supplement our internal staff, an increase of $0.9 million each in allocated overhead costs and software-related costs, an increase of $0.5 million in taxes, licenses and insurance, and an increase of $0.3 million in travel-related costs. Interest income (expense) and other, net *N/M = not meaningful For the year ended January 31, 2019 as compared to the year ended January 31, 2018, the change in interest income (expense) and other, net was primarily driven by an increase of $2.8 million in interest income. This was partially offset by an increase in convertible preferred stock warrant expense of $0.5 million, an unfavorable net change of $0.3 million related to foreign currency gains and losses, and an increase in interest expense of $0.1 million. Comparison of the years ended January 31, 2018 and 2017 Revenue The increase in subscription revenue between periods was driven by contributions from new customers, as evidenced by the 11% increase in the number of domain-based customers, closely followed by increased contributions from existing customers, as evidenced by our dollar-based net retention rate of 130% for the trailing 12-month period ended January 31, 2018. During the 12-month period ended January 31, 2018, the number of customers with ACVs of $50,000 or more increased by 149%. The increase in professional services revenue was primarily driven by increasing demand for our consulting and training services. Cost of revenue, gross profit, and gross margin The increase in cost of subscription revenue was primarily due to an increase of $1.2 million in employee-related expenses due to increased headcount, an increase of $0.5 million in credit card processing fees, an increase of $0.5 million in costs of delivering Connectors to third-party applications, an increase of $0.4 million in data center and hosting-related costs as we increased capacity to support our growth, an increase of $0.2 million in allocated overhead costs, and an increase of $0.1 million in software subscription costs. Our gross margin for subscription revenue increased as we continued to realize gains from economies of scale. The increase in cost of professional services was primarily due to an increase of $3.6 million in employee-related expenses as we continued to grow our professional services offerings and workforce, an increase of $0.4 million in allocated overhead costs, an increase of $0.2 million in travel-related expenses as we delivered more professional services engagements in remote locations, an increase of $0.2 million in training costs and billable expenses, an increase of $0.1 million in software subscription costs, and an increase of $0.1 million for recruiting expenses. Our gross margin for professional services increased because the timing for additional hiring lagged the delivery of services. We expect our gross margin for professional services to decline as we expand and build our team to support increasing demand. Operating expenses Research and development expenses The increase in research and development expenses was primarily due to an increase of $15.1 million in employee-related expenses due to increased headcount, of which $5.1 million was related to share-based compensation expense from the 2017 Tender Offer and $0.5 million was related to all other share-based compensation expense, an increase of $1.2 million for software subscription costs and hardware maintenance expenses, an increase of $1.1 million in allocated overhead costs, an increase of $0.4 million in travel-related expenses, and an increase of $0.2 million for fees from external parties used to supplement our internal workforce and recruiting expenses. Sales and marketing expenses The increase in sales and marketing expenses was primarily due to an increase of $21.5 million in employee-related expenses due to higher headcount, of which $0.6 million related to share-based compensation expense from the 2017 Tender Offer and $0.7 million related to all other share-based compensation expenses, an increase in marketing and event costs of $4.3 million partially due to our first ENGAGE customer conference conducted in September 2017, an increase of $2.7 million in allocated overhead expenses, an increase of $1.8 million in travel-related expenses, an increase of $1.3 million in consulting services, an increase of $0.9 million in software subscription costs, and an increase of $0.4 million for recruiting expenses. General and administrative expenses The increase in general and administrative expenses was primarily due to an increase of $15.4 million in employee-related expenses due to higher headcount, of which $9.7 million related to share-based compensation expense associated with the 2017 Tender Offer and $0.7 million related to all other share-based compensation expense. The remaining $4.4 million of the increase was primarily due to an increase in professional services of $1.3 million in areas of systems implementation, legal, and accounting as we prepared for readiness as a public company, an increase of $0.9 million in taxes, licenses, and insurance related expenses, an increase of $0.7 million in software subscription costs, an increase of $0.6 million in allocated overhead expenses, an increase of $0.3 million for travel-related expenses, an increase of $0.3 million for recruiting and other professional fees, and an increase of $0.3 million for bad debt expense associated with higher accounts receivable balances. Interest income (expense) and other, net *N/M = not meaningful The change in interest income (expense) and other, net was primarily driven by an increase of $0.6 million in convertible preferred stock warrant expense and an increase of $0.2 million in interest expense. These were partially offset by an increase of $0.2 million in interest income and a favorable net change of $0.2 million related to foreign currency gains and losses. Quarterly Results of Operations and Other Data The following tables set forth selected unaudited quarterly statements of operations data for each of the eight fiscal quarters ended January 31, 2019, as well as the percentage of total revenue that each line item represents for each quarter. 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 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. This data should be read in conjunction with our audited consolidated financial statements and related notes included elsewhere in this Annual Report. These quarterly results are not necessarily indicative of our results of operations to be expected for any future period. (1) Amounts include share-based compensation expense other than related to the 2017 Tender Offer as follows: Amounts also include share-based expense compensation expense related to the 2017 Tender Offer as follows: All values from the statement of operations, expressed as percentage of total revenue were as follows: Quarterly revenue trends Our quarterly revenue increased sequentially in each of the periods presented due primarily to expansion within existing customers, increases in the number of new customers, and sales of new offerings. We believe that our professional services business is subject to negative seasonal trends during the holiday period of our fourth fiscal quarter due to the fewer number of business days during this period. The growth in our business has offset this seasonal trend to date, but its impact may be more pronounced in future periods. Quarterly cost of revenue and gross margin trends Our quarterly gross margin has remained relatively consistent, varying between 80% and 81%, as we have invested in our own co-location data centers, which has generated economies of scale, partially offset by a proportional increase in lower-margin professional services revenue. As our professional services business continues to grow, as we continue to migrate more of our infrastructure to cloud-based hosting providers, and as we deploy additional cloud-based offerings, our gross margin may decline. Quarterly operating expense trends Total operating expenses generally increased for the fiscal quarters presented primarily due to the addition of personnel, related overhead, and investments in hardware and software in connection with the expansion of our business. Operating expenses for the three months ended July 31, 2017 were also affected by the incremental share-based compensation expense associated with the 2017 Tender Offer. Our sales and marketing expenses as a percentage of total revenue generated in the three months ended October 31 of each year increased due to our ENGAGE customer conference. We intend to continue to host ENGAGE annually during our third fiscal quarter. Our general and administrative expenses as a percentage of total revenue have increased since the quarter ended January 31, 2018 in preparation for, and as a result of, operating as a public company. We expect these expenses to increase in absolute dollars as our business grows, and to gradually decrease over the long-term as a percentage of total revenue due to economies of scale. Non-GAAP Financial Measures In addition to our results determined in accordance with generally accepted accounting principles in the United States (“GAAP”), we believe the following non-GAAP financial measures are useful in evaluating our operating performance. We use the below referenced non-GAAP financial measures, collectively, to evaluate our ongoing operations and for internal planning and forecasting purposes. We believe that non-GAAP financial measures, when taken collectively, may be helpful to investors because they provide consistency and comparability with past financial performance, and assist in comparisons with other companies, some of which use similar non-GAAP financial measures to supplement their GAAP results. The non-GAAP financial measures are presented for supplemental informational purposes only, and should not be considered a substitute for financial measures presented in accordance with GAAP, and may be different from similarly-titled non-GAAP measures used by other companies. A reconciliation is provided below for each non-GAAP financial measure to the most directly comparable financial measure stated in accordance with GAAP. Investors are encouraged to review the related GAAP financial measures and the reconciliation of these non-GAAP financial measures to their most directly comparable GAAP financial measures. Limitations of non-GAAP financial measures Our non-GAAP financial measures have limitations as analytical tools and you should not consider them in isolation or as a substitute for an analysis of our results under GAAP. There are a number of limitations related to the use of these non-GAAP financial measures versus their nearest GAAP equivalents. First, free cash flow and calculated billings are not substitutes for net cash used in operating activities and total revenue, respectively. Similarly, non-GAAP gross profit and non-GAAP operating loss are not substitutes for gross profit and operating loss, respectively. Second, other companies may calculate similar non-GAAP financial measures differently or may use other measures as tools for comparison. Additionally, the utility of free cash flow as a measure of our financial performance and liquidity is further limited as it does not represent the total increase or decrease in our cash balance for a given period. Furthermore, as calculated billings are affected by a combination of factors, including the timing of sales, the mix of monthly and annual subscriptions sold and the relative duration of subscriptions sold, and each of these elements has unique characteristics in the relationship between calculated billings and total revenue, our calculated billings activity is not closely correlated to revenue except over longer periods of time. Non-GAAP gross profit and non-GAAP gross margin We define non-GAAP gross profit as gross profit adjusted for share-based compensation expense and amortization of acquisition-related intangible assets. Non-GAAP gross margin represents non-GAAP gross profit as a percentage of total revenue. (1) Share-based compensation expense for the year ended January 31, 2018 includes share-based compensation expense related to the 2017 Tender Offer. Non-GAAP operating loss and non-GAAP operating margin We define non-GAAP operating loss as loss from operations adjusted for share-based compensation expense, amortization of acquisition-related intangible assets, and one-time costs of acquisition. Non-GAAP operating margin represents non-GAAP operating loss as a percentage of total revenue. (1) Share-based compensation expense for the year ended January 31, 2018 includes share-based compensation expense related to the 2017 Tender Offer. Free cash flow We define free cash flow as net cash provided by (used in) operating activities less cash used for purchases of property and equipment, capitalized internal-use software, and payments on capital lease obligations. We believe free cash flow facilitates period-to-period comparisons of liquidity. We consider free cash flow to be a key performance metric because it measures the amount of cash we generate from our operations after our capital expenditures, payments on capital lease obligations and changes in working capital. We use free cash flow in conjunction with traditional GAAP measures as part of our overall assessment of our liquidity, including the preparation of our annual operating budget and quarterly forecasts, to evaluate the effectiveness of our business strategies, and to communicate with our board of directors concerning our liquidity. Calculated billings We define calculated billings as total revenue plus the change in deferred revenue in the period. Because we recognize subscription revenue ratably over the subscription term, calculated billings can be used to measure our subscription sales activity for a particular period, to compare subscription sales activity across particular periods, and as an indicator of future subscription revenue. Because we generate most of our revenue from customers who are invoiced on an annual basis, and because we have a wide range of customers, from those who pay us less than $200 per year to those who pay us more than $2.0 million per year, we experience seasonality and variability that is tied to typical enterprise buying patterns and contract renewal dates of our largest customers. We expect that our billings trends will continue to vary in future periods based on the timing and size of new and renewal bookings. Non-GAAP weighted average shares outstanding We use non-GAAP weighted average shares outstanding in calculating non-GAAP earnings per share. Our number of non-GAAP weighted average shares outstanding is calculated after assuming conversion of all outstanding preferred stock into shares of common stock either at the beginning of the fiscal period presented or when issued, if later. Non-GAAP net loss We define non-GAAP net loss as net loss adjusted for share-based compensation expense, amortization of acquisition-related intangible assets, one-time costs of acquisition, and remeasurement of convertible preferred stock warrant liability. (1) Share-based compensation expense for the year ended January 31, 2018 includes share-based compensation expense related to the 2017 Tender Offer. Liquidity and Capital Resources As of January 31, 2019, our principal sources of liquidity were cash and cash equivalents totaling $213.1 million which were held for working capital purposes. Our cash equivalents were comprised primarily of money market funds. We have generated significant operating losses and negative cash flows from operations as reflected in our accumulated deficit and consolidated statements of cash flows. We expect to continue to incur operating losses and negative cash flows from operations for the foreseeable future. We have financed our operations primarily through payments received from customers for subscriptions and professional services, net proceeds we received through sales of equity securities, option exercises, and contributions from our Employee Stock Purchase Plan (“ESPP”), and capitalized leases. On May 1, 2018, upon the closing of the IPO, we received net proceeds of $160.4 million after deducting underwriting discounts and commissions of $12.3 million and other issuance costs of $3.4 million. We believe our existing cash and cash equivalents and cash provided by sales of our products and services will be sufficient to meet our working capital and capital expenditure needs for at least the next 12 months. Our future capital requirements will depend on many factors, including our subscription growth rate, subscription renewal activity, billing frequency, the timing and extent of spending to support development efforts, the expansion of sales and marketing activities, the introduction of new and enhanced product offerings, and the continuing market adoption of our product. We may, in the future, enter into arrangements to acquire or invest in complementary businesses, services, and technologies, including 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 or generate cash flows necessary to expand our operations and invest in new technologies, our ability to compete successfully could be reduced, and this could harm our results of operations. A significant majority of our customers pay in advance for annual subscriptions. Therefore, a substantial source of our cash is from our deferred revenue, which is included on our balance sheet as a liability. Deferred revenue consists primarily of the unearned portion of billed fees for our subscriptions, which is recognized as revenue in accordance with our revenue recognition policy. As of January 31, 2019, we had deferred revenue of $96.1 million, of which $95.8 million was recorded as a current liability and was expected to be recognized as revenue in the subsequent 12 months, provided all recognition criteria are met. Cash flows The following table summarizes our cash flows for the periods indicated: Operating activities Our largest sources of operating cash are cash collections from our customers for subscription and professional services. Our primary uses of cash from operating activities are for employee-related expenditures and sales and marketing expenses. Historically, we have generated negative cash flows from operating activities during most fiscal years, and have supplemented working capital requirements through net proceeds from the sale of equity securities. During the year ended January 31, 2019, net cash used in operating activities was $2.9 million, driven by our net loss of $53.9 million, adjusted for non-cash charges of $35.7 million, and net cash inflows of $15.3 million provided by changes in our operating assets and liabilities. Non-cash charges primarily consisted of share-based compensation, amortization of deferred commissions, depreciation of property and equipment, remeasurement of the convertible preferred stock warrant liability, and amortization of intangible assets. Notable fluctuations in operating assets and liabilities included an increase in deferred revenue of $38.9 million, an increase in deferred commissions of $24.5 million, an increase in accounts receivable of $15.3 million, an increase in accounts payable and accrued expenses of $14.2 million, an increase in other long-term liabilities of $1.3 million, a decrease in prepaid expenses and other current assets of $0.5 million, and a decrease in other long-term assets of $0.2 million. During the year ended January 31, 2018, net cash used in operating activities was $13.6 million, driven by our net loss of $49.1 million, adjusted for non-cash charges of $28.4 million, an increase in deferred revenue of $24.6 million, and net cash outflows of $17.4 million provided by changes in our operating assets and liabilities other than deferred revenue. Non-cash charges primarily consisted of share-based compensation, amortization of deferred commission costs, depreciation of property and equipment, and remeasurement of the convertible preferred stock warrant liability. Other than changes in deferred revenue, other notable fluctuations in operating assets and liabilities included an increase in deferred commissions of $14.7 million, an increase in accounts receivable of $9.5 million, an increase in accounts payable and accrued expenses of $9.2 million, and an increase in prepaid expenses and other current assets of $1.9 million. During the year ended January 31, 2017, net cash provided by operating activities was $0.1 million, driven by our net loss of $15.2 million, adjusted for non-cash charges of $4.5 million and net cash outflows of $2.4 million provided by changes in our operating assets and liabilities other than deferred revenue. Changes in deferred revenue contributed an additional inflow of $13.1 million as we recorded a 65% increase in billings during the year ended January 31, 2017 as compared to the year ended January 31, 2016. Non-cash charges primarily consisted of share-based compensation, depreciation and amortization of property and equipment, and remeasurement of the convertible preferred stock warrant liability. Other than changes in deferred revenue, other notable fluctuations in operating assets and liabilities included an increase in accounts receivable of $2.8 million as we primarily invoice our customers in advance and mostly for 12-month subscriptions, an increase in deferred commissions of$4.9 million, an increase in prepaid expenses and other current assets of $0.8 million, and an increase in accounts payable and accrued expenses of $6.1 million. Investing activities Net cash used in investing activities during the year ended January 31, 2019 of $13.8 million consisted of purchases of property and equipment of $5.8 million, payments for business acquisitions, net of cash acquired, of $5.0 million, and capitalized internal-use software development costs of $3.0 million. Net cash used in investing activities during the year ended January 31, 2018 of $0.8 million was primarily attributable to proceeds from the sales and maturities of investments of $10.1 million, which was offset by purchases of property and equipment of $6.0 million, capitalized internal-use software development costs of $3.4 million, payments for business acquisition, net of cash acquired, of $1.5 million, and purchases of intangible assets of $0.1 million. Net cash provided by investing activities during the year ended January 31, 2017 of $9.6 million was primarily attributable to proceeds from the sales and maturities of investments of $16.6 million, which was partially offset by purchases of investments of $5.1 million, and purchases of property and equipment of $1.8 million to support additional office space and headcount growth. Financing activities Net cash provided by financing activities during the year ended January 31, 2019 of $171.3 million was primarily due to $163.8 million in proceeds from the IPO, net of underwriters’ discounts and commissions, $7.1 million in proceeds from our ESPP, and $6.6 million in proceeds from the exercise of stock options. These proceeds were partially offset by principal payments on capital leases of $3.3 million, payments of deferred offering costs of $2.6 million, and taxes paid related to net share settlement of restricted stock units of $0.4 million. Net cash provided by financing activities during the year ended January 31, 2018 of $51.4 million was primarily due to $52.4 million in proceeds from the issuance of Series F convertible preferred stock, and $2.2 million in proceeds from the exercise of stock options, partially offset by payments on principal of a capital lease of $2.3 million, and payments of deferred offering costs of $0.8 million. Net cash provided by financing activities during the year ended January 31, 2017 of $0.6 million was primarily due to $0.9 million in proceeds from the exercise of stock options, partially offset by payments on principal of a capital lease of $0.3 million. Obligations and Other Commitments Our contractual obligations consist of obligations under our operating leases for office space, capital leases for our co-location data center-related equipment, our commitment with a cloud-based hosting service provider, and noncancelable purchase commitments. The following table summarizes our contractual obligations as of January 31, 2019: (1) Amounts include our commitment with a cloud-based hosting service provider for $4.0 million within one year and $11.0 million within one to three years. Indemnification Agreements In the ordinary course of business, we enter into agreements of varying scope and terms pursuant to which we agree to indemnify customers, vendors, lessors, business partners, and other parties with respect to certain matters, including, but not limited to, losses arising out of the breach of such agreements, services to be provided by us, or from intellectual property infringement claims made by third parties. In addition, we have entered into indemnification agreements with our directors and certain officers and employees that will require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors, officers, or employees. There are no claims that we are aware of at this time that could have a material effect on our balance sheets, statements of operations and comprehensive loss, or statements of cash flows. Off-Balance Sheet Arrangements As of January 31, 2019, we did not have any relationships with organizations or financial partnerships, such as structured finance or special purpose entities that would 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 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. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and related disclosure of contingent assets and liabilities, revenue and expenses. Generally, we base our estimates on historical experience and on various other assumptions in accordance with GAAP that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. 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 We derive our revenue primarily from subscription services and professional services. Revenue is recognized when control of these services is transferred to our customers, in an amount that reflects the consideration we expect to be entitled to in exchange for those services, net of any sales taxes. We determine revenue recognition through the following steps: • identification of the contract, or contracts, with a customer; • identification of the performance obligations in the contract; • determination of the transaction price; • allocation of the transaction price to the performance obligations in the contract; and • recognition of revenue when, or as, we satisfy a performance obligation. Subscription revenue Subscription revenue primarily consists of fees from customers for access to our cloud-based platform. Our subscription revenue is recognized on a ratable basis over the subscription contract term, beginning on the date the access to our platform is provided, as no implementation work is required, if consideration we are entitled to receive is considered probable of collection. Subscription contracts generally have terms of one year or one month, are billed in advance, and are non-cancelable. The subscription arrangements do not allow the customer the contractual right to take possession of the platform; as such, the arrangements are considered to be service contracts. Certain of our subscription contracts contain performance guarantees related to service continuity. To date, refunds related to such guarantees have been immaterial in all periods presented. Professional services revenue Professional services revenue primarily includes revenue recognized from fees for consulting and training services. Our consulting services consist of platform configuration and use case optimization, and are primarily invoiced on a time and materials basis, monthly in arrears. Services revenue is recognized over time, as service hours are delivered. Smaller consulting engagements are on occasion provided for a fixed fee. These smaller consulting arrangements are typically of short duration (less than three months). In these cases, revenue is recognized over time, based on the proportion of hours of work performed, compared to the total hours expected to complete the engagement. Configuration and use case optimization services do not result in significant customization or modification of the software platform or user interface. Training services are billed in advance, on a fixed-fee basis, and revenue is recognized after the training program is delivered, or after customer’s right to receive training services expires. Associated out-of-pocket travel expenses related to the delivery of professional services are typically reimbursed by the customer. Out-of-pocket expense reimbursements are recognized as revenue at the point in time, or as, the distinct performance obligation to which they relate is delivered. Out-of-pocket expenses are recognized as cost of professional services revenue as incurred. On occasion, we sell our subscriptions to third-party resellers. The price at which we sell to the reseller is typically discounted, as compared to the price at which we would sell to an end customer, in order to enable the reseller to realize a margin on the eventual sale to the end customer. As we retain a fixed amount of the contract from the reseller, and do not have visibility into the pricing provided by the reseller to the end customer, the revenue is recorded net of any reseller margin. Contracts with multiple performance obligations Some of our contracts with customers contain multiple performance obligations. We account for individual performance obligations separately, as they have been determined to be distinct, i.e., the services are separately identifiable from other items in the arrangement and the customer can benefit from them on their own or with other resources that are readily available to the customer. The transaction price is allocated to the distinct performance obligations on a relative stand-alone selling price basis. Stand-alone selling prices are determined based on the prices at which we separately sell subscription services, consulting services and training, and based on our overall pricing objectives, taking into consideration market conditions, value of our contracts, the types of offerings sold, customer demographics, and other factors. Accounts receivable Accounts receivable are primarily comprised of trade receivables that are recorded at the invoice amount, net of an allowance for doubtful accounts. Subscription fees billed in advance of the related subscription term represent contract liabilities and are presented as accounts receivable and deferred revenues upon establishment of the unconditional right to invoice, typically upon signing of the non-cancelable service agreement. The allowance for doubtful accounts is based on the Company’s assessment of the collectability of accounts by considering the composition of the accounts receivable aging and historical trends on collectability. Amounts deemed uncollectible are recorded to the allowance for doubtful accounts in the consolidated balance sheets with an offsetting decrease in related deferred revenue and a charge to general and administrative expense in the statements of operations. Deferred revenue Deferred revenue is recorded for subscription services contracts upon establishment of unconditional right to payment under a non-cancelable contract before transferring the related services to the customer. Deferred revenue for such services is amortized into revenue over time, as those subscription services are delivered. Similarly, we record deferred revenue for fixed-fee professional services upon establishment of an unconditional right to payment under a non-cancelable contract. Deferred revenue for training services is recognized as revenue upon delivery of training services or upon expiration of customer’s right to receive such services. Deferred revenue for consulting services is recognized as hours of service are delivered to the customer. Deferred commissions The majority of sales commissions earned by our sales force are considered incremental and recoverable costs of obtaining a contract with a customer. Sales commission are paid on initial contracts and on any upsell contracts with a customer. No sales commissions are paid on customer renewals. Sales commissions are deferred and then amortized on a straight-line basis over a period of benefit that we have determined to be three years. We determined the period of benefit by taking into consideration our customer contracts, expected customer life, the expected life of our technology and other factors. Amortization expense is included in sales and marketing expenses in the accompanying statements of operations. Internal-use software development costs The Company capitalizes certain qualifying costs incurred during the application development stage in connection with the development of internal-use software. Costs related to preliminary project activities and post-implementation activities are expensed in research and development (“R&D”) as incurred. R&D expenses consist primarily of employee-related costs, hardware- and software-related costs, costs of outside services used to supplement our internal staff, and overhead allocations. Internal-use software costs of $3.5 million were capitalized in the year ended January 31, 2019, of which $1.5 million related to costs incurred during the application development stage of software development for the Company’s platform to which subscriptions are sold. Internal-use software costs of $3.4 million were capitalized in the year ended January 31, 2018, none of which related to costs incurred during the application development stage of software development for the Company’s platform to which subscriptions are sold. Capitalized software development costs are included within property and equipment, net on the balance sheets, and are amortized over the estimated useful life of the software, which is typically three years. The related amortization expense is recognized in the consolidated statements of comprehensive loss within the function that receives the benefit of the developed software. The Company evaluates the useful lives of these assets and tests for impairment whenever events or changes in circumstances occur that could impact the recoverability of these assets. Business combinations When we acquire a business, the purchase price is allocated to the net tangible and identifiable intangible assets acquired based on their estimated fair values. Any residual purchase price is recorded as goodwill. The allocation of the purchase price requires management to make significant estimates in determining the fair values of assets acquired and liabilities assumed, especially with respect to intangible assets. These estimates can include, but are not limited to, the cash flows that an asset is expected to generate in the future, the appropriate weighted-average cost of capital and the cost savings expected to be derived from acquiring an asset. These estimates are inherently uncertain and unpredictable. During the measurement period, which may be up to one year from the acquisition date, adjustments to the fair value of these tangible and intangible assets acquired and liabilities assumed may be recorded, with the corresponding offset to goodwill. Upon the conclusion of the measurement period or final determination of the fair value of assets acquired or liabilities assumed, whichever comes first, any subsequent adjustments are recorded to our consolidated statements of operations. Goodwill on our consolidated balance sheets totaled $5.5 million and $0.4 million at January 31, 2019 and 2018, respectively. Goodwill is tested for impairment annually on September 1, or more frequently if events or changes in circumstances indicate that impairment may exist. Based on the annual assessment, no indicator of impairment was noted and therefore no goodwill impairments were recorded during the years ended January 31, 2019, 2018, or 2017. Self-funded health insurance In December 2017, the Company elected to partially self-fund its health insurance plan. To reduce its risk related to high-dollar claims, the Company maintains individual and aggregate stop-loss insurance. The Company estimates its exposure for claims incurred but not paid at the end of each reporting period and uses historical claims data to estimate its self-funded insurance liability. As of January 31, 2019 and 2018, the Company’s net self-insurance reserve estimate was $0.8 million and $0.6 million, respectively, included in other accrued liabilities in the accompanying consolidated balance sheets. Share-based compensation The Company measures and recognizes compensation expense for all share-based awards granted to employees and directors, based on the estimated fair value of the award on the date of grant. Expense is recognized on a straight-line basis over the vesting period of the award based on the estimated portion of the award that is expected to vest. The Company uses the Black-Scholes option pricing model to measure the fair value of stock option awards when they are granted. The Company makes several estimates in determining share-based compensation and these estimates generally require significant analysis and judgment to develop. These assumptions and estimates are as follows: Fair value of common stock. As our stock was not publicly traded prior to our IPO, we were required to estimate the fair value of common stock, as discussed in “Valuation of Common Stock” below. Expected term. The expected term of options represents the period that share-based awards are expected to be outstanding. We estimate the expected term using the simplified method due to the lack of historical exercise activity for our company. Risk-free interest rate. The risk-free interest rate is based on the implied yield available at the time of the option grant in the U.S. Treasury securities at maturity with a term equivalent to the expected term of the option. Expected volatility. Expected volatility is based on an average volatility of stock prices for a group of publicly traded peer companies. In considering peer companies, we assess characteristics such as industry, state of development, size and financial leverage. Dividend yield. We have never declared or paid any cash dividends and do not plan to pay cash dividends in the foreseeable future, and, therefore, use an expected dividend yield of zero. If any assumptions used in the Black-Scholes option pricing model change significantly, share-based compensation for future awards may differ materially compared with the awards granted previously. In addition to the assumptions used in the Black-Scholes option pricing model, we must also estimate a forfeiture rate to calculate the share-based compensation expense for awards. Our forfeiture rate is derived from historical employee termination behavior. If the actual number of forfeitures differs from these estimates, additional adjustments to compensation expense will be required. Valuation of common stock Given the absence of an active market for our common stock prior to our IPO, our board of directors was required to estimate the fair value of our common stock at the time of each option grant based upon several factors, including its consideration of input from management and contemporaneous third-party valuations. The exercise price for all stock options granted was at the estimated fair value of the underlying common stock, as estimated on the date of grant by our board of directors in accordance with the guidelines outlined in the American Institute of Certified Public Accountants, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. Each fair value estimate was based on a variety of factors, which included the following: •contemporaneous valuations performed by an unrelated third-party valuation firm; •the prices, rights, preferences and privileges of our preferred stock relative to those of our common stock; •the lack of marketability of our common stock; •our actual operating and financial performance; •current business conditions and projections; •hiring of key personnel and the experience of our management; •our history and the timing of the introduction of new applications and capabilities; •our stage of development; •the likelihood of achieving a liquidity event, such as an initial public offering or a merger or acquisition of our business given prevailing market conditions; •the market performance of comparable publicly traded companies; and •U.S. and global capital market conditions. In valuing our common stock, our board of directors determined the equity value of our business using valuation methods they deemed appropriate under the circumstances applicable at the valuation date. One method, the market approach, estimates value based on a comparison of our company to comparable public companies in a similar line of business. To determine our peer group of companies, we considered public enterprise cloud-based application providers and selected those that are similar to us in size, stage of life cycle, and financial leverage. From the comparable companies, a representative market value multiple is determined which is applied to our operating results to estimate the value of our company. The market value multiple was determined based on consideration of the last 12-month revenue and the implied multiples for each of the comparable companies. Another method, the prior sale of our stock approach, estimates value by considering any prior arm’s length sales of our equity. When considering prior sales of our equity, the valuation considers the size of the equity sale, the relationship of the parties involved in the transaction, the timing of the equity sale, and our financial condition at the time of the sale. Once an equity value was determined, our board of directors used one of the following methods to allocate the equity value to each of our classes of stock: (1) the option pricing method, or OPM; or (2) a probability weighted expected return method, or PWERM. The OPM treats common stock and preferred stock as call options on a business, with exercise prices based on the liquidation preference of the preferred stock. Therefore, the common stock only has value if the funds available for distribution to the holders of common stock exceed the value of the liquidation preference of the preferred stock at the time of a liquidity event, such as a merger, sale, or initial public offering, assuming the business has funds available to make a liquidation preference meaningful and collectible by shareholders. The common stock is modeled as a call option with a claim on the business at an exercise price equal to the remaining value immediately after the preferred stock is liquidated. The OPM uses the Black-Scholes option pricing model to price the call option. The estimated value of the common stock derived from the OPM is then discounted by a non-marketability factor due to the fact that shareholders of private companies do not have access to trading markets similar to those enjoyed by shareholders of public companies, which impacts liquidity. The PWERM employs various market approach calculations depending upon the likelihood of various liquidation scenarios. For each of the various scenarios, an equity value is estimated and the rights and preferences for each shareholder class are considered to allocate the equity value to common shares. The common stock value is then multiplied by a discount factor reflecting the calculated discount rate and the timing of the event. Lastly, the common stock value is multiplied by an estimated probability for each scenario. The probability and timing of each scenario are based on discussions between our board of directors and our management team. Under the PWERM, the value of our common stock is based upon possible future exit events for our company. Subsequent to the closing of the IPO on May 1, 2018, the fair value of our common stock is represented by the price quoted on the New York Stock Exchange. Recent accounting pronouncements See the sections titled “Summary of Significant Accounting Policies-Recently adopted accounting pronouncements” and “Recent accounting pronouncements not yet adopted” in Note 2 to our Consolidated Financial Statements for more information. Emerging growth company status As an “emerging growth company,” the JOBS Act allows us to delay adoption of new or revised accounting pronouncements 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. While we have not made such an irrevocable election, we have not delayed the adoption of any applicable accounting standards.

<s>[INST] Overview We empower everyone to improve how they work. We are a leading cloudbased platform for work execution, enabling teams and organizations to plan, capture, manage, automate, and report on work at scale, resulting in more efficient processes and better business outcomes. We were founded in 2005 with a vision to build a universal application for work management that does not require coding capabilities. Unstructured or dynamic work is work that has historically been managed using a combination of email, spreadsheets, whiteboards, phone calls, and inperson meetings to communicate with team members and complete projects and processes. It is frequently changing, often adhoc, and highly reactive to new information. Our platform helps manage this kind of unstructured work and serves as a single source of truth across work processes, fostering accountability and engagement within teams, leading to more efficient decisionmaking and better business outcomes. We generate revenue primarily from the sale of subscriptions to our cloudbased platform. For subscriptions, customers select the plan that meets their needs and can begin using Smartsheet within minutes. We offer four subscription levels: Individual, Business, Enterprise, and Premier, the pricing for which varies by the capabilities provided. Customers can also purchase Connectors, which provide data integration and automation to thirdparty applications. We also offer Control Center and Accelerators, which enable customers to implement solutions for a specific use case for large scale projects, initiatives, or processes. Professional services are offered to help customers create and administer solutions for specific use cases and for training purposes. Customers can begin using our platform by purchasing a subscription directly from our website or through our sales force, starting a free trial, or working as a collaborator on a project. Key Business Metrics We review the following key business metrics to evaluate our business, measure our performance, identify trends affecting our business, formulate business plans, and make strategic decisions. Number of domainbased customers We define domainbased customers as organizations with a unique email domain name such as @cisco. All other customers, which we designate as ISP customers, are typically small teams or individuals who register for our services with an email address hosted on a widely used domain such as @gmail, @outlook, or @yahoo. We believe that the number of customers, particularly our domainbased customers, using our platform is an indicator of our market penetration, the growth of our business, and our potential future business opportunities. Increasing awareness of our platform and its broad range of capabilities, coupled with the mainstream adoption of cloudbased technology, has expanded the diversity of our customer base to include organizations of all sizes across virtually all industries. Average ACV per domainbased customer We use average annualized contract value (“ACV”) per domainbased customer to measure customer commitment to our platform and sales force productivity. We define average ACV per domainbased customer as total outstanding ACV for domainbased subscriptions as of the end of the reporting period divided by the number of domainbased customers as of the same date. Dollarbased net retention rate We calculate dollarbased net retention rate as of a period end by starting with the ACV from the cohort of all customers as of the 12 months prior to such period end (“Prior Period ACV”). We then calculate the ACV from these same customers as of the current period end (“Current Period ACV”). Current Period ACV includes any upsells and is net of contraction or attrition over the trailing 12 months, but excludes subscription revenue from new customers in the current period. We then divide the total Current Period ACV by the total Prior Period ACV to arrive at the dollarbased net retention rate. The dollarbased net retention rate is used by us to evaluate the longterm value of our customer relationships and is driven by our ability to retain and expand the subscription revenue generated from our existing customers. Components of Results of Operations Revenue Subscription revenue Subscription revenue primarily consists of fees from customers for access to our cloudbased platform. We recognize subscription revenue ratably over the term of the subscription period beginning on the date access to our platform is provided, as no implementation work is required, assuming all other revenue recognition criteria have been met. Professional services revenue Professional services revenue includes primarily fees for consulting and training services. Our consulting services consist of platform configuration and use case optimization, and are primarily invoiced on a time and materials basis, with some smaller engagements being provided for a fixed fee. We recognize revenue [/INST] Negative. </s>

Lyft, 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 of our financial condition and results of operations should be read in conjunction with the section titled “Selected Consolidated Financial and Other Data” and the consolidated financial statements and related notes thereto included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Factors that could cause or contribute to such differences include those identified below and those discussed in the section titled “Risk Factors” and other parts of this Annual Report on Form 10-K. Our historical results are not necessarily indicative of the results that may be expected for any period in the future. Financial Results for the Year Ended December 31, 2019 •Total revenue was $3.6 billion, an increase of 68% year-over-year. •Total costs and expenses were $6.3 billion, including stock-based compensation expense of $1.6 billion and insurance costs generally required under TNC and city regulations for ridesharing and bike and scooter rentals of $1.2 billion, of which $219.2 million was related to changes to insurance reserves attributed to historical periods. This adverse development is largely attributable to historical auto losses that predate our relationship with our new third-party administrators for insurance claims. •Loss from operations was $2.7 billion. •Net loss was $2.6 billion. •Cash used in operating activities was $105.7 million. •Cash and cash equivalents and restricted cash and cash equivalents were $564.5 million. Active Rider Trends We continue to experience growth in the number of Active Riders as well as revenue per Active Rider. The number of Active Riders is a key indicator of the scale of our community and awareness of our brand. Revenue per Active Rider represents our ability to drive usage and monetization of our platform. We define Active Riders as all riders who take at least one ride during a quarter where the Lyft Platform processes the transaction. An Active Rider is identified by a unique phone number. If a rider has two mobile phone numbers or changed their phone number and such rider took rides using both phone numbers during the quarter, that person would count as two Active Riders. If a rider has a personal and business profile tied to the same mobile phone number, that person would be considered a single Active Rider. If a ride has been requested by an organization using our Concierge offering for the benefit of a rider, we exclude this rider in the calculation of Active Riders. In the fourth quarter of 2019, we updated the definition of Active Riders to include riders who have migrated from the legacy Motivate platform to the Lyft platform, which resulted in a 0.01% increase, or an additional 1,167 Active Riders, in the fourth quarter. Prior to the fourth quarter of 2019, for Motivate, only riders that had taken a ride or rented a bike or scooter through the Lyft App during the quarter were counted as an Active Rider. This change had no impact on the Active Riders disclosed in any of the prior periods presented. Initial Public Offering Our IPO Registration Statement was declared effective on March 28, 2019 and our Class A common stock began trading on the Nasdaq Global Select Market on March 29, 2019. Our IPO was completed on April 2, 2019 and the partial exercise of the underwriters’ option to purchase additional shares was completed on April 9, 2019. Our consolidated financial statements as of December 31, 2019 and for the year then-ended reflect the sale by us of an aggregate of 35,496,845 shares in our IPO, including pursuant to the partial exercise of the underwriters’ option to purchase additional shares, at the public offering price of $72.00 per share, for aggregate net proceeds to us of approximately $2.5 billion, after underwriting discounts and commissions and offering expenses, and the conversion of all outstanding shares of our redeemable convertible preferred stock into an aggregate of 219,175,709 shares of Class A common stock. Our consolidated financial statements as of December 31, 2019 and for the year then-ended reflect stock-based compensation expense of $1.6 billion primarily associated with the vesting of RSUs for which the requisite service condition was met as of December 31, 2019. The liquidity event condition for RSUs, if any, was satisfied upon the effectiveness of our IPO Registration Statement on March 28, 2019. Critical Accounting Policies and Estimates Our consolidated financial statements and the related notes thereto included elsewhere in this Annual Report on Form 10-K are prepared in accordance with GAAP. The preparation of consolidated financial statements also requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs and expenses and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ significantly from our estimates. To the extent that there are differences between our estimates and actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected. We believe that the accounting policies described below involve a significant degree of judgment and complexity. Accordingly, we believe these are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of operations. For further information, see Note 2 of the notes to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. Revenue Recognition Ridesharing Marketplace We recognize revenue from fees paid by drivers for use of our Lyft platform offerings using the five-step revenue recognition model described in Note 2 of the notes to our consolidated financial statements, in accordance with ASC 606. Drivers enter into terms of service (“ToS”) with us in order to use our Lyft Driver app. We provide a service to drivers to complete a successful transportation service for riders. This service includes on-demand lead generation that assists drivers to find, receive and fulfill on-demand requests from riders seeking transportation services and related collection activities using our Lyft platform. As a result, our single performance obligation in the transaction is to connect drivers with riders to facilitate the completion of a successful transportation service for riders. We evaluate the presentation of revenue on a gross versus net basis based on whether we act as a principal by controlling the transportation service provided to the rider or whether we act as an agent by arranging for third parties to provide the service to the rider. We facilitate the provision of a transportation service by a driver to a rider (the driver’s customer) in order for the driver to fulfill their contractual promise to the rider. The driver fulfills their promise to provide a transportation service to their customer through use of the Lyft platform. While we facilitate setting the price for transportation services, the drivers and riders have the discretion in accepting the transaction price through the platform. We do not control the transportation services being provided to the rider nor do we have inventory risk related to the transportation services. As a result, we act as an agent in facilitating the ability for a driver to provide a transportation service to a rider. We report revenue on a net basis, reflecting the service fees and commissions owed to us from the drivers as revenue, and not the gross amount collected from the rider. We made this determination of not being primarily responsible for the services since we do not promise the transportation services, do not contract with drivers to provide transportation services on our behalf, do not control whether the driver accepts or declines the transportation request via the Lyft platform, and do not control the provision of transportation services by drivers to riders at any point in time either before, during, or after, the trip. We consider the ToS and our customary business practices in identifying the contracts under ASC 606. As our customary business practice, a contract exists between the driver and us when the driver’s ability to cancel the trip lapses, which typically is upon pickup of the rider. We collect the fare and related charges from riders on behalf of drivers using the rider’s pre-authorized credit card or other payment mechanism and retain any fees owed to us before making the remaining disbursement to drivers; thus the driver’s ability and intent to pay is not subject to significant judgment. We earn service fees and commissions from the drivers either as the difference between an amount paid by a rider based on an upfront quoted fare and the amount earned by a driver based on actual time and distance for the trip or as a fixed percentage of the fare charged to the rider. In an upfront quoted fare arrangement, as we do not control the driver’s actions at any point in the transaction to limit the time and distance for the trip, we take on risks related to the driver’s actions which may not be fully mitigated. We earn a variable amount from the drivers and may record a loss from a transaction, which is recorded as a reduction to revenue, in instances where an up-front quoted fare offered to a rider is less than the amount we are committed to pay the driver. We recognize revenue upon completion of a ride as the single performance obligation is satisfied and we have the right to receive payment for the services rendered upon the completion of the ride. We offer various incentive programs to drivers that are recorded as reduction to revenue if we do not receive a distinct good or service in consideration or if we cannot reasonably estimate the fair value of goods or services received. Bikes and Scooters In 2018, we started to generate revenue from subscription fees and single-use ride fees paid by riders of shared bikes and scooters to access our network of shared bikes and scooters. Subscription fees are recognized on a straight-line basis over the subscription period. Single-use ride fees are recognized upon completion of each ride. Express Drive Program Revenue During 2018, we expanded our Express Drive program with Flexdrive. Under our agreement with Flexdrive, we are required to pay fleet operating costs over periods ranging from two to three years for vehicles that we have committed will remain in a dedicated fleet to be ready to be rented by drivers using our platform. Fleet operating costs include monthly fixed payments and other vehicle operating costs. Such payments are required to be made regardless of whether the vehicles are rented by drivers using our platform. Drivers who rent vehicles through the arrangement with Flexdrive are charged rental fees which we collect from the driver. We collect rental fees by deducting such amounts from the driver’s on our platform, or though charging the driver’s credit card. We are a principal in car rental transactions involving Flexdrive as we become a lessee for each vehicle prior to its rental by a driver and are committed to the payment of fixed monthly payments and other vehicle operating costs. We sublease the vehicles to drivers when they are rented by drivers and, as a result, we consider ourselves to be the accounting sublessor in our arrangements with drivers. Vehicle leases with Flexdrive are classified as operating leases and, accordingly, each sublease representing a car rental transaction with a driver is also an operating lease. Sublease income (revenue) and head lease expense for our transactions involving Flexdrive are recognized on a gross basis in our consolidated financial statements. The rental revenue recognized for the years ended December 31, 2019 and 2018 under the Flexdrive arrangement was $111.3 million and $54.8 million, respectively. Revenue from the Express Drive program was not material for the year ended December 31, 2017. In February 2020, we signed and closed the acquisition of Flexdrive, refer to Note 16 “Subsequent Events” to our consolidated financial statements for information regarding this acquisition. Insurance Reserves We utilize both a wholly-owned insurance subsidiary and third-party insurance, which may include deductibles and self-insured retentions, to insure or reinsure costs, including auto liability, uninsured and underinsured motorist, auto physical damage and general business liabilities up to certain limits. The recorded liabilities reflect the estimated ultimate cost for claims incurred but not paid and claims that have been incurred but not yet reported and any estimable administrative run-out expenses related to the processing of these outstanding claim payments. Liabilities are evaluated for appropriateness with claims reserve valuations provided by an independent third-party actuary on a quarterly basis. Insurance claims may take several years to completely settle, and we have limited historical loss experience. Because of the limited operational history, we make certain assumptions based on currently available information and industry statistics and utilize actuarial models and techniques to estimate the reserves. A number of factors can affect the actual cost of a claim, including the length of time the claim remains open, economic and healthcare cost trends and the results of related litigation. Furthermore, claims may emerge in future years for events that occurred in a prior year at a rate that differs from previous actuarial projections. Reserves are continually reviewed and adjusted as necessary as experience develops or new information becomes known. However, while we believe that the insurance reserve amount is adequate, the ultimate liability may be in excess of, or less than, the amount provided. As a result, the net amounts will be paid to settle the liability and when amounts will be paid may vary from the estimated amounts provided for on the consolidated balance sheets. Stock-Based Compensation We incur stock-based compensation expense primarily from restricted stock units (“RSUs”), stock options, and stock purchase rights granted under the Company’s Employee Stock Purchase Plan (“ESPP”). We estimate the fair value of stock options granted to employees, directors and consultants and ESPP purchase rights using the Black-Scholes option-pricing model. The fair value of stock options that are expected to vest is recognized as compensation expense on a straight-line basis over the requisite service period. We recognize compensation expense related to the ESPP purchase rights on a straight-line basis over the offering period, which is typically 12 months. The fair value of RSUs is estimated based on the fair market value of our common stock on the date of grant, which subsequent to our IPO is determined based on the closing price of our Class A common stock as reported on the date of grant. Prior to our IPO, we granted RSUs which vest upon the satisfaction of both a service condition and a performance condition. Compensation expense for RSUs with service and performance conditions is amortized on a graded basis over the requisite service period as long as the performance condition in the form of a specified liquidity event is probable to occur. The liquidity event condition was satisfied upon the effectiveness of our IPO Registration Statement on March 28, 2019. On that date we recorded a cumulative stock-based compensation expense of $857.2 million using the accelerated attribution method for the RSUs for which the service condition was satisfied as of March 28, 2019. The remaining unrecognized stock-based compensation expense related to these RSUs is recorded over their remaining requisite service periods. The compensation expense for RSUs granted after March 28, 2019, which vest upon satisfaction of a service-based condition only, is recognized on a straight-line basis over the requisite service period. As of December 31, 2019, the total unrecognized compensation cost related to RSUs was $1.1 billion, which we expect to recognize over the remaining weighted-average period of approximately 2.6 years. Stock-based compensation expense is based on awards ultimately expected to vest and reflects estimated forfeitures. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from initial estimates. Business Combinations We account for our business combinations using the acquisition method of accounting, which requires, among other things, allocation of the fair value of purchase consideration to the tangible and intangible assets acquired and liabilities assumed at their estimated fair values on the acquisition date. The excess of the fair value of purchase consideration over the values of these identifiable assets and liabilities is recorded as goodwill. When determining the fair value of assets acquired and liabilities assumed, we make significant estimates and assumptions, especially with respect to intangible assets. 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, not to exceed one year from the date of acquisition, we may record adjustments to the assets acquired and liabilities assumed, with a corresponding offset to goodwill if new information is obtained related to facts and circumstances that existed as of the acquisition date. After the measurement period, any subsequent adjustments are reflected in the consolidated statements of operations. Acquisition costs, such as legal and consulting fees, are expensed as incurred. Goodwill Goodwill represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired in a business combination. Intangible assets resulting from the acquisition of entities accounted for using the purchase method of accounting are estimated by us based on the fair value of assets received. Intangible assets are amortized on a straight-line basis over the estimated useful lives which range from two to twelve years. Goodwill is not subject to amortization, but is tested for impairment on an annual basis during the fourth quarter or whenever events or changes in circumstances indicate the carrying amount of the goodwill may not be recoverable. As part of the annual goodwill impairment test, we first perform a qualitative assessment to determine whether further impairment testing is necessary. If, as a result of its qualitative assessment, it is more-likely-than-not that the fair value of the reporting unit is less than its carrying amounts, the quantitative impairment test will be required. There was no impairment of goodwill recorded for the years ended December 31, 2019, 2018 and 2017. Recent Accounting Pronouncements In February 2016, the FASB issued ASU No. 2016-02 “Leases (Topic 842),” which increases lease transparency and comparability among organizations. Under the new standard, lessees will be required to recognize all assets and liabilities arising from leases on the balance sheet, with the exception of leases with a term of 12 months or less, which permits a lessee to make an accounting policy election by class of underlying asset not to recognize lease assets and liabilities. In March 2018, the FASB approved an alternative transition method to the modified retrospective approach, which eliminates the requirement to restate prior period financial statements and requires the cumulative effect of the retrospective allocation to be recorded as an adjustment to the opening balance of retained earnings at the date of adoption. We adopted the standard on January 1, 2019 using the transition method that provides for a cumulative-effect adjustment to retained earnings upon adoption. There was no impact on our accumulated deficit as of January 1, 2019 as a result of the adoption of this standard. The consolidated financial statements for the year ended December 31, 2019 is presented under the new standard, while the comparative periods presented are not adjusted and continue to be reported in accordance with our historical accounting policy. The adoption of the new lease standard resulted in the recognition of operating lease right-of-use assets of $285.6 million and operating lease liabilities, including operating lease liabilities - current, of $314.1 million as of January 1, 2019. In connection with the adoption of this standard, deferred rent of $28.5 million, which was previously recorded in accrued and other current liabilities and in other long-term liabilities on the consolidated balance sheet as of December 31, 2018, was derecognized. See Note 2 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for recently issued accounting pronouncements not yet adopted as of the date of this report. Components of Results of Operations Revenue We primarily generate revenue from drivers for use of our ridesharing marketplace, riders for use of our bikes and scooters and renters under our Express Drive program with Flexdrive. With our rideshare marketplace, our core offering since 2012, we generate substantially all of our revenue from service fees and commissions paid by drivers for use of our ridesharing marketplace to connect with riders to successfully complete a ride. Driver earnings are primarily based on the time and distance of the ride. We receive a service fee plus a commission that varies based on the price of the ride. We recognize revenue upon the completion of each ride. We report revenue based upon the net amount earned, which is reduced by certain driver and rider incentives we provided. In 2018, we started to generate revenue from subscription fees paid by riders to access our network of shared bikes and single-use ride fees paid by riders to access our network of shared bikes and scooters. Revenue is earned based on the gross amounts for subscription fees or single-use ride fees paid by riders for use of our bikes and scooters, reduced by certain rider incentives we provide. Revenue from the network of shared bikes and scooters was not material for the years ended December 31, 2019 and 2018. Under the Express Drive program, we connect drivers who need access to a car with third-party rental car companies. We facilitate the car rental transactions between car rental companies and drivers. During 2018, we expanded our Express Drive program with Flexdrive. Under our agreement with Flexdrive, we are required to pay fleet operating costs over periods ranging from two to three years for vehicles that we have committed will remain in a dedicated fleet to be ready to be rented by drivers using our platform. Fleet operating costs include monthly fixed payments and other vehicle operating costs. Such payments are required to be made regardless of whether the vehicles are rented by drivers using our platform. Drivers who rent vehicles through the arrangement with Flexdrive are charged rental fees, which we collect from the driver. We collect rental fees by deducting such amounts from the driver’s earnings on our platform, or through charging the driver’s credit card. We are a principal in car rental transactions involving Flexdrive as we become a lessee for each vehicle prior to its rental by a driver and are committed to the payment of fixed monthly amounts and other fleet operating costs. We sublease the vehicles to drivers when they are rented by drivers and, as a result, we consider ourselves to be the accounting sublessor in its arrangements with drivers. Vehicle leases with Flexdrive are classified as operating leases and, accordingly, each sublease representing a car rental transaction with a driver is also an operating lease. Sublease income (revenue) and head lease expense for our transactions involving Flexdrive are recognized on a gross basis in the consolidated financial statements. The rental revenue recognized under the Flexdrive program was $111.3 million and $54.8 million for the years ended December 31, 2019 and 2018. Revenue from the Express Drive program was not material for the year ended December 31, 2017. In February 2020, we signed and closed the acquisition of Flexdrive, refer to Note 16 “Subsequent Events” to our consolidated financial statements for information regarding this acquisition. In some cases, we also earn Concierge platform fees from organizations that use our Concierge offering, which is a product that allows organizations to request rides for their customers and employees through our ridesharing marketplace. Concierge platform fees are earned as a fixed dollar amount per ride or a percentage of the ride price depending on the contract and such Concierge platform fee revenue is recognized on a gross basis. Cost of Revenue Cost of revenue primarily consists of insurance costs that are generally required under TNC and city regulations for ridesharing and bike and scooter rentals, respectively, payment processing charges, including merchant fees, chargebacks and failed charges, hosting and platform-related technology costs, certain direct costs related to bikes and scooters and car rental programs for Lyft Rentals and Flexdrive, personnel-related compensation costs and amortization of technology-related intangible assets. We plan to continue to drive an increased volume of rides and expand the reach of our platform through increased usage, geographic expansion, as well as through additional offerings. We expect that cost of revenue will increase in absolute dollars in future periods and vary from period to period as a percentage of revenue. Operations and Support Operations and support expenses primarily consist of personnel-related compensation costs of local operations teams and teams who provide phone, email and chat support to users, bike and scooter fleet operations support costs, driver background checks and onboarding costs, fees paid to third parties providing operations support, facility costs and certain car rental fleet support costs. We plan to continue to invest in our operations and support to ensure that we continue to provide exceptional support to users on our platform and grow our local operations. We expect that operations and support expenses will increase in absolute dollars in future periods and vary from period to period as a percentage of revenue. Research and Development Research and development expenses primarily consist of personnel-related compensation costs and facilities costs. Such expenses include costs related to our autonomous vehicle technology initiatives. Research and development costs are expensed as incurred. We plan to continue to hire employees to support our research and development efforts to expand the capabilities and scope of our platform and enhance the user experience. We expect that research and development expenses will increase in absolute dollars in future periods partially as a result of the termination of a co-development partnership for developing autonomous technology at the end of 2019. We expect that research and development expenses will vary from period-to-period as a percentage of revenue. Sales and Marketing Sales and marketing expenses primarily consist of rider incentives, driver incentives for referring new drivers or riders, personnel-related compensation costs, advertising expenses, rider refunds and marketing partnerships with third parties. Sales and marketing costs are expensed as incurred. We plan to continue to invest in sales and marketing to attract and retain riders and drivers on our platform and increase our brand awareness. We expect that sales and marketing expenses will increase in absolute dollars in future periods and vary from period-to-period as a percentage of revenue in the near term. We expect that, in the long-term, our sales and marketing expenses will decrease as a percentage of revenue as we continue to drive efficiencies by reducing rider acquisition expenses and the use of rider incentives. General and Administrative General and administrative expenses primarily consist of personnel-related compensation costs, certain insurance costs that are generally not required under TNC regulations, professional services fees, certain loss contingency expenses including legal accruals and settlements, insurance claims administrative fees, facility costs, and other corporate costs. General and administrative expenses are expensed as incurred. We are incurring and expect to continue to incur additional general and administrative expenses as a result of operating as a public company, including expenses related to compliance with the rules and regulations of the SEC and the listing standards of the Nasdaq Global Select Market, additional corporate and director and officer insurance expenses, greater investor relations expenses and increased legal, audit and consulting fees. We also expect to increase the size of our general and administrative function to support our increased compliance requirements and the growth of our business. As a result, we expect that our general and administrative expenses will increase in absolute dollars in future periods and vary from period-to-period as a percentage of revenue. Interest Income Interest income consists primarily of interest earned on our cash and cash equivalents, and restricted and unrestricted short-term investments less interest expense incurred. Provision for Income Taxes Our provision for income taxes consists primarily of income taxes in foreign jurisdictions and U.S. state income taxes. As we expand the scale of our international business activities, any changes in the U.S. and foreign taxation of such activities may increase our overall provision for income taxes in the future. We have a valuation allowance for our U.S. deferred tax assets, including federal and state net operating loss carryforwards, or NOLs. We expect to maintain this valuation allowance until it becomes more likely than not that the benefit of our federal and state deferred tax assets will be realized by way of expected future taxable income in the United States. Results of Operations The following table summarizes our historical consolidated statements of operations data: The following table sets forth the components of our consolidated statements of operations data as a percentage of revenue: Comparison of Years Ended December 31, 2019, 2018 and 2017 Revenue 2019 Compared to 2018 Revenue increased $1.5 billion, or 68%, in the year ended December 31, 2019 compared to the prior year, driven primarily by an increase in the number of Active Riders and the revenue generated on our platform per Active Rider. The number of Active Riders increased between 23% and 44% in each of the quarters of 2019 compared to the same periods in 2018 primarily due to the wider market adoption of ridesharing in addition to our initiatives to attract and retain riders. We also believe the publicity and attention surrounding our IPO contributed to the increase in the number of Active Riders in the first and second quarters of 2019 as compared to the same periods in 2018. Revenue per Active Rider increased between 22% and 36% in each of the quarters ended in 2019 as compared to the same periods in 2018 primarily from increased service fees and commissions including efficiencies from Shared Rides, greater efficiency and effectiveness of driver incentives, revenue from our network of shared bikes and scooters and revenue from the Flexdrive program. We expect that Active Rider growth on a percentage basis will continue to moderate and the number of Active Riders may fluctuate as we continue to focus on profitable growth by attracting and retaining the more valuable Active Riders and increasing revenue per Active Rider. 2018 Compared to 2017 Revenue increased $1.1 billion, or 103%, in the year ended December 31, 2018 compared to the prior year, driven primarily by an increase in the number of Active Riders and the revenue generated on our platform per Active Rider. The number of Active Riders increased between 47% and 74% in each of the quarters of 2018 compared to the same periods in 2017 primarily due to an increase in our market share and wider market adoption of ridesharing. Cost of Revenue 2019 Compared to 2018 Cost of revenue increased $933.1 million, or 75% in the year ended December 31, 2019 compared to the prior year. This increase was primarily due to an increase of $502.7 million in insurance costs related to ridesharing, largely driven by increases in insurance reserves related to current and historical periods as a result of updating actuarial assumptions to reflect currently available information, of which $215.2 million was related to an increase in changes to insurance reserves attributed to historical periods, an increase of $105.9 million in costs associated with the expansion of our network of shared bikes and scooters and the related insurance costs, largely driven by an increase in depreciation and disposal of bikes and scooters, an increase of $80.8 million in stock-based compensation expense largely driven by expenses associated with RSUs which we started to recognize upon the effectiveness of our IPO Registration Statement, an increase of $68.7 million in payment processing fees driven by an increase of ride activities on our platform, an increase of $68.2 million in web hosting fees to support our platform and an increase of $49.0 million in costs related to our relationship with Flexdrive as we expand the Express Drive Program. 2018 Compared to 2017 Cost of revenue increased $583.9 million, or 89%, in the year ended December 31, 2018 compared to the prior year. This increase was primarily due to an increase of $318.5 million in insurance costs, an increase of $109.6 million in payment processing fees, and an increase of $74.9 million in hosting and platform-related technology costs. Operations and Support 2019 Compared to 2018 Operations and support expenses increased $297.7 million, or 88%, in the year ended December 31, 2019 compared to the prior year. The increase was primarily due to an increase of $108.4 million in costs associated with expansion of our network of shared bikes and scooters largely driven by costs incurred in servicing and maintaining the fleet, an increase of $75.0 million in stock-based compensation expense largely driven by expenses associated with RSUs which we started to recognize upon the effectiveness of our IPO Registration Statement, an increase of $65.9 in personnel costs and facility-related costs driven by increases in headcount and real estate leases to support the growth of our operations and an increase of $29.5 million in costs related to Flexdrive as we expand the Express Drive Program. 2018 Compared to 2017 Operations and support expenses increased $154.9 million, or 84%, in the year ended December 31, 2018 compared to the prior year. The increase was primarily due to an increase of $47.0 million in personnel-related costs related to increased headcount to support the growth of our local operations, an increase of $44.5 million in user support costs, and an increase of $12.3 million in costs for driver background checks and onboarding, driven by the growth in the number of new drivers. Research and Development 2019 Compared to 2018 Research and development expenses increased $1.2 billion, or 400%, in the year ended December 31, 2019 compared to the prior year. The increase was primarily due to an increase of $967.8 million in stock-based compensation expense largely driven by expenses associated with RSUs which we started to recognize upon the effectiveness of our IPO Registration Statement, and an increase of $165.3 million in other personnel-related costs as a result of an increase in headcount to support our expanded research and development activities. The increase in research and development expenses was partially offset by an increase of $10.0 million in reimbursements by a partner for our autonomous technology efforts. 2018 Compared to 2017 Research and development expenses increased $164.2 million, or 120%, in the year ended December 31, 2018 compared to the prior year. The increase was primarily due to an increase of $151.4 million in personnel-related costs as a result of increased headcount, an increase of $18.2 million in contractor costs and an increase of $12.0 million in facilities costs. Our increased research and development expenses were driven by our efforts to launch new innovations, including our autonomous technology efforts, increase functionality on our platform and improve our efficiency in attracting and retaining drivers and riders. The increase in research and development expenses was partially offset by an increase of $45.0 million in reimbursements by a partner for our autonomous technology efforts. Sales and Marketing 2019 Compared to 2018 Sales and marketing expenses increased $10.4 million, or 1%, in the year ended December 31, 2019 compared to the prior year. The increase was primarily due to an increase of $82.2 million in costs related to incentive programs to attract riders and drivers to use the Lyft Platform and to increase rider loyalty and ride frequency, an increase of $71.8 million in stock-based compensation expense largely driven by expenses associated with RSUs which we started to recognize upon the effectiveness of our IPO Registration Statement, and an increase of $30.0 million in other personnel-related costs as a result of an increase in headcount to support our expanded growth in marketing activities. The increase in sales and marketing expenses was partially offset by a decrease of $141.8 million in costs associated with driver and passenger acquisition and a decrease of $23.1 million in costs associated with brand and other marketing. 2018 Compared to 2017 Sales and marketing expenses increased $236.7 million, or 42%, in the year ended December 31, 2018 compared to the prior year. The increase was primarily due to an increase in costs associated with driver referral and targeted rider incentive programs, which increased by $141.0 million from $155.6 million for the year ended December 31, 2017 to $296.6 million for the year ended December 31, 2018. The increase in the incentive programs was primarily due to an increased use of targeted rider incentive programs to increase rider loyalty and ride frequency. In addition, there was increased spending of $37.3 million on marketing programs, driven by an increase in driver advertising costs as we continue to grow our number of drivers, and an $18.3 million increase in personnel-related compensation costs driven by an increase in our headcount. General and Administrative 2019 Compared to 2018 General and administrative expenses increased $738.2 million, or 165%, in the year ended December 31, 2019 compared to the prior year. The increase was primarily due to an increase of $395.3 million in stock-based compensation expense largely driven by expenses associated with RSUs which we started to recognize upon the effectiveness of our IPO Registration Statement, an increase of $95.5 million in other personnel-related costs as a result of increased headcount to support our growth in operations and needs as a public company, an increase of $78.6 million in corporate insurance costs, an increase of $64.3 million in certain loss contingencies including legal accruals and settlements, and an increase of $51.6 million in consultant and advisory costs due to overall growth in our business. 2018 Compared to 2017 General and administrative expenses increased $226.5 million, or 102%, in the year ended December 31, 2018 compared to the prior year. The increase was primarily due to a $66.0 million increase in certain loss contingencies including legal accruals and settlements, a $35.7 million increase in consultant and advisory costs due to overall growth in our business, a $34.6 million increase in personnel-related compensation costs driven by an increase in our headcount and a $21.7 million increase in claims administrative fees. Interest Income 2019 Compared to 2018 Interest income increased $36.0 million, or 54%, in the year ended December 31, 2019 compared to the prior year. The increase was primarily driven by an increase in our cash equivalents and short-term investments balance as we invested the proceeds from our IPO. 2018 Compared to 2017 Interest income increased $46.2 million, or 228%, in the year ended December 31, 2018 compared to the prior year. The increase was primarily driven by increases in our cash equivalents and restricted and unrestricted short-term investments during 2018 as compared to 2017. Additionally, in 2018, the yield curve for maturities under one year increased and we earned a higher return on our investments. Quarterly Results of Operations The following table sets forth our unaudited quarterly consolidated results of operations for each of the eight quarters in the period ended December 31, 2019. These unaudited quarterly results of operations have been prepared 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, the financial information set forth in the table below reflects all normal recurring adjustments necessary for the fair statement of results of operations for these periods. Our historical results are not necessarily indicative of the results that may be expected in the future and the results of a particular quarter or other interim period are not necessarily indicative of the results for a full year. You should read the following unaudited quarterly consolidated results of operations in conjunction with the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes included elsewhere in this Annual Report on 10-K. Quarterly Consolidated Statements of Operations _______________ (1)Costs and expenses include stock-based compensation expense as follows: The three months ended March 31, 2019 includes $857.2 million of stock-based compensation expense related to RSUs, for which the performance-based condition, if any, was satisfied on March 28, 2019, the effective date of our IPO Registration Statement, and the requisite service conditions was met as of December 31, 2019. Consolidated Statements of Operations, as a percentage of revenue Non-GAAP Financial Measures _______________ (1)Contribution, Contribution Margin, Adjusted EBITDA and Adjusted EBITDA Margin are non-GAAP financial measures and metrics. For more information regarding our use of these measures and a reconciliation of these measures to the most comparable GAAP measures, see “Reconciliation of Non-GAAP Financial Measures.” Contribution and Contribution Margin Contribution and Contribution Margin are measures used by our management to understand and evaluate our operating performance and trends. We believe Contribution and Contribution Margin are key measures of our ability to achieve profitability and increase it over time. Contribution Margin has generally increased over the periods presented as revenue has increased at a faster rate than the costs included in the calculation of Contribution. We define Contribution as revenue less cost of revenue, adjusted to exclude the following items from cost of revenue: •amortization of intangible assets; •stock-based compensation expense; •payroll tax expense related to stock-based compensation; and •changes to the liabilities for insurance required by regulatory agencies attributable to historical periods. For more information about cost of revenue, see the section titled “Components of Results of Operations-Cost of Revenue.” Contribution Margin is calculated by dividing Contribution for a period by revenue for the same period. We record historical changes to liabilities for insurance required by regulatory agencies for financial reporting purposes in the quarter of positive or adverse development even though such development may be related to claims that occurred in prior periods. For example, if in the first quarter of a given year, the cost of claims grew by $1 million for claims related to the prior fiscal year or earlier, the expense would be recorded for GAAP purposes within the first quarter instead of in the results of the prior period. We believe these prior period changes to insurance liabilities do not illustrate the current period performance of our ongoing operations since these prior period changes relate to claims that could potentially date back years. We have limited ability to influence the ultimate development of historical claims. Accordingly, including the prior period changes would not illustrate the performance of our ongoing operations or how the business is run or managed by us. For consistency, we do not adjust the calculation of Contribution for any prior period based on any positive or adverse development that occurs subsequent to the quarter end. Annual Contribution is calculated by adding Contribution of the last four quarters. We believe the adjustment to exclude the historical changes to liabilities for insurance required by regulatory agencies from Contribution and Adjusted EBITDA is useful to investors by enabling them to better assess our operating performance in the context of current period results. For more information regarding the limitations of Contribution and Contribution Margin and a reconciliation of revenue to Contribution, see the section titled "Reconciliation of Non-GAAP Financial Measures." Adjusted EBITDA and Adjusted EBITDA Margin Adjusted EBITDA and Adjusted EBITDA Margin are key performance measures that our management uses to assess our operating performance and the operating leverage in our business. Because Adjusted EBITDA and Adjusted EBITDA Margin facilitate internal comparisons of our historical operating performance on a more consistent basis, we use these measures for business planning purposes. We expect Adjusted EBITDA and Adjusted EBITDA Margin will increase over the long term as we continue to scale our business and achieve greater efficiencies in our operating expenses. We calculate Adjusted EBITDA as net loss, adjusted to exclude: •interest income; •other income, net; •provision for income taxes; •depreciation and amortization; •stock-based compensation expense; •payroll tax expense related to stock-based compensation; •costs related to acquisitions, if any; and •changes to the liabilities for insurance required by regulatory agencies attributable to historical periods. Adjusted EBITDA Margin is calculated by dividing Adjusted EBITDA for a period by revenue for the same period. For more information regarding the limitations of Adjusted EBITDA and Adjusted EBITDA Margin and a reconciliation of net loss to Adjusted EBITDA, see the section titled “Reconciliation of Non-GAAP Financial Measures.” Reconciliation of Non-GAAP Financial Measures We use Contribution, Contribution Margin, Adjusted EBITDA and Adjusted EBITDA Margin in conjunction with GAAP measures as part of our overall assessment of our performance, including the preparation of our annual operating budget and quarterly forecasts, to evaluate the effectiveness of our business strategies, and to communicate with our board of directors concerning our financial performance. Our definitions may differ from the definitions used by other companies and therefore comparability may be limited. In addition, other companies may not publish these or similar metrics. Furthermore, these measures have certain limitations in that they do not include the impact of certain expenses that are reflected in our consolidated statements of operations that are necessary to run our business. Thus, our Contribution, Contribution Margin, Adjusted EBITDA and Adjusted EBITDA Margin should be considered in addition to, not as substitutes for, or in isolation from, measures prepared in accordance with GAAP. We compensate for these limitations by providing a reconciliation of Contribution and Adjusted EBITDA to the related GAAP financial measures, revenue and net loss, respectively. We encourage investors and others to review our financial information in its entirety, not to rely on any single financial measure and to view Contribution, Contribution Margin, Adjusted EBITDA and Adjusted EBITDA Margin in conjunction with their respective related GAAP financial measures. The following table provides a reconciliation of revenue to Contribution (in millions): _______________ (1)$270.3 of insurance expense recorded during the year ended December 31, 2019 reflects changes to reserves estimates of claims from the third quarter of 2019 and earlier periods. $3.4 million of insurance expense recorded during the year ended December 31, 2018 reflects changes to reserves estimates of claims from 2017 and earlier periods. The following table provides a reconciliation of net loss to Adjusted EBITDA (in millions): _______________ (1)$270.3 million of insurance expense recorded during the year ended December 31, 2019 reflects changes to reserves estimates of claims from the third quarter of 2019 and earlier periods. $3.4 million of insurance expense recorded during the year ended December 31, 2018 reflects changes to reserves estimates of claims from 2017 and earlier periods. Liquidity and Capital Resources As of December 31, 2019, our principal sources of liquidity were cash and cash equivalents of approximately $358.3 million and short-term investments of approximately $2.5 billion, exclusive of restricted cash, cash equivalents and investments of $1.6 billion. Cash and cash equivalents consisted of institutional money market funds and certificates of deposits denominated in U.S. dollars as well as commercial paper, corporate bonds and money market deposit accounts. Short-term investments consisted of commercial paper, certificates of deposit, corporate bonds and term deposits, which mature in 12 months or less. Restricted cash, cash equivalents and investments consisted primarily of amounts held in separate trust accounts and restricted bank accounts as collateral for insurance purposes and amounts pledged to secure certain letters of credit. In April 2019, we received net proceeds of $2.5 billion upon the completion of our IPO. Since our inception, we have generated negative cash flows from operations, and we have financed our operations primarily through private sales of equity securities, our recent IPO and payments received through our platform. We believe our existing cash and cash equivalents will be sufficient to meet our working capital and capital expenditures needs over at least the next 12 months. We collect the fare and related charges from riders on behalf of drivers at the time the ride is delivered using the rider’s authorized payment method, and we retain any fees owed to us before making the remaining disbursement to drivers. Accordingly, we maintain no accounts receivable from drivers. Our contracts with insurance providers require reinsurance premiums to be deposited into trust accounts with a third-party financial institution from which the insurance providers are reimbursed for claims payments. Our restricted reinsurance trust investments as of December 31, 2019 and 2018 were $1.4 billion and $863.7 million, respectively. Our future capital requirements will depend on many factors, including, but not limited to our growth, our ability to attract and retain drivers and riders on our platform, the continuing market acceptance of our offerings, the timing and extent of spending to support our efforts to develop our platform and autonomous technology, actual insurance payments for which we have made reserves, the timing and extent of investment we are making in policy, government relations and the California ballot initiative, and the expansion of sales and marketing activities. Further, we may in the future enter into arrangements to acquire or invest in businesses, products, services and technologies. We may decide to, or be required to, seek additional equity or debt financing for any of these reasons, or others that may arise. In the event that we decide, or are required, to seek additional financing 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, financial condition and results of operations could be adversely affected. Cash Flows The following table summarizes our cash flows for the periods indicated: Operating Activities Cash used in operating activities was $105.7 million for the year ended December 31, 2019. This consisted primarily of a net loss of $2.6 billion offset by non-cash stock-based compensation expense of $1.6 billion largely driven by the recognition of costs related to RSUs which we started to recognize upon the effectiveness of our IPO Registration Statement on March 28, 2019. Additionally, there was an increase in insurance reserves and accrued and other liabilities of $0.9 billion. Cash used in operating activities was $280.7 million for the year ended December 31, 2018. This consisted of a net loss of $911.3 million, an increase in prepaid expenses and other assets of $75.6 million and a decrease in accounts payable of $40.8 million due to the timing of payments, partially offset by an increase in insurance reserves and accrued and other liabilities of $741.9 million. Cash used in operating activities was $393.5 million for the year ended December 31, 2017. This consisted of a net loss of $688.3 million and an increase in prepaid expenses and other assets of $111.8 million, partially offset by increased accounts payable, insurance reserves and accrued and other liabilities of $399.0 million. Investing Activities Cash used in investing activities was $1.6 billion for the year ended December 31, 2019, which primarily consisted of purchases of short-term investments of $6.4 billion, partially offset by proceeds from sales and maturities of marketable securities of $5.2 billion. Cash used in investing activities was $1.0 billion for the year ended December 31, 2018, which primarily consisted of purchases of short-term investments of $5.5 billion, partially offset by proceeds from sales and maturities of marketable securities of $4.7 billion. Cash used in investing activities was $991.4 million for the year ended December 31, 2017, which primarily consisted of purchases of short-term investments of $2.6 billion, partially offset by proceeds from sales and maturities of marketable securities of $1.6 billion. Financing Activities Cash provided by financing activities was $1.6 billion for the year ended December 31, 2019, which primarily consisted of proceeds from the issuance of our Class A common stock in our IPO of $2.5 billion, partially offset by taxes paid related to net share settlement of equity awards of $0.9 billion. Cash provided by financing activities was $852.2 million and $2.0 billion for the years ended December 31, 2018 and 2017, respectively, which consisted almost exclusively of proceeds from issuances of redeemable convertible preferred stock, net of issuance costs. Contractual Obligations and Commitments The following table summarizes our contractual obligations and commitments as of December 31, 2019 (in millions): _______________ (1)The table excludes insurance reserves due to uncertainties in the timing of settlement of these reserves. (2)On November 30, 2018, we completed the acquisition of Motivate, a New York headquartered bikeshare company. Over the approximately five years following the transaction, we committed to invest an aggregate of $100 million in the bikeshare program for the New York metro area. We also assumed certain pre-existing contractual obligations to increase the bike fleets in other locations which are not considered to be material. Due to the uncertainty with respect to the timing of future cash flows associated with these commitments, we have not included these commitments in the above table. (3)Noncancelable purchase commitments include amounts related to our March 2018 commercial agreement, which was subsequently amended in January 2019, with Amazon Web Services, or AWS. Under this amended arrangement, we are committed to spend an aggregate of at least $300 million between January 2019 and December 2021, with a minimum amount of $80 million in each of the three years, on AWS services. Off-Balance Sheet Arrangements We did not have during the periods presented, and we do not currently have, any off-balance sheet financing arrangements or any relationships with unconsolidated entities or financial partnerships, including entities sometimes referred to as structured finance or special purpose entities, that were established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

<s>[INST] Financial Results for the Year Ended December 31, 2019 Total revenue was $3.6 billion, an increase of 68% yearoveryear. Total costs and expenses were $6.3 billion, including stockbased compensation expense of $1.6 billion and insurance costs generally required under TNC and city regulations for ridesharing and bike and scooter rentals of $1.2 billion, of which $219.2 million was related to changes to insurance reserves attributed to historical periods. This adverse development is largely attributable to historical auto losses that predate our relationship with our new thirdparty administrators for insurance claims. Loss from operations was $2.7 billion. Net loss was $2.6 billion. Cash used in operating activities was $105.7 million. Cash and cash equivalents and restricted cash and cash equivalents were $564.5 million. Active Rider Trends We continue to experience growth in the number of Active Riders as well as revenue per Active Rider. The number of Active Riders is a key indicator of the scale of our community and awareness of our brand. Revenue per Active Rider represents our ability to drive usage and monetization of our platform. We define Active Riders as all riders who take at least one ride during a quarter where the Lyft Platform processes the transaction. An Active Rider is identified by a unique phone number. If a rider has two mobile phone numbers or changed their phone number and such rider took rides using both phone numbers during the quarter, that person would count as two Active Riders. If a rider has a personal and business profile tied to the same mobile phone number, that person would be considered a single Active Rider. If a ride has been requested by an organization using our Concierge offering for the benefit of a rider, we exclude this rider in the calculation of Active Riders. In the fourth quarter of 2019, we updated the definition of Active Riders to include riders who have migrated from the legacy Motivate platform to the Lyft platform, which resulted in a 0.01% increase, or an additional 1,167 Active Riders, in the fourth quarter. Prior to the fourth quarter of 2019, for Motivate, only riders that had taken a ride or rented a bike or scooter through the Lyft App during the quarter were counted as an Active Rider. This change had no impact on the Active Riders disclosed in any of the prior periods presented. Initial Public Offering Our IPO Registration Statement was declared effective on March 28, 2019 and our Class A common stock began trading on the Nasdaq Global Select Market on March 29, 2019. Our IPO was completed on April 2, 2019 and the partial exercise of the underwriters’ option to purchase additional shares was completed on April 9, 2019. Our consolidated financial statements as of December 31, 2019 and for the year thenended reflect the sale by us of an aggregate of 35,496,845 shares in our IPO, including pursuant to the partial exercise of the underwriters’ option to purchase additional shares, at the public offering price of $72.00 per share, for aggregate net proceeds to us of approximately $2.5 billion, after underwriting discounts and commissions and offering expenses, and the conversion of all outstanding shares of our redeemable convertible preferred stock into an aggregate of 219,175,709 shares of Class A common stock. Our consolidated financial statements as of December 31, 2019 and for the year thenended reflect stockbased compensation expense of $1.6 billion primarily associated with the vesting of RSUs for which the requisite service condition was met as of December 31, 2019. The liquidity event condition for RSUs, if any, was satisfied upon the effectiveness of our IPO Registration Statement on March 28, 2019. Critical Accounting Policies and Estimates Our consolidated financial statements and the related notes thereto included elsewhere in this Annual Report on Form 10K are prepared in accordance with GAAP. The preparation of consolidated financial statements also requires us to make estimates [/INST] Negative. </s>

Hess Midstream LP

2020-02-21

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 should be read in conjunction with the consolidated financial statements and notes thereto included in Item 8 of this Annual Report on Form 10-K. Financial information presented in this report has been retrospectively adjusted for the acquisition of Hess Infrastructure Partners LP. Unless otherwise stated or the context otherwise indicates, references in this report to “Predecessor,” “we,” “us” or like terms, when referring to periods prior to April 10, 2017, refer to Hess Midstream Partners LP Predecessor (“Predecessor”), our predecessor for accounting purposes. All references to “Hess Midstream Operations LP,” “the Partnership,” “us,” “we” or similar terms, when referring to periods between April 10, 2017 and December 16, 2019, refer to Hess Midstream Operations LP (formerly known as Hess Midstream Partners LP, the predecessor registrant to Hess Midstream LP), including its consolidated subsidiaries. All references to “Hess Midstream LP,” “the Company,” “us,” “our,” “we” or similar terms, when referring to periods subsequent to December 16, 2019, refer to Hess Midstream LP, including its consolidated subsidiaries. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below and those discussed in the section entitled “Risk Factors” included elsewhere in this report. Overview We are a fee-based, growth-oriented, limited partnership formed by Hess Infrastructure Partners GP LLC (“HIP GP LLC”) and our general partner to own, operate, develop and acquire a diverse set of midstream assets and provide fee-based services to Hess and third-party customers. We are managed and controlled by Hess Midstream GP LLC, the general partner of our general partner. Our assets are primarily located in the Bakken and Three Forks shale plays in the Williston Basin area of North Dakota, which we collectively refer to as the Bakken. On January 25, 2018, we entered into a 50/50 joint venture with Targa Resources Corp. (“Targa”) to construct a new 200 MMcf/d gas processing plant called Little Missouri 4 (“LM4”). LM4 was placed in service in the third quarter of 2019. Targa is the operator of the plant. On March 1, 2019, Hess Infrastructure Partners LP (“HIP”) acquired 100% of the membership interest in Hess’ Bakken water services business (“Hess Water Services”) for cash consideration of $225.0 million. On March 22, 2019, we acquired the crude oil, gas and water gathering assets of Summit Midstream Partners’ Tioga Gathering System for cash consideration of $89.2 million, with the potential for an additional $10.0 million of contingent payments in future periods subject to certain future performance metrics. On April 25, 2019, we announced plans to expand natural gas processing capacity at the Tioga Gas Plant by 150 MMcf/d for total processing capacity of 400 MMcf/d for expected capital expenditures of approximately $150 million, to be in service by mid-2021. On December 16, 2019, the Company and the Partnership completed the transactions (the “Restructuring”) contemplated by the Partnership Restructuring Agreement, dated October 3, 2019, by and among the Company, the Partnership and the other parties thereto. As a result of the Restructuring, the Company was delegated control of the Partnership and replaced the Partnership as its publicly traded successor. Prior to the Restructuring, the Company and the Partnership were indirectly controlled by HIP GP LLC, the general partner of HIP. HIP was originally formed as a joint venture between Hess and GIP (together, the “Sponsors”) and owned an 80% economic interest in certain of the Partnership’s existing assets (the “Joint Interest Assets”), a 100% interest in certain other businesses, including Hess Water Services and a 100% interest in Hess Midstream Partners GP LP (“MLP GP LP”), which held all of the Partnership’s outstanding incentive distribution rights and the general partner interest in the Partnership, and controlled the Partnership. Pursuant to the Restructuring, the Partnership acquired HIP, including HIP’s 80% interest in the Joint Interest Assets, 100% interest in Hess Water Services and the outstanding economic general partner interest and incentive distribution rights in the Partnership. The Partnership’s organizational structure converted from a master limited partnership into an “Up-C” structure in which the Partnership’s public unitholders received newly issued Class A shares (“Class A Shares”) in Hess Midstream LP in a one-for-one exchange. The Partnership changed its name to “Hess Midstream Operations LP” and became a consolidated subsidiary of the Company. After consummation of the Restructuring, the Sponsors and their affiliates received an aggregate of 898,000 Class A Shares in the Company, 266,416,928 Class B units representing noncontrolling limited partner interests in the Partnership and received aggregate cash consideration of $601.8 million. The Sponsors own 100% interest in the general partner of the Company and, through their ownership of the general partner, continue to have the right to elect the entire board of directors. The acquisition of HIP by the Partnership, including its 80% economic interest in the Joint Interest Assets and 100% interest in Hess Water Services, was accounted for as an acquisition of a business under common control. Accordingly, our consolidated financial statements prior to the acquisition date of December 16, 2019 were retrospectively recast to include the financial results of HIP. Our principal business objective is to grow our business, free cash flow and distributable cash flow supported by fee-based contracts and disciplined financial strategy. We expect to achieve this objective through the following business strategies: • Focus on Cash Flow Stability and Growth Supported by Long-Term, Fee-Based Contracts and a Disciplined Financial Strategy. We seek to grow our free cash flow and distributable cash flow to be able to fund our expansion capital and growing distributions while maintaining balance sheet strength. Our commercial agreements include dedications covering substantially all of Hess’ existing and future owned or controlled production in the Bakken, minimum volume commitments, inflation escalators and fee recalculation mechanisms, all of which are intended to provide us with cash flow stability and downside risk protection. • Capitalize on Hess’ Growing Bakken Production. Our midstream infrastructure footprint services Hess’ leading acreage position in the Bakken. We believe our volumes and investment opportunities will continue to expand as Hess drills new wells in the Bakken. We intend to invest additional capital to continue extending and expanding our strategically positioned infrastructure to meet Hess’ current and future production growth. • Leverage Core Asset Base to Attract Additional Third-Party Business. We currently handle volumes from third-party producers and midstream companies under our commercial agreements with Hess, and we are pursuing both additional projects and strategic relationships with third-party customers with operations in the Bakken in order to maximize our utilization rates. • Grow Through Accretive Acquisitions from Our Sponsors and Third Parties. We plan to pursue acquisitions of complementary midstream assets from our Sponsors as well as from third parties. Our assets and operations are organized into the following three reportable segments: (i) gathering, (ii) processing and storage and (iii) terminaling and export. Gathering Our gathering segment includes Hess North Dakota Pipeline Operations LP, or Gathering Opco, and Hess Water Services Holdings LLC, which own the following assets: • Natural Gas Gathering and Compression. A natural gas gathering and compression system located primarily in McKenzie, Williams and Mountrail Counties, North Dakota connecting Hess and third-party owned or operated wells to the Tioga Gas Plant, Little Missouri 4 gas processing plant and third-party pipeline facilities. The system also includes the Hawkeye Gas Facility. • Crude Oil Gathering. A crude oil gathering system located primarily in McKenzie, Williams and Mountrail Counties, North Dakota, connecting Hess and third-party owned or operated wells to the Ramberg Terminal Facility, the Tioga Rail Terminal and the Johnson’s Corner Header System. The system also includes the Hawkeye Oil Facility. • Produced Water Gathering and Disposal. A produced water gathering system and disposal facilities located primarily in Williams and Mountrail counties, North Dakota. Processing and Storage Our processing and storage segment includes Hess TGP Operations LP, or HTGP Opco, and Hess Mentor Storage Holdings LLC, or Mentor Holdings, which own the following assets, respectively: • Tioga Gas Plant (“TGP”). A natural gas processing and fractionation plant located in Tioga, North Dakota. • Equity Investment in Little Missouri 4 (“LM4”) Joint Venture. A 50% equity method investment in LM4 joint venture that owns a natural gas processing plant located in McKenzie County, North Dakota that was placed in service in the third quarter of 2019. • Mentor Storage Terminal. A propane storage cavern and rail and truck loading and unloading facility located in Mentor, Minnesota. Terminaling and Export Our terminaling and export segment includes Hess North Dakota Export Logistics Operations LP, or Logistics Opco, which owns each of the following assets: • Ramberg Terminal Facility. A crude oil pipeline and truck receipt terminal located in Williams County, North Dakota that is capable of delivering crude oil into an interconnecting pipeline for transportation to the Tioga Rail Terminal and to multiple third-party pipelines and storage facilities. • Tioga Rail Terminal. A crude oil and NGL rail loading terminal in Tioga, North Dakota that is connected to the Tioga Gas Plant, the Ramberg Terminal Facility and our crude oil gathering system. • Crude Oil Rail Cars. A total of 550 crude oil rail cars, constructed to the most recent DOT-117 safety standards, which we operate as unit trains consisting of approximately 100 to 110 crude oil rail cars. • Johnson’s Corner Header System. An approximately six-mile crude oil pipeline header system located in McKenzie County, North Dakota that receives crude oil by pipeline from Hess and third parties and delivers crude oil to third-party interstate pipeline systems. Significant 2019 Financial and Operating Results Significant financial and operating results for the year ended December 31, 2019 include: • Completed the Partnership’s acquisition of oil, gas and water gathering assets of Summit Midstream Partners’ Tioga Gathering System. • Completed the Partnership’s acquisition of a produced water services business from Hess. • Completed our acquisition of HIP, incentive distribution rights simplification and conversion to an Up-C corporate structure. • Net income was $317.7 million, or $1.21 per Class A Share/limited partner unit after deduction for income attributable to noncontrolling interests and net parent investment. Net income attributable to the Company was $70.1 million. • Net cash provided by operating activities was $470.7 million. • Adjusted EBITDA was $550.7 million, excluding impacts from transaction costs of $26.2 million. • Paid cash distributions of $1.1915 per unit for the first three quarters of 2019 and declared a cash distribution of $0.4258 per Class A Share for the fourth quarter of 2019, which was paid in February 2020. • Completed the ramp-up of processing volumes through the LM4 gas processing plant. • Compared with the prior year, throughput volumes increased 33% for crude oil gathering, 30% for crude oil terminaling, 12% for gas processing, 11% for gas gathering and 64% for water gathering driven by Hess’ growing production, capturing additional third-party customer volumes and ramp-up of the LM4 gas processing plant. For additional information regarding our non-GAAP financial measures, see “How We Evaluate Our Operations” and “Reconciliation of Non-GAAP Financial Measures” below. How We Generate Revenues We generate substantially all of our revenues by charging fees for gathering, compressing and processing natural gas and fractionating NGLs; gathering, terminaling, loading and transporting crude oil and NGLs; storing and terminaling propane; and gathering and disposing of produced water. We have entered into long-term, fee-based commercial agreements with Hess dated effective January 1, 2014, for oil and gas services agreements, and effective January 1, 2019, for water services agreements. In addition, in 2018 and a portion of 2017, Hess Water Services had documented intercompany arrangements with certain subsidiaries of Hess pursuant to which it provided produced water gathering and disposal services and charged agreed-upon fees per barrel for the services performed. Except for the water services agreements and except for a certain gathering sub-system, as described below, each of our commercial agreements with Hess has an initial 10-year term and we have the unilateral right to renew each of these agreements for one additional 10-year term. Initial term for the water services agreements is 14 years and the secondary term is 10 years. In September 2018, we amended our gas gathering and gas processing and fractionation agreements to enable us to provide certain services to Hess in respect of volumes to be delivered to and processed at the LM4 plant. The amended and restated gas gathering agreement also extends the initial term of the gathering agreement with respect to a certain gathering sub-system by 5 years to provide for a 15-year initial term and decreases the secondary term for that gathering sub-system by 5 years to provide for a 5-year secondary term. These agreements include dedications covering substantially all of Hess’ existing and future owned or controlled production in the Bakken, minimum volume commitments, inflation escalators and fee recalculation mechanisms, all of which are intended to provide us with cash flow stability and growth, as well as downside risk protection. In particular, Hess’ minimum volume commitments under our commercial agreements provide minimum levels of cash flows and the fee recalculation mechanisms under the agreements allow fees to be adjusted annually to provide us with cash flow stability. Our revenues also include revenues from third-party volumes contracted with Hess and delivered to us under these commercial agreements with Hess, as well as pass-through third-party rail transportation costs, third-party produced water trucking and disposal costs and electricity fees for which we recognize revenues in an amount equal to the costs. Together with Hess, we are pursuing strategic relationships with third-party producers and other midstream companies with operations in the Bakken in order to maximize our utilization rates. How We Evaluate Our Operations Our management uses a variety of financial and operating metrics to analyze our operating results and profitability. These metrics include (i) volumes, (ii) operating and maintenance expenses, (iii) Adjusted EBITDA, (iv) free cash flow, and (v) distributable cash flow. Volumes. The amount of revenues we generate primarily depends on the volumes of crude oil, natural gas, NGLs and produced water that we handle at our gathering, processing, terminaling, storage and disposal facilities. These volumes are affected primarily by the supply of and demand for crude oil, natural gas and NGLs in the markets served directly or indirectly by our assets, including changes in crude oil prices, which may further affect volumes delivered by Hess. Although Hess has committed to minimum volumes under our commercial agreements described above, our results of operations will be impacted by our ability to: • utilize the remaining uncommitted capacity on, or add additional capacity to, our existing assets, and optimize our existing assets; • identify and execute expansion projects, and capture incremental throughput volumes from Hess and third parties for these expanded facilities; • increase throughput volumes at our Ramberg Terminal Facility, Tioga Rail Terminal and the Johnson’s Corner Header System by interconnecting with new or existing third-party gathering pipelines; and • increase gas processing throughput volumes by interconnecting with new or existing third-party gathering pipelines. Operating and Maintenance Expenses. Our management seeks to maximize the profitability of our operations by effectively managing operating and maintenance expenses. These expenses are comprised primarily of costs charged to us under our omnibus agreement and employee secondment agreement, third-party contractor costs, utility costs, insurance premiums, third-party service provider costs, related property taxes and other non-income taxes and maintenance expenses, such as expenditures to repair, refurbish and replace storage facilities and to maintain equipment reliability, integrity and safety. These expenses generally remain relatively stable across broad ranges of throughput volumes but can fluctuate from period to period depending on the mix of activities performed during that period and the timing of substantial expenses, such as gas plant turnarounds. We seek to manage our maintenance expenditures by scheduling periodic maintenance on our assets in order to minimize significant variability in these expenditures and minimize their impact on our cash flow. Adjusted EBITDA, Free Cash Flow and Distributable Cash Flow. We define Adjusted EBITDA as net income (loss) before net interest expense, income tax expense (benefit), depreciation and amortization and our proportional share of depreciation of our equity affiliates, as further adjusted to eliminate the impact of certain items that we do not consider indicative of our ongoing operating performance, such as transaction costs, other income and other non-cash, non-recurring items, if applicable. We define free cash flow as Adjusted EBITDA less capital expenditures. We use distributable cash flow to analyze our liquidity and performance. We define distributable cash flow as Adjusted EBITDA less net interest, excluding amortization of deferred financing costs, cash paid for federal and state income taxes and maintenance capital expenditures. Distributable cash flow does not reflect changes in working capital balances. Adjusted EBITDA, free cash flow and distributable cash flow are non-GAAP supplemental financial measures that management and external users of our consolidated financial statements, such as industry analysts, investors, lenders and rating agencies, may use to assess: • our operating performance as compared to other publicly traded companies in the midstream energy industry, without regard to historical cost basis or, in the case of Adjusted EBITDA, financing methods; • the ability of our assets to generate sufficient cash flow to make distributions to our shareholders; • our ability to incur and service debt and fund capital expenditures; and • the viability of acquisitions and other capital expenditure projects and the returns on investment of various investment opportunities. We believe that the presentation of Adjusted EBITDA, free cash flow and distributable cash flow provides useful information to investors in assessing our financial condition and results of operations. The GAAP measures most directly comparable to Adjusted EBITDA, free cash flow and distributable cash flow are net income (loss) and net cash provided by (used in) operating activities. Adjusted EBITDA, free cash flow and distributable cash flow should not be considered as alternatives to GAAP net income (loss), income (loss) from operations, net cash provided by (used in) operating activities or any other measure of financial performance or liquidity presented in accordance with GAAP. Adjusted EBITDA, free cash flow and distributable cash flow have important limitations as analytical tools because they exclude some but not all items that affect net income and net cash provided by operating activities. You should not consider Adjusted EBITDA, free cash flow or distributable cash flow in isolation or as a substitute for analysis of our results as reported under GAAP. Additionally, because Adjusted EBITDA, free cash flow and distributable cash flow may be defined differently by other companies in our industry, our definition of Adjusted EBITDA, free cash flow and distributable cash flow may not be comparable to similarly titled measures of other companies, thereby diminishing their utility. Results of Operations The following tables summarize our consolidated results of operations for the years ended December 31, 2019, 2018 and 2017. The financial information presented has been retrospectively adjusted for the acquisition of HIP. See Note 3, Acquisitions in Item 8. Financial Statements and Supplementary Data. The results of operations are discussed in further detail following this overview (in millions, unless otherwise noted). Year ended December 31, 2019 Compared to Year Ended December 31, 2018 Gathering Revenues increased $47.7 million in 2019 compared to 2018, of which $21.2 million is attributable to higher third-party produced water trucking and disposal pass-through revenues and $3.9 million is attributable to pass-through electricity fees. In addition, $6.1 million of the increase is attributable to higher gas gathering and compression volumes, $5.8 million is attributable to higher water gathering volumes and $5.4 million is attributable to higher crude oil gathering volumes relative to 2018 minimum volume commitment levels driven by growing Hess production and additional third-party volumes contracted with Hess and delivered to us. The remaining $5.3 million of the increase in revenues is attributable to higher tariff rates. Operating and maintenance expenses increased $41.9 million, of which $21.2 million is attributable to higher third-party produced water trucking and disposal pass-through costs driven by growing Hess production, $14.1 million is attributable to higher maintenance activity on our expanded infrastructure, $3.9 million is attributable to pass-through electricity costs due to additional compressors coming online, and $2.7 million is attributable to higher property taxes due to additional assets acquired and placed into service. Depreciation expense increased $14.4 million due to gathering assets acquired from Summit Midstream Partners, LP at the end of the first quarter of 2019 and other new assets being brought into service. General and administrative expenses increased $5.0 million primarily attributable to higher charges from Hess under our omnibus and employee secondment agreements. Processing and Storage Revenues and other income increased $43.9 million in 2019 compared to 2018, of which $27.0 million is attributable to higher volumes, driven by LM4 ramp-up, which was placed into service in the third quarter of 2019, and continued backfilling of TGP with third-party volumes contracted with Hess and delivered to us. In addition, $15.2 million of the increase is attributable to higher tariff rates. The remaining $1.1 million of the increase in revenues is attributable to higher pass-through electricity fees and $0.6 million other income. Operating and maintenance expenses increased $17.0 million, of which $9.6 million is attributable to higher maintenance activity, including initial work on the TGP turnaround, which is planned for 2020, $6.3 million is attributable to LM4 processing fees and $1.1 million is attributable to pass-through electricity costs. The increase in general and administrative expenses of $2.2 million is primarily attributable to higher charges from Hess under our omnibus and employee secondment agreements. Terminaling and Export Revenues and other income increased $44.0 million in 2019 compared to 2018, of which $23.4 million is attributable to higher rail transportation pass-through revenues. In addition, $10.5 million of the increase is attributable to higher tariff rates and $10.1 million is attributable to higher crude oil throughput volumes at our terminals, driven by growing Hess production and increased third-party volumes contracted with Hess and delivered to us. Operating and maintenance expenses increased $24.4 million primarily attributable to higher rail transportation pass-through costs. Interest and Other General and administrative expenses increased $30.6 million, of which $26.2 million is attributable to transaction costs incurred in the fourth quarter of 2019 in connection with the Restructuring and $4.4 million of the increase is attributable to higher other professional fees. Interest expense, net of interest income, increased $9.1 million primarily driven by borrowings on HIP revolving credit facility prior to the Restructuring and additional interest expense on newly issued $550 million of 5.125% fixed-rate senior notes. Year Ended December 31, 2018 Compared to Year Ended December 31, 2017 Gathering Revenues increased $89.7 million in 2018 compared to 2017, of which $36.4 million is attributable to higher third-party produced water trucking and disposal pass-through revenues and produced water gathering volumes driven by growing Hess production. In addition, $28.3 million is attributable to higher gas gathering and compression volumes driven by growing Hess production and additional third-party volumes contracted with Hess and delivered to us, and $20.4 million of the increase is attributable to higher crude oil gathering volumes also driven by growing Hess production and increased minimum volume commitments. The remaining $4.6 million of the increase is attributable to higher crude oil gathering tariff rates and pass-through electricity fees. Operating and maintenance expenses increased $12.3 million primarily attributable to higher produced water trucking and disposal costs driven by growing Hess production. Depreciation expense increased $9.4 million primarily due to a full year of depreciation of the Hawkeye Oil and Gas Facilities in 2018 compared to 2017 and additional new assets being brought into service in 2018. Processing and Storage Revenues increased $24.1 million in 2018 compared to 2017, of which $21.9 million of the increase is attributable to higher volumes processed through the Tioga Gas Plant, driven by growing Hess production and additional third-party volumes contracted with Hess and delivered to us. The remaining $2.2 million of the increase is primarily attributable to higher pass-through electricity fees in 2018 compared to 2017. Operating and maintenance expenses decreased $2.4 million primarily attributable to lower charges from Hess under our omnibus and employee secondment agreements. General and administrative expenses increased $1.2 million primarily attributable to professional fees related to the LM4 transaction. Terminaling and Export Revenues increased $19.4 million in 2018 compared to 2017, of which $11.7 million is attributable to higher crude oil throughput volumes at our terminals, driven by completion of the Johnson’s Corner Header System in the second half of 2017, growing Hess production and increased third-party volumes contracted with Hess and delivered to us. In addition, $5.4 million of the increase is attributable to higher tariff rates in 2018 compared to 2017, $1.9 million of the increase is attributable to higher NGL volumes and $0.7 million of the increase is attributable to other income. These increases were partially offset by $0.3 million lower rail transportation pass-through revenue. Operating and maintenance expenses decreased $2.4 million primarily attributable to lower charges from Hess under our omnibus and employee secondment agreements. Interest and Other General and administrative expenses decreased $0.9 million in 2018 compared to 2017, of which $1.8 million is attributable to fees incurred in 2017 related to the Partnership’s initial public offering and issuance of HIP fixed-rate senior notes, and $1.3 million of the decrease is attributable to rail car storage fees incurred in 2017. These decreases were partially offset by $2.2 million increase in public company costs as a result of us being a public company for the full year 2018 when compared to 2017. Interest expense, net of interest income increased $27.5 million, driven by the issuance of HIP fixed-rate senior notes in the fourth quarter of 2017. In 2018, we sold the remaining 105 older specification rail cars and recognized a gain of $0.6 million. As of December 31, 2018, we did not have any older specification rail cars in our fleet. Other Factors Expected to Significantly Affect Our Future Results We currently generate substantially all of our revenues under fee-based commercial agreements with Hess, including third parties contracted with affiliates of Hess. These contracts promote cash flow stability and minimize our direct exposure to commodity price fluctuations, since we generally do not own any of the crude oil, natural gas, or NGLs that we handle and do not engage in the trading of crude oil, natural gas, or NGLs. However, commodity price fluctuations indirectly influence our activities and results of operations over the long term, since they can affect production rates and investments by Hess and third parties in the development of new crude oil and natural gas reserves. For example, as a result of the decline in crude oil prices beginning in late 2014, Hess reduced its rig count to two rigs in the Bakken during 2016. During this time, minimum volume commitments provided minimum levels of cash flows and the fee recalculation mechanisms under the agreements supported cash flow stability. Hess subsequently increased its rig count and operated six rigs in the Bakken in 2019. The throughput volumes at our facilities depend primarily on the volumes of crude oil and natural gas produced by Hess in the Bakken, which, in turn, is ultimately dependent on Hess’ exploration and production margins. Exploration and production margins depend on the price of crude oil, natural gas, and NGLs. These prices are volatile and influenced by numerous factors beyond our or Hess’ control, including the domestic and global supply of and demand for crude oil, natural gas and NGLs. The commodities trading markets, as well as global and regional supply and demand factors, may also influence the selling prices of crude oil, natural gas and NGLs. Furthermore, our ability to execute our growth strategy in the Bakken will depend on crude oil and natural gas production in that area, which is also affected by the supply of and demand for crude oil and natural gas. Reconciliation of Non-GAAP Financial Measures The following table presents a reconciliation of Adjusted EBITDA to net income and net cash provided by operating activities, the most directly comparable GAAP financial measures, for each of the periods indicated. (1) During the year ended December 31, 2018, cash interest paid was largely offset by interest income received. (2) Under our contribution agreement, HIP agreed to bear the full costs we incurred for maintenance capital expenditures during the year ended December 31, 2017. (3) Distributable cash flow prior to the Restructuring is calculated net of any amounts attributable to noncontrolling interest. Distributable cash flow prior to the Restructuring for 2019 is presented for the nine months ended September 30, 2019. Subsequent to the Restructuring, we will generally make cash distributions to holders of Class A Shares pro rata, including to our general partner as holder of an aggregate of 898,000 Class A Shares. The Partnership will generally make cash distributions to holders of units in the Partnership, including to the Sponsors as holders of an aggregate of 266,416,928 Class B Units, pro rata. Therefore, distributable cash flow subsequent to the Restructuring includes amounts attributable to noncontrolling interest and pertains to the three months ended December 31, 2019. Capital Resources and Liquidity We expect our ongoing sources of liquidity to include: • cash on hand; • cash generated from operations; • borrowings under our revolving credit facility; • issuances of additional debt securities; and • issuances of additional equity securities. We believe that cash generated from these sources will be sufficient to meet our operating requirements, our planned capital expenditures, debt service requirements, our quarterly cash distribution requirements, future internal growth projects or potential acquisitions. Our partnership agreement requires that we distribute all of our available cash to shareholders. During the year ended December 31, 2019, we made distributions of $85.4 million, to the holders of our equity securities representing limited partner interests in us. On January 27, 2020, we declared a quarterly cash distribution of $0.4258 per Class A Share that was paid on February 14, 2020 to shareholders of record on February 6, 2020. Fixed-Rate Senior Notes In November 2017, HIP issued $800.0 million of 5.625% fixed-rate senior notes due 2026 to qualified institutional investors. In December 2019, in connection with the Restructuring, the Partnership, Hess Midstream Operations LP, a consolidated subsidiary of the Company, assumed $800.0 million of outstanding HIP senior notes in a par-for-par exchange for newly issued 5.625% senior notes due 2026 of the Partnership and paid approximately $2.0 million of exchange consent fees. The notes are guaranteed by certain subsidiaries of the Partnership. Interest is payable semi-annually on February 15 and August 15. In December 2019, the Partnership issued $550.0 million of 5.125% fixed-rate senior notes due 2028 to qualified institutional investors. The notes are guaranteed by certain subsidiaries of the Partnership. Interest is payable semi-annually on June 15 and December 15. The Partnership used the net proceeds to finance the acquisition of HIP, including to repay borrowings under HIP’s credit facilities, and pay related fees and expenses. Each of the indentures for the 2026 and 2028 senior notes contains customary covenants that restrict our ability and the ability of our restricted subsidiaries to (i) declare or pay any dividend or make any other restricted payments; (ii) transfer or sell assets or subsidiary stock; (iii) incur additional debt; or (iv) make restricted investments, unless, at the time of and immediately after giving pro forma effect to such restricted payments and any related incurrence of indebtedness or other transactions, no default has occurred and is continuing or would occur as a consequence of such restricted payment and if the leverage ratio does not exceed 4.25 to 1.00. As of December 31, 2019, we were in compliance with all debt covenants under the indentures. In addition, the covenants included in the indentures governing the senior notes contain provisions that allow the Company to satisfy the Partnership’s reporting obligations under the indenture, as long as any such financial information of the Company contains information reasonably sufficient to identify the material differences, if any, between the financial information of the Company, on the one hand, and the Partnership and its subsidiaries on a stand-alone basis, on the other hand and the Company does not directly own capital stock of any person other than the Partnership and its subsidiaries, or material business operations that would not be consolidated with the financial results of the Partnership and its subsidiaries. The Company is a holding company and has no independent assets or operations. Other than the interest in the Partnership and the effect of federal and state income taxes that are recognized at the Company level, there are no material differences between the consolidated financial statements of the Partnership and the consolidated financial statements of the Company. Credit Facilities In December 2019, the Partnership entered into senior secured syndicated credit facilities (the “Credit Facilities”) consisting of a $1,000.0 million 5-year revolving credit facility and a fully drawn $400.0 million 5-year Term Loan A facility. Facility fees accrue on the total capacity of the revolving credit facility. Borrowings under the 5-year Term Loan A facility will generally bear interest at LIBOR plus an applicable margin ranging from 1.55% to 2.50%, while the applicable margin for the 5-year syndicated revolving credit facility ranges from 1.275% to 2.000%. Pricing levels for the facility fee and interest rate margins are based on the Partnership’s ratio of total debt to EBITDA (as defined in the Credit Facilities). If the Partnership obtains an investment grade credit rating, the pricing levels will be based on the Partnership’s credit ratings in effect from time to time. At December 31, 2019, borrowings of $32.0 million were drawn under the Partnership’s revolving credit facility, and borrowings of $400.0 million, excluding deferred issuance costs, were drawn under the Partnership’s Term Loan A facility. The Credit Facilities can be used for borrowings and letters of credit for general corporate purposes. The Credit Facilities are guaranteed by each direct and indirect wholly owned material domestic subsidiary of the Partnership, and are secured by first priority perfected liens on substantially all of the presently owned and after-acquired assets of the Partnership and its direct and indirect wholly owned material domestic subsidiaries, including equity interests directly owned by such entities, subject to certain customary exclusions. The Credit Facilities contain representations and warranties, affirmative and negative covenants and events of default that the Partnership considers to be customary for an agreement of this type, including a covenant that requires the Partnership to maintain a ratio of total debt to EBITDA (as defined in the Credit Facilities) for the prior four fiscal quarters of not greater than 5.00 to 1.00 as of the last day of each fiscal quarter (5.50 to 1.00 during the specified period following certain acquisitions) and, prior to the Partnership obtaining an investment grade credit rating, a ratio of secured debt to EBITDA for the prior four fiscal quarters of not greater than 4.00 to 1.00 as of the last day of each fiscal quarter. As of December 31, 2019, the Partnership was in compliance with these financial covenants. At December 31, 2018, HIP had $800 million of senior secured syndicated credit facilities maturing in 2022, consisting of a $600.0 million 5-year revolving credit facility and a drawn $200.0 million 5-year Term Loan A facility. In addition, the Partnership had a $300.0 million 4-year senior secured revolving credit facility maturing in 2021. In connection with the Restructuring, the Partnership entered into new Credit Facilities, as described above. The proceeds from the new Credit Facilities were used to finance the acquisition of HIP, including to repay borrowings under HIP’s credit facilities, and pay related fees. Cash Flows The following table sets forth a summary of our cash flows (in millions): Operating Activities. Cash flows provided by operating activities increased $3.8 million in 2019 compared to 2018. The change in operating cash flows resulted from an increase in revenues and other income of $135.6 million and an increase in cash provided by changes in working capital of $2.7 million, offset by an increase in expenses, other than depreciation, amortization, equity-based compensation and other non-cash gains and losses of $134.5 million. Cash flows provided by operating activities increased $130.4 million in 2018 compared to 2017. The change in operating cash flows resulted from an increase in revenues and other income of $133.2 million and an increase in cash provided by changes in working capital of $29.2 million, offset by an increase in expenses, other than depreciation, amortization, unit-based compensation and other non-cash gains and losses of $32.0 million. Investing Activities. Cash flows used in investing activities increased $189.9 million in 2019 compared to 2018. The increase in investing cash outflows resulted from the acquisition of Summit Midstream Partners’ Tioga Gathering System of $89.2 million, net of cash acquired, the acquisition of $68.9 million of net assets in connection with the Hess Water Services acquisition, an increase in payments for capital expenditures of $64.5 million and a decrease in proceeds from sale of property, plant and equipment of $1.6 million. These cash outflows were offset by a decrease in our payments for our equity investment in LM4 of $34.3 million. Cash flows used in investing activities increased $176.2 million in 2018 compared to 2017, primarily due to an increase in payments for capital expenditures of $97.7 million, our investment in the LM4 joint venture of $67.3 million and lower proceeds from sale of property, plant and equipment of $11.2 million. Financing Activities. Cash flows used in financing activities decreased $326.5 million in 2019 compared to 2018 as a result of increased net borrowings of $767.6 million, net of any changes in financing costs, a decrease in distributions to Hess, GIP and our limited partners and other distributions of $160.7 million, offset by cash consideration paid related to the Restructuring of $601.8 million. Cash flows used in financing activities increased $554.6 million in 2018 compared to 2017. In 2018, total distributions to Hess, GIP and our limited partners totaled $402.2 million. HIP also repaid $2.5 million of the Term Loan A facility and paid $1.0 million financing costs related to its fixed-rate senior notes. In 2017, net cash proceeds driven by the use of HIP credit facilities and debt restructuring activities were $243.0 million, net proceeds retained from the Partnership’s IPO were $10.0 million, offset by distributions to Hess, GIP, and our limited partners of $104.1 million. Capital Expenditures Our operations can be capital intensive, requiring investments to expand, upgrade, maintain or enhance existing operations and to meet environmental and operational regulations. Our partnership agreement requires that we distinguish between maintenance capital expenditures and expansion capital expenditures. Maintenance capital expenditures are capital expenditures made to maintain, over the long term, our operating capacity, operating income or revenue. Examples of maintenance capital expenditures are expenditures to repair, refurbish or replace existing assets, to maintain equipment reliability, integrity and safety and to address environmental laws and regulations. In contrast, expansion capital expenditures are expenditures incurred for acquisitions or capital improvements that we expect will increase our operating capacity, operating income or revenue over the long term. Examples of expansion capital expenditures include the acquisition of equipment, construction, development or acquisition of additional capacity, or expenditures for connecting additional wells to our gathering systems, to the extent such capital expenditures are expected to expand our long-term operating capacity, operating income or revenue. The following table sets forth a summary of maintenance and expansion capital expenditures and reconciles capital expenditures on an accrual basis to additions to property, plant and equipment on a cash basis: Capital expenditures are primarily attributable to continued expansion of our gathering system and compression capacity to support Hess and third-party growth. Capital expenditures in 2019 also include amounts attributable to engineering, procurement, civil construction and fabrication activities for the planned expansion of the Tioga Gas Plant. Additionally, in 2019, we acquired Hess Water Services for cash consideration of $225.0 million, of which $68.9 million was recognized as additions to property, plant, and equipment and $156.1 million was recognized as a distribution to Hess. We also acquired Summit Midstream Partners’ Tioga Gathering System for cash consideration of $89.2 million, with the potential for an additional $10 million of contingent payments in future periods subject to certain future performance metrics. Contractual Obligations A summary of our contractual obligations as of December 31, 2019, is as follows: Off-Balance Sheet Arrangements We have not entered into any transactions, agreements or other contractual arrangements that would result in off-balance sheet liabilities. Critical Accounting Policies and Estimates Accounting policies and estimates affect the recognition of assets and liabilities in our consolidated balance sheets and revenues and expenses in our consolidated statements of operations. The accounting methods used can affect net income, partners’ capital and various financial statement ratios. However, the accounting methods generally do not change cash flows or liquidity. We consider the following policies to be the most critical in understanding the judgments that are involved in preparing our financial statements and the uncertainties that could impact our financial condition and results of operations. Property, Plant and Equipment Property, plant and equipment are stated at the lower of historical cost less accumulated depreciation, subject to the results of impairment testing. We capitalize all construction-related direct labor and material costs, as well as indirect construction costs. Indirect construction costs include general engineering, taxes and the cost of funds used during construction of material projects. Costs, including complete asset replacements and enhancements or upgrades that increase the original efficiency, productivity or capacity of property, plant and equipment, are also capitalized. The costs of repairs, minor replacements and other projects, which do not increase the original efficiency, productivity or capacity of property, plant and equipment, are expensed as incurred. The determination of cost componentization and related estimated useful lives is a significant element in arriving at the results of operations. The estimates affect depreciation expense in our accompanying consolidated statements of operations and balance sheets. Impairment of Long-Lived Assets We review long-lived assets for impairment whenever events or changes in business circumstances indicate the net book values of the assets may not be recoverable. Impairment is indicated when the undiscounted cash flows estimated to be generated by those assets are less than the assets’ net book value. Undiscounted cash flows are based on identifiable cash flows that are largely independent of the cash flows of other assets and liabilities. If impairment occurs, a loss is recognized for the difference between fair value and net book value. Such fair value is generally determined by discounting anticipated future net cash flows, an income valuation approach, or by a market-based valuation approach, which are Level 3 fair value measurements. Factors that indicate potential impairment include a significant decrease in the market value of the asset, operating or cash flow losses associated with the use of the asset, and a significant change in the asset’s physical condition or use. No impairments of long-lived assets were recorded during the periods included in the accompanying consolidated financial statements. The determination of impairments could be a significant element in arriving at the results of operations. Impairment charges would impact total costs and expenses and net Property, Plant & Equipment in our accompanying consolidated statements of operations and balance sheets. Depreciation Expense We calculate depreciation using the straight-line method based on the estimated useful lives after considering salvage values of our assets. When assets are placed into service, we make estimates with respect to their useful lives that we believe are reasonable. Depreciation lives related to our significant assets primarily range between 12 to 35 years. However, factors such as maintenance levels, economic conditions impacting the demand for these assets, and regulatory or environmental requirements could cause us to change our estimates, and impact our future calculation of depreciation. The determination of estimated useful lives is a significant element in arriving at depreciation expense. The estimates affect depreciation expense and cost componentization in our accompanying consolidated statements of operations and balance sheets. Contingencies In the ordinary course of business, we may become party to lawsuits, administrative proceedings and governmental investigations, including environmental, regulatory and other matters. Damages or penalties may be sought from us in some matters for which the likelihood of loss may be probable or possible but the amount of loss is not currently estimable. Costs that relate to an existing condition caused by past operations are expensed. Contingent liabilities are recorded when probable and reasonably estimable. On the basis of existing information, we believe that the resolution of any such matters, individually or in the aggregate, will not have a material adverse effect on our financial position or results of operations. Estimates related to contingencies affect operating expenses in our accompanying consolidated statements of operations and liabilities in our balance sheets.

<s>[INST] Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the consolidated financial statements and notes thereto included in Item 8 of this Annual Report on Form 10K. Financial information presented in this report has been retrospectively adjusted for the acquisition of Hess Infrastructure Partners LP. Unless otherwise stated or the context otherwise indicates, references in this report to “Predecessor,” “we,” “us” or like terms, when referring to periods prior to April 10, 2017, refer to Hess Midstream Partners LP Predecessor (“Predecessor”), our predecessor for accounting purposes. All references to “Hess Midstream Operations LP,” “the Partnership,” “us,” “we” or similar terms, when referring to periods between April 10, 2017 and December 16, 2019, refer to Hess Midstream Operations LP (formerly known as Hess Midstream Partners LP, the predecessor registrant to Hess Midstream LP), including its consolidated subsidiaries. All references to “Hess Midstream LP,” “the Company,” “us,” “our,” “we” or similar terms, when referring to periods subsequent to December 16, 2019, refer to Hess Midstream LP, including its consolidated subsidiaries. This discussion contains forwardlooking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below and those discussed in the section entitled “Risk Factors” included elsewhere in this report. Overview We are a feebased, growthoriented, limited partnership formed by Hess Infrastructure Partners GP LLC (“HIP GP LLC”) and our general partner to own, operate, develop and acquire a diverse set of midstream assets and provide feebased services to Hess and thirdparty customers. We are managed and controlled by Hess Midstream GP LLC, the general partner of our general partner. Our assets are primarily located in the Bakken and Three Forks shale plays in the Williston Basin area of North Dakota, which we collectively refer to as the Bakken. On January 25, 2018, we entered into a 50/50 joint venture with Targa Resources Corp. (“Targa”) to construct a new 200 MMcf/d gas processing plant called Little Missouri 4 (“LM4”). LM4 was placed in service in the third quarter of 2019. Targa is the operator of the plant. On March 1, 2019, Hess Infrastructure Partners LP (“HIP”) acquired 100% of the membership interest in Hess’ Bakken water services business (“Hess Water Services”) for cash consideration of $225.0 million. On March 22, 2019, we acquired the crude oil, gas and water gathering assets of Summit Midstream Partners’ Tioga Gathering System for cash consideration of $89.2 million, with the potential for an additional $10.0 million of contingent payments in future periods subject to certain future performance metrics. On April 25, 2019, we announced plans to expand natural gas processing capacity at the Tioga Gas Plant by 150 MMcf/d for total processing capacity of 400 MMcf/d for expected capital expenditures of approximately $150 million, to be in service by mid2021. On December 16, 2019, the Company and the Partnership completed the transactions (the “Restructuring”) contemplated by the Partnership Restructuring Agreement, dated October 3, 2019, by and among the Company, the Partnership and the other parties thereto. As a result of the Restructuring, the Company was delegated control of the Partnership and replaced the Partnership as its publicly traded successor. Prior to the Restructuring, the Company and the Partnership were indirectly controlled by HIP GP LLC, the general partner of HIP. HIP was originally formed as a joint venture between Hess and GIP (together, the “Sponsors”) and [/INST] Negative. </s>

Tradeweb Markets Inc.

2020-02-21

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 sections titled “Basis of Presentation” and “Selected Historical Consolidated Financial and Other Data” and our audited consolidated financial statements and related notes and other information included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from the results described in or implied by the forward-looking statements. Factors that could cause or contribute to those differences include, but are not limited to, those identified below and those discussed in the sections titled “Risk Factors” and “Cautionary Note Regarding Forward-Looking Statements” included elsewhere in this Annual Report on Form 10-K. Overview We are a leader in building and operating electronic marketplaces for our global network of clients across the financial ecosystem. Our network is comprised of clients across the institutional, wholesale and retail client sectors, including many of the largest global asset managers, hedge funds, insurance companies, central banks, banks and dealers, proprietary trading firms and retail brokerage and financial advisory firms as well as regional dealers. Our marketplaces facilitate trading across a range of asset classes, including rates, credit, equities and money markets. We are a global company serving clients in over 65 countries with offices in North America, Europe and Asia. We believe our proprietary technology and culture of collaborative innovation allow us to adapt our offerings to enter new markets, create new platforms and solutions and adjust to regulations quickly and efficiently. We support our clients by providing solutions across the trade lifecycle, including pre-trade, execution, post-trade and data. Our institutional client sector serves institutional investors in over 40 markets across 25 currencies, and in over 65 countries around the globe. We connect institutional investors with pools of liquidity using our flexible order and trading systems. Our clients trust the integrity of our markets and recognize the value they get by trading electronically: enhanced transparency, competitive pricing, efficient trade execution and regulatory compliance. In our wholesale client sector, we provide a broad range of electronic, voice and hybrid platforms to more than 300 dealers and financial institutions with more than 100 actively trading on our electronic or hybrid markets with our Dealerweb platform. This platform was launched in 2008 following the acquisition of inter-dealer broker Hilliard Farber & Co., Inc. In 2011, we acquired the brokerage assets of Rafferty Capital Markets. Today, Dealerweb actively competes across a range of rates, credit, derivatives and equity markets. In our retail client sector, we provide advanced trading solutions for financial advisory firms and traders with our Tradeweb Direct platform. We entered the retail sector in 2006 and launched our Tradeweb Direct platform following the 2013 acquisition of BondDesk Group LLC, which was built to bring innovation and efficiency to the wealth management community. Tradeweb Direct has provided financial advisory firms access to live offerings, accurate pricing in the marketplace and fast execution. Our markets are large and growing. Electronic trading continues to increase across the markets in which we operate as a result of market demand for greater transparency, higher execution quality, operational efficiency and lower costs, as well as regulatory changes. We believe our deep client relationships, asset class breadth, geographic reach, regulatory knowledge and scalable technology position us to continue to be at the forefront of the evolution of electronic trading. Our platforms provide transparent, efficient, cost-effective and compliant trading solutions across multiple products, regions and regulatory regimes. As market participants seek to trade across multiple asset classes, reduce their costs of trading and increase the effectiveness of their trading, including through the use of data and analytics, we believe the demand for our platforms and electronic trading solutions will continue to grow. Trends and Other Factors Impacting Our Performance Economic Environment Our business is impacted by the overall market activity and, in particular, trading volumes and market volatility. Lower volatility is correlated to lower liquidity, which may result in lower trading volume for our clients and may negatively impact our operating performance. Factors that may impact market activity in 2020 include, among other things, economic, political and social conditions, legislative, regulatory or government policy changes and health concerns associated with the coronavirus. As a result, our business is sensitive to slow trading environments and the continuity of conservative monetary policies of central banks internationally, which tend to lessen volatility. While our business is impacted by the overall activity of the market and market volatility, our revenues consist of a mix of fixed and variable fees that partially mitigates this impact. More importantly, we are actively engaged in the further electronification of trading activities, which will help mitigate this impact as we believe secular growth trends can partially offset market volatility risk. Regulatory Environment Our business is subject to extensive regulations in the United States and internationally, which may expose us to significant regulatory risk and cause additional legal costs to ensure compliance. See “Business - Regulation.” The existing legal framework that governs the financial markets is periodically reviewed and amended, resulting in enforcement of new laws and regulations that apply to our business. The current regulatory environment in the United States may be subject to future legislative changes driven by the current administration and could be further impacted, depending on the results of the upcoming U.S. 2020 elections. The impact of any reform efforts on us and our operations remains uncertain. In addition, as a result of the referendum in favor of the United Kingdom’s withdrawal from the European Union (“Brexit”) in June 2016, which occurred on January 31, 2020, we have incurred additional costs to address the potential effects of Brexit, including costs associated with establishing a new regulated subsidiary in the Netherlands. Compliance with regulations may require us to dedicate additional financial and operational resources, which may adversely affect our profitability. In addition, compliance with regulations may require our clients to dedicate significant financial and operational resources, which may negatively affect their ability to pay our fees and use our platforms and, as a result, our profitability. However, under certain circumstances regulation may increase demand for our platforms and solutions, and we believe we are well positioned to benefit from any potential increased electronification due to regulatory changes as market participants seek platforms that meet regulatory requirements and solutions that help them comply with their regulatory obligations. For example, our 2018 revenue increased due in part to higher trading volumes as a result of, and the introduction of our new APA service in connection with, the implementation of MiFID II in January 2018. Competitive Environment We and our competitors compete to introduce innovations in market structure and new electronic trading capabilities. While we endeavor to be a leader in innovation, new trading capabilities of our competitors are also adopted by market participants. On the one hand, this increases liquidity and electronification for all participants, but it also puts pressure on us to further invest in our technology and to innovate to ensure the continued growth of our network of clients and continued improvement of liquidity, electronic processing and pricing on our platforms. Our ability to compete is influenced by key factors such as (i) developments in trading platforms and solutions, (ii) the liquidity we provide on transactions, (iii) the transaction costs we incur in providing our solutions, (iv) the efficiency in execution of transactions on our platforms, (v) our ability to hire and retain talent and (vi) our ability to maintain the security of our platforms and solutions. Our competitive position is also influenced by the familiarity and integration of our clients with our electronic, voice and hybrid systems. When either a client wants to trade in a new product or we want to introduce a new product, trading protocol or other solution, we believe we benefit from our clients’ familiarity with our offerings as well as our integration into their order management systems and back offices. See “Business - Competition” for more detail on our competitors. Technology and Cybersecurity Environment Our business and its success are largely impacted by the introduction of increasingly complex and sophisticated technology systems and infrastructures and new business models. Offering specialized trading venues and solutions through the development of new and enhanced platforms is essential to maintaining our level of competitiveness in the market and attracting new clients seeking platforms that provide advanced automation and better liquidity. We believe we will continue to increase demand for our platforms and solutions and the volume of transactions on our platforms, and thereby enhance our client relationships, by responding to new trading and information requirements by utilizing technological advances and emerging industry standards and practices in an effective and efficient way. We plan to continue to focus on and invest in technology infrastructure initiatives and continually improve and expand our platforms and solutions to further enhance our market position. We experience cyber-threats and attempted security breaches. If these were successful, these cyber security incidents could impact revenue and operating income and increase costs. We therefore continue to make investments, which may result in increased costs, to strengthen our cybersecurity measures. Foreign Currency Exchange Rate Environment We earn revenues, pay expenses, hold assets and incur liabilities in currencies other than the U.S. dollar. Accordingly, fluctuations in foreign currency exchange rates can affect our results of operations from period to period. In particular, fluctuations in exchange rates for non-U.S. dollar currencies may reduce the U.S. dollar value of revenues, earnings and cash flows we receive from non-U.S. markets, increase our operating expenses (as measured in U.S. dollars) in those markets, negatively impact our competitiveness in those markets or otherwise adversely impact our results of operations or financial condition. Future fluctuations of foreign currency exchange rates and their impact on our results of operations and financial condition are inherently uncertain. As we continue to grow the size of our global operations, these fluctuations may be material. See Part II,

<s>[INST] Overview We are a leader in building and operating electronic marketplaces for our global network of clients across the financial ecosystem. Our network is comprised of clients across the institutional, wholesale and retail client sectors, including many of the largest global asset managers, hedge funds, insurance companies, central banks, banks and dealers, proprietary trading firms and retail brokerage and financial advisory firms as well as regional dealers. Our marketplaces facilitate trading across a range of asset classes, including rates, credit, equities and money markets. We are a global company serving clients in over 65 countries with offices in North America, Europe and Asia. We believe our proprietary technology and culture of collaborative innovation allow us to adapt our offerings to enter new markets, create new platforms and solutions and adjust to regulations quickly and efficiently. We support our clients by providing solutions across the trade lifecycle, including pretrade, execution, posttrade and data. Our institutional client sector serves institutional investors in over 40 markets across 25 currencies, and in over 65 countries around the globe. We connect institutional investors with pools of liquidity using our flexible order and trading systems. Our clients trust the integrity of our markets and recognize the value they get by trading electronically: enhanced transparency, competitive pricing, efficient trade execution and regulatory compliance. In our wholesale client sector, we provide a broad range of electronic, voice and hybrid platforms to more than 300 dealers and financial institutions with more than 100 actively trading on our electronic or hybrid markets with our Dealerweb platform. This platform was launched in 2008 following the acquisition of interdealer broker Hilliard Farber & Co., Inc. In 2011, we acquired the brokerage assets of Rafferty Capital Markets. Today, Dealerweb actively competes across a range of rates, credit, derivatives and equity markets. In our retail client sector, we provide advanced trading solutions for financial advisory firms and traders with our Tradeweb Direct platform. We entered the retail sector in 2006 and launched our Tradeweb Direct platform following the 2013 acquisition of BondDesk Group LLC, which was built to bring innovation and efficiency to the wealth management community. Tradeweb Direct has provided financial advisory firms access to live offerings, accurate pricing in the marketplace and fast execution. Our markets are large and growing. Electronic trading continues to increase across the markets in which we operate as a result of market demand for greater transparency, higher execution quality, operational efficiency and lower costs, as well as regulatory changes. We believe our deep client relationships, asset class breadth, geographic reach, regulatory knowledge and scalable technology position us to continue to be at the forefront of the evolution of electronic trading. Our platforms provide transparent, efficient, costeffective and compliant trading solutions across multiple products, regions and regulatory regimes. As market participants seek to trade across multiple asset classes, reduce their costs of trading and increase the effectiveness of their trading, including through the use of data and analytics, we believe the demand for our platforms and electronic trading solutions will continue to grow. Trends and Other Factors Impacting Our Performance Economic Environment Our business is impacted by the overall market activity and, in particular, trading volumes and market volatility. Lower volatility is correlated to lower liquidity, which may result in lower trading volume for our clients and may negatively impact our operating performance. Factors that may impact market activity in 2020 include, among other things, economic, political and social conditions, legislative, regulatory or government policy changes and health concerns associated with the coronavirus. As a result, our business is sensitive to slow trading environments and the continuity of conservative monetary policies of central banks internationally, which tend to lessen volatility. While our business is impacted by the overall activity of the market and market volatility, our revenues consist of a mix of fixed and variable fees that partially mitigates this impact. More importantly, we are actively engaged in the further electronification of trading activities, which will help mitigate this impact as we believe secular growth trends can partially offset market volatility risk. Regulatory Environment Our business is subject to extensive regulations in the United States and internationally [/INST] Positive. </s>

Uber Technologies, 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 consolidated financial statements and related notes included in Part II, Item 8, “Financial Statements and Supplementary Data”, of this Annual Report on Form 10-K. In addition to our historical consolidated financial information, 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. You should review the sections titled “Special Note Regarding Forward-Looking Statements” for a discussion of forward-looking statements and in Part I, Item 1A, “Risk Factors”, for a discussion of 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 and elsewhere in this Annual Report on Form 10-K. Overview We are a technology platform that uses a massive network, leading technology, operational excellence and product expertise to power movement from point A to point B. We develop and operate proprietary technology applications supporting a variety of offerings on our platform. We connect consumers with providers of ride services, restaurants and food delivery services, public transportation networks, e-bikes, e-scooters and other personal mobility options. We use this same network, technology, operational excellence and product expertise to connect shippers with carriers in the freight industry. We are also developing technologies that provide autonomous driving vehicle solutions to consumers, networks of vertical take-off and landing vehicles and new solutions to solve everyday problems. Financial and Operational Highlights (1) See the section titled “Reconciliations of Non-GAAP Financial Measures” for more information and reconciliations to the most directly comparable GAAP financial measure. (2) See the section titled “Certain Key Metrics and Non-GAAP Financial Measures” below for more information. (3) MAPCs presented for annual periods are MAPCs for the fourth quarter of the year. The 2018 MAPCs exclude the impact of our 2018 Divested Operations. (4) Net income (loss) attributable to Uber Technologies, Inc. includes stock-based compensation expense of $137 million, $172 million and $4.6 billion during the years ended December 31, 2017, 2018 and 2019, respectively. ** Percentage not meaningful. Highlights for 2019 In 2019, we crossed the 100 million mark for MAPCs, ending the year with 111 million MAPCs or 22% growth compared to 2018, while also seeing a 68% increase in the number of consumers using both Rides and Eats. Gross Bookings grew over $15 billion for the third consecutive year, up to $65.0 billion or 35%, on a constant currency basis. Revenue and Adjusted Net Revenue grew to $14.1 billion and $12.9 billion, respectively, with quarterly growth rates accelerating throughout 2019 and ending with a full-year Take Rate of 19.8%. Rides Adjusted EBITDA grew $530 million to $2.1 billion, exiting the year with a record quarter Rides Adjusted EBITDA profit of $742 million which more than covered our Corporate G&A and Platform R&D in the fourth quarter of 2019. Rides Adjusted EBITDA margin as a percentage of Rides revenue and Rides Adjusted Net Revenue improved every quarter in 2019. Eats Gross Bookings grew $6.6 billion to $14.5 billion, growing 83%, or 87% on a constant currency basis. Eats revenue grew 72%, or 76% on a constant currency basis. Eats Adjusted Net Revenue grew 82%, or 86% on a constant currency basis, while Eats full-year Take Rate was 9.5%. We continued to expand our other offerings, including Freight and Other Bets, resulting in a combined revenue growth of 128%. We ended the year with $11.3 billion in cash, cash equivalents and short-term investments. 2019 Significant Developments Driver Appreciation Award In April 2019, we paid a $299 million Driver appreciation award to Drivers who met certain criteria. The payment was accounted for as a Driver incentive in the second quarter of 2019. Initial Public Offering On May 9, 2019, our registration statement on Form S-1 (File No. 333-230812) related to our initial public offering (“IPO”) was declared effective by the SEC, and our common stock began trading on the NYSE on May 10, 2019. Our IPO closed on May 14, 2019. For additional information, see Note 1 - Description of Business and Summary of Significant Accounting Policies included in Part II, Item 8, “Financial Statements and Supplementary Data”, of this Annual Report on Form 10-K. PayPal, Inc. (“PayPal”) Private Placement On May 16, 2019, we closed a private placement by PayPal in which we issued and sold 11 million shares of our common stock at a purchase price of $45.00 per share and received aggregate proceeds of $500 million. Additionally, we and PayPal agreed to extend our global partnership, including a commitment to jointly explore certain commercial collaborations. Segment Change During the third quarter of 2019, following a number of leadership and organizational changes, the chief operating decision maker (“CODM”) changed how he assesses performance and allocates resources to a more disaggregated level in order to optimize utilization of the Company’s platform as well as manage research and development of new technologies. Based on this change, in the third quarter of 2019, we determined that we have five operating and reportable segments: Rides, Eats, Freight, Other Bets, and ATG and Other Technology Programs. For additional information, see Note 14 - Segment Information and Geographic Information included in Part II, Item 8, “Financial Statements and Supplementary Data”, of this Annual Report on Form 10-K. ATG Investment: Preferred Unit Purchase Agreement In July 2019, the investment by the ATG Investors in ATG was consummated. We received, in aggregate, consideration of $1.0 billion from Softbank, Toyota, and DENSO (collectively the “ATG Investors”). For additional information, see Note 17 - Non-Controlling Interests to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data”, of this Annual Report on Form 10-K. 2027 Senior Notes In September 2019, we issued 7.5% senior unsecured notes with an aggregate principal amount of $1.2 billion due on September 15, 2027 in a private placement offering. For additional information, see Note 8 - Long-Term Debt and Revolving Credit Arrangements to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data”, of this Annual Report on Form 10-K. Pending Acquisition of Majority Ownership in Cornershop In October 2019, we agreed to purchase a controlling interest in Cornershop, an online grocery delivery platform operating primarily in Chile and Mexico. For additional information, see Note 1 - Description of Business and Summary of Significant Accounting Policies to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data”, of this Annual Report on Form 10-K. U.S. Insurance Carrier Changes In October 2019, James River Group companies (“James River”) delivered a notice of early cancellation of all insurance policies (primarily auto insurance policies) issued to one of our wholly-owned subsidiaries, effective December 31, 2019, two-months earlier than the contractual expiration on February 29, 2020. In the fourth quarter of 2019, James River withdrew all funds previously held in a trust account. These funds continue to serve as collateral for our current and future claim settlement obligations under the indemnification agreements for these insurance policies issued by James River. Effective December 31, 2019, we executed insurance policies with new and existing carriers to provide the same coverage as provided under the James River policies. For additional information, see Note 1 - Description of Business and Summary of Significant Accounting Policies to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data”, of this Annual Report on Form 10-K. Recent Developments Acquisition of Careem On January 2, 2020, we acquired all entities of Careem Inc. and its subsidiaries, (collectively “Careem”) in jurisdictions where we received regulatory approval or did not require regulatory approval. For additional information, see Note 20 - Subsequent Events to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data”, of this Annual Report on Form 10-K. Divestiture of Uber Eats India to Zomato On January 21, 2020, we entered into a definitive agreement and completed the divestiture of our food delivery operations in India (“Uber Eats India”) to Zomato Media Private Limited (“Zomato”). For additional information, see Note 20 - Subsequent Events to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data”, of this Annual Report on Form 10-K. Legal and Regulatory Developments California State Assembly Bill 5 (“AB5”) AB5 is a recently enacted statute that codifies a test to determine whether a worker is an employee under California law. The test is referred to as the “ABC” test, and was originally handed down by the California Supreme Court in Dynamex Operations v. Superior Court in 2018. Under the ABC test, workers performing services for a hiring entity are considered employees unless the hiring entity can demonstrate three things: the worker (A) is free from the hiring entity’s control, (B) performs work that is outside the usual course of the hiring entity’s business, and (C) customarily engages in the independent trade, work or type of business performed for the hiring entity. AB5 went into effect in January 2020. AB5 provides a mechanism for determining whether workers of a hiring entity are employees or independent contractors, but the new law does not result in any immediate change in how workers are classified. If the State of California, cities or municipalities, or workers disagree with how a hiring entity classifies workers, AB5 sets forth the test for evaluating their classification. A similar ABC test was adopted more than 10 years ago in Massachusetts. We continue to evaluate the impact of AB5 on our business. In January 2020, we introduced a number of product changes in California intended to, among other things, provide Drivers with more information about rider destinations, trip distance, and expected fares, display prices more clearly, and allow users to select preferred drivers, all of which are intended to further strengthen the independence of Drivers in California and protect their ability to work flexibly when using the Uber platform. In addition, we are considering legal responses, additional potential business changes, a potential legislative amendment and have filed a California state ballot initiative which will be voted on in November 2020. The ballot initiative does not ask for exemption from AB5, although many other industries in California received an exemption from the ABC test through special amendments. Instead, we are working to provide voters with an opportunity to support a framework that advocates for legal certainty regarding the status of independent work, and seeks to protect worker flexibility and the quality of on-demand work, while establishing the following: • a guaranteed minimum earnings standard for Drivers; • occupational/accident insurance for injury protection; • healthcare subsidies; and • protection against discrimination and harassment. As we explore legal options, we have received and expect to continue to receive claims by or on behalf of Drivers that claim that the Drivers have been misclassified. The Company believes that these claims are without merit and intends to defend itself vigorously. For a discussion of risk factors related to AB5, including how AB5 may impact our business, result of operations, financial position and operating condition, see the risk factor titled “-Our business would be adversely affected if Drivers were classified as employees” included in Part I, Item 1A, “Risk Factors”, and Note 15 - Commitments and Contingencies to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data”, of this Annual Report on Form 10-K. Transport for London (“TfL”) TfL denied our application for a new license on November 25, 2019. We are continuing to operate in London, while we have appealed TfL’s decision and expect a hearing in Westminster Magistrates Court in mid-2020. We are taking steps to address issues identified by TfL (such as information technology service management processes) and also plan to roll out additional systems to strengthen identity confirmation of Rides Drivers, which may include a facial matching process, which we believe are the most robust in the industry. Certain Key Metrics and Non-GAAP Financial Measures Unless otherwise noted, all of our key metrics exclude historical results from China, Russia/CIS, and Southeast Asia, geographies where we previously had operations through the first quarter of 2018 and where we now participate solely through our minority-owned affiliates. Adjusted Net Revenue and Adjusted EBITDA, as well as revenue and ANR growth rates in constant currency, are non-GAAP financial measures. For more information about how we use these non-GAAP financial measures in our business, the limitations of these measures, and a reconciliation of these measures to the most directly comparable GAAP financial measures, see the section titled “Reconciliations of Non-GAAP Financial Measures.” Monthly Active Platform Consumers. MAPCs is the number of unique consumers who completed a Rides or New Mobility ride or received an Eats meal on our platform at least once in a given month, averaged over each month in the quarter. While a unique consumer can use multiple product offerings on our platform in a given month, that unique consumer is counted as only one MAPC. We use MAPCs to assess the adoption of our platform and frequency of transactions, which are key factors in our penetration of the countries in which we operate. Trips. We define Trips as the number of completed consumer Rides or New Mobility rides and Eats meal deliveries in a given period. For example, an UberPOOL ride with three paying consumers represents three unique Trips, whereas an UberX ride with three passengers represents one Trip. We believe that Trips are a useful metric to measure the scale and usage of our platform. Gross Bookings. We define Gross Bookings as the total dollar value, including any applicable taxes, tolls, and fees, of Rides and New Mobility rides, Eats meal deliveries, and amounts paid by Freight shippers, in each case without any adjustment for consumer discounts and refunds, Driver and Restaurant earnings, and Driver incentives. Gross Bookings do not include tips earned by Drivers. Gross Bookings are an indication of the scale of our current platform, which ultimately impacts revenue. Adjusted Net Revenue. See the section titled “Reconciliations of Non-GAAP Financial Measures” for our definition and a reconciliation to the most directly comparable GAAP financial measure. Take Rate is defined as Adjusted Net Revenue as a percentage of Gross Bookings. For purposes of Take Rate, Gross Bookings include the impact of our 2018 Divested Operations, defined as operations in (i) Southeast Asia prior to the sale of those operations to Grab and (ii) Russia/CIS prior to the formation of our Yandex.Taxi joint venture. 2019 Compared to 2018 Adjusted Net Revenue increased $2.6 billion, or 25%, primarily driven by growth in Trips and Gross Bookings within Rides and Eats. Rides Take Rate was 21.4%, down from 21.9% in 2018, primarily driven by an increase in incentive spend in Latin America. Eats Take Rate was 9.5%, slightly down from 9.6% in 2018, primarily due to an increase in Delivery People and restaurant payments coupled with higher delivery and subscription discounts, partially offset by lower incentive spend in the U.S. and Canada markets. Adjusted EBITDA. See the section titled “Reconciliations of Non-GAAP Financial Measures” for our definition and a reconciliation of net income (loss) attributable to Uber Technologies, Inc. to Adjusted EBITDA. 2019 Compared to 2018 Adjusted EBITDA loss increased $878 million, or 48%, primarily attributable to continued investments within our non-Rides offerings and an increase in corporate overhead as we grow the business. These investments drove an increase in our Adjusted EBITDA loss margin as a percentage of Adjusted Net Revenue of (3)% to (21)%. Components of Results of Operations The following discussion on trends in our components of results of operations excludes IPO related impacts as well as the Driver appreciation award of $299 million, both of which occurred during the second quarter of 2019. The Driver appreciation award was accounted for as a Driver incentive. For additional information about our IPO, see Note 1 - Description of Business and Summary of Significant Accounting Policies to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data”, of this Annual Report on Form 10-K. Revenue We generate substantially all of our revenue from fees paid by Drivers and Restaurants for use of our platform. We have concluded that we are an agent in these arrangements as we arrange for other parties to provide the service to the end-user. Under this model, revenue is net of Driver and Restaurant earnings and Driver incentives. We act as an agent in these transactions by connecting consumers to Drivers and Restaurants to facilitate a Trip or meal delivery service. For additional discussion related to our revenue, see the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates - Revenue Recognition,” Note 1 - Description of Business and Summary of Significant Accounting Policies - Revenue Recognition, and Note 2 - Revenue to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data”, of this Annual Report on Form 10-K. Cost of Revenue, Exclusive of Depreciation and Amortization Cost of revenue, exclusive of depreciation and amortization, consists primarily of insurance costs, credit card processing fees, hosting and co-located data center expenses, mobile device and service expenses, amounts related to fare chargebacks and other credit card losses, excess Driver incentives, and costs incurred with carriers for Freight transportation. Insurance expenses include coverage for auto liability, general liability, uninsured and underinsured motorist liability, and auto physical damage related to our Rides products and Eats offering. Excess Driver incentives are primarily related to our Rides products in emerging markets and our Eats offering. We expect that cost of revenue, exclusive of depreciation and amortization, will increase on an absolute dollar basis for the foreseeable future to the extent we continue to see growth on the platform. As Trips increase, we expect related increases for insurance costs, credit card processing fees, hosting and co-located data center expenses, and other cost of revenue, exclusive of depreciation and amortization. Cost of revenue, exclusive of depreciation and amortization, may vary as a percentage of revenue from period to period based on our investments in our business, including excess Driver incentives, and our Freight offering and New Mobility products, each of which have higher costs as a percentage of revenue than our Rides and Eats products, as we are the principal in these arrangements, as well as the cost of scooters, which are expensed once placed in service. Operations and Support Operations and support expenses consist primarily of compensation expenses, including stock-based compensation to employees who support operations in cities, Driver operations employees, community management employees, and platform user support representatives, as well as costs for allocated overhead and those associated with Driver background checks. We expect that operations and support expenses will increase on an absolute dollar basis for the foreseeable future as we continue to grow our operations and hire additional employees and platform user support representatives. To the extent we are successful in becoming more efficient in supporting platform users, we would expect operations and support expenses as a percentage of revenue to decrease over the long term. Sales and Marketing Sales and marketing expenses consist primarily of compensation expenses, including stock-based compensation to sales and marketing employees, advertising expenses, expenses related to consumer acquisition and retention, including consumer discounts, rider facing loyalty programs, promotions, refunds, and credits, Driver referrals, and allocated overhead. We expense advertising and other promotional expenditures as incurred. We expect that sales and marketing expenses will increase on an absolute dollar basis and vary from period to period as a percentage of revenue for the foreseeable future as we plan to continue to invest in sales and marketing to grow the number of platform users and increase our brand awareness. The trend and timing of our brand marketing expenses will depend in part on the timing of marketing campaigns. Research and Development Research and development expenses consist primarily of compensation expenses for engineering, product development, and design employees, including stock-based compensation, expenses associated with ongoing improvements to, and maintenance of, our platform offerings, and ATG and Other Technology Programs development expenses, as well as allocated overhead. We expense substantially all research and development expenses as incurred. We expect that research and development expenses will increase on an absolute dollar basis and vary from period to period as a percentage of revenue for the foreseeable future as we continue to invest in research and development activities relating to ongoing improvements to and maintenance of our platform offerings, as well as ATG and Other Technology Programs, and other research and development programs, including the hiring of engineering, product development, and design employees to support these efforts. General and Administrative General and administrative expenses consist primarily of compensation expenses, including stock-based compensation, for executive management and administrative employees, including finance and accounting, human resources, and legal, as well as facilities and general corporate, and director and officer insurance expenses. General and administrative expenses also include legal settlements. We expect that general and administrative expenses will increase on an absolute dollar basis and vary from period to period as a percentage of revenue for the foreseeable future as we focus on processes, systems, and controls to enable our internal support functions to scale with the growth of our business. We expect to incur additional expenses as a result of operating as a public company, including expenses to comply with the rules and regulations applicable to companies listed on a national securities exchange, expenses related to compliance and reporting obligations pursuant to the rules and regulations of the SEC, as well as higher expenses for general and director and officer insurance, investor relations, and professional services. Depreciation and Amortization Depreciation and amortization consists of all depreciation and amortization expenses associated with our property and equipment and acquired intangible assets. Depreciation includes expenses associated with buildings, site improvements, computer and network equipment, leased vehicles, furniture, fixtures, and dockless e-bikes, as well as leasehold improvements. Amortization includes expenses associated with our capitalized internal-use software and acquired intangible assets. We expect that depreciation and amortization expenses will increase on an absolute dollar basis as we continue to build out our data center and network infrastructure and build new office locations. Interest Expense Interest expense consists primarily of interest expense associated with our outstanding debt, including accretion of debt discount. Other Income (Expense), Net Other income (expense), net primarily includes the following items: • Interest income, which consists primarily of interest earned on our cash and cash equivalents and restricted cash and cash equivalents. • Gain on business divestitures, which consists of gain on sale of divested operations. • Gain (loss) on debt and equity securities, net, which consists primarily of gains from fair value adjustments relating to our investments such as our investment in Didi. • Foreign currency exchange gains (losses), net, which consist primarily of remeasurement of transactions and monetary assets and liabilities denominated in currencies other than the functional currency at the end of the period. • Change in fair value of embedded derivatives, which consists primarily of gains and losses on embedded derivatives related to our Convertible Notes until their extinguishment in connection with our IPO. • Gain on extinguishment of convertible notes and settlement of derivatives. • Other, which consists primarily of changes in the fair value of warrants and income from forfeitures of warrants. Provision for (Benefit from) Income Taxes We are subject to income taxes in the United States and foreign jurisdictions in which we do business. These foreign jurisdictions have different statutory tax rates than those in the United States. Additionally, certain of our foreign earnings may also be taxable in the United States. Accordingly, our effective tax rate will vary depending on the relative proportion of foreign to domestic income, use of foreign tax credits, changes in the valuation of our deferred tax assets, and liabilities and changes in tax laws. Equity Method Investment, Net of Tax Equity method investment, net of tax primarily includes the results of our share of income or loss from our Yandex.Taxi joint venture. Results of Operations The following table summarizes our consolidated statements of operations for each of the periods presented (in millions): The following table sets forth the components of our consolidated statements of operations for each of the periods presented as a percentage of revenue (1): (1) Totals of percentage of revenues may not foot due to rounding. Comparison of the Years Ended December 31, 2017, 2018 and 2019 Revenue (1) Including previously reported Other Core Platform revenue of $390 million, $255 million and $133 million for the years ended December 31, 2017, 2018 and 2019, respectively. (2) Consists of $42 million collaboration revenue from Toyota recognized for the year ended December 31, 2019. For additional information, see Note 17 - Non-Controlling Interests to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data”, of this Annual Report on Form 10-K. ** Percentage not meaningful. 2019 Compared to 2018 Revenue increased $2.9 billion, or 26%, primarily attributable to an increase in Gross Bookings of 31% which was made up of a 20% increase in Rides, an 83% increase in Eats, and a 121% increase in other offerings including Freight and Other Bets. The overall increase in Gross Bookings was driven by a 22% increase in MAPCs due to global expansion of our Eats product offerings combined with wider market adoption of our Rides product, and overall growth in our other offerings. 2018 Compared to 2017 Revenue increased $3.3 billion, or 42%, primarily attributable to an increase in Gross Bookings of 45% which was made up of a 32% increase in Rides, an 168% increase in Eats, as well as an increase in other offerings including Freight and Other Bets. The overall increase in Gross Bookings was driven by a 34% increase in MAPCs primarily due to an increase in booking fees in Rides and expansion in Eats. Cost of Revenue, Exclusive of Depreciation and Amortization 2019 Compared to 2018 Cost of revenue, exclusive of depreciation and amortization, increased $1.6 billion, or 28%, primarily attributable to an increase in insurance and credit card processing expenses due to overall growth in Trips in our Rides and Eats businesses as well as courier payments related to our Freight business and excess Driver incentives. Excess Driver incentives increased $310 million in 2019 compared to 2018. 2018 Compared to 2017 Cost of revenue, exclusive of depreciation and amortization, increased $1.5 billion, or 35%, primarily attributable to an increase in insurance and credit card processing expenses largely due to an increase in miles driven in Rides, and excess Driver incentives largely due to expansion in our Eats business. Excess Driver incentives increased $306 million in 2018 compared to 2017. Operations and Support 2019 Compared to 2018 Operations and support expenses increased $786 million, or 52%, primarily attributable to an increase in stock-based compensation related to RSUs with a performance condition satisfied upon our IPO, employee headcount costs and external contractor expenses. 2018 Compared to 2017 Operations and support expenses increased $162 million, or 12%, primarily attributable to a 32% increase in platform user support operations headcount that resulted in $95 million in increased compensation expenses and allocated facilities expenses related to our expansion into new cities and increased penetration in existing cities, as well as an increase in Driver background-check costs. Sales and Marketing 2019 Compared to 2018 Sales and marketing expenses increased $1.5 billion, or 47%, primarily attributable to an increase in consumer discounts, rider facing loyalty expense, promotions, credits and refunds, stock-based compensation related to RSUs with a performance condition satisfied upon our IPO and employee headcount costs. Consumer discounts, rider facing loyalty expense, promotions, credits and refunds increased $1.1 billion to $2.5 billion compared to $1.4 billion in 2018. 2018 Compared to 2017 Sales and marketing expenses increased by $627 million, or 25%, primarily attributable to an increase in consumer discounts, promotions, credits and refunds, and consumer advertising and other marketing programs. Additionally, we had a 27% increase in sales and marketing headcount that resulted in $111 million in increased compensation and allocated facilities expenses as we continued to make investments in attracting, retaining, and engaging platform users. Consumer discounts, rider facing loyalty expense, promotions, credits and refunds increased to $1.4 billion compared to $949 million in 2017. Research and Development 2019 Compared to 2018 Research and development expenses increased $3.3 billion, or 221%, primarily attributable to an increase in stock-based compensation related to RSUs with a performance condition satisfied upon our IPO and employee headcount costs. 2018 Compared to 2017 Research and development expenses increased by $304 million, or 25%. This increase was primarily due to a 17% increase in research and development headcount as we work to drive continued product innovation, resulting in a $354 million increase in compensation and allocated facilities expenses, partially offset by a $44 million decrease in external engineering and research and development equipment spend. General and Administrative 2019 Compared to 2018 General and administrative expenses increased $1.2 billion, or 58%, primarily attributable to an increase in stock-based compensation related to RSUs with a performance condition satisfied upon our IPO and employee headcount costs. 2018 Compared to 2017 General and administrative expenses decreased $181 million, or 8%, primarily attributable to a $325 million decrease in legal, tax, and regulatory reserves and settlements, partially offset by an increase in general and administrative headcount of 28% resulting in an $89 million increase in compensation and allocated facilities expenses and a $43 million increase in contractors and outside service provider expenses to support the overall growth of our business. Depreciation and Amortization 2019 Compared to 2018 Depreciation and amortization expenses increased $46 million, or 11%, primarily attributable to data center servers depreciation. 2018 Compared to 2017 Depreciation and amortization decreased by $84 million, or 16%. This decrease was primarily due to a $198 million decrease in Vehicle Solutions depreciation as the vehicles were held for sale as of December 31, 2017 and no longer subject to depreciation. The decrease was partially offset by increased depreciation of leased computer equipment of $75 million, a $21 million increase in data center equipment depreciation, and a $12 million increase in leasehold improvements depreciation. There was also a $6 million increase in developed technology amortization as a result of the acquisition of JUMP in 2018. Interest Expense 2019 Compared to 2018 Interest expense decreased by $89 million, or 14%, primarily due to the conversion of all our outstanding Convertible Notes into common stock upon our IPO in May 2019, partially offset by additional interest expense resulting from the issuance of our 2023 Senior Notes and our 2026 Senior Notes in October 2018. 2018 Compared to 2017 Interest expense increased by $169 million, or 35%. This increase was primarily due to our entry into our $1.5 billion 2018 Senior Secured Term Loan in April 2018, the issuance of $500 million of our 2023 Senior Notes in October 2018, and the issuance of $1.5 billion of our 2026 Senior Notes in October 2018. Interest on Convertible Notes was paid in kind, and therefore interest expense increased due to the higher debt balance outstanding. Other Income (Expense), Net ** Percentage not meaningful. 2019 Compared to 2018 Interest income increased by $130 million or 125% primarily due to interest income earned on higher average cash balances from the proceeds of our IPO and additional investment from our ATG Investors. Foreign currency exchange gains (losses), net decreased by $5 million due to unrealized impacts on foreign exchange resulting from remeasurement of our foreign currency monetary assets and liabilities denominated in currencies other than the functional currency of an entity. Gain on business divestitures decreased by $3.2 billion due to the non-recurrence in 2019 of gains on the divestitures of our Southeast Asia and Russia/CIS operations in 2018. Gain (loss) on debt and equity securities, net decreased by $2.0 billion primarily due to the non-recurrence in 2019 of a gain from a fair value adjustment of our Didi investment in 2018. Change in fair value of embedded derivatives increased by $559 million as a result of their revaluation, primarily due to changes in discount yield and time to liquidity. Gain on extinguishment of convertible notes and settlement of derivatives increased by $444 million due to the conversion of our 2021 Convertible Notes and the 2022 Convertible Notes and settlement of the related derivative in connection with our IPO during the second quarter of 2019. Other decreased by $201 million primarily due to non-recurrence in 2019 of income from forfeitures of warrants during the year ended December 31, 2018. 2018 Compared to 2017 Interest income increased by $33 million, or 46%, from 2017 to 2018. This increase was primarily due to higher average cash balances in 2018 from the proceeds from our entry into our 2018 Senior Secured Term Loan, the issuance of our 2023 and 2026 Senior Notes, and the issuance of shares of our Series G-1 redeemable convertible preferred stock. Foreign currency exchange gains (losses), net decreased by $87 million from 2017 to 2018. This decrease was primarily due to unrealized impacts on foreign exchange resulting from remeasurement of our foreign currency monetary assets and liabilities denominated in non-functional currencies. The movements were primarily due to fluctuations of the Singapore dollar and Australian dollar against the U.S. dollar. The increase was also due to realized impacts on foreign exchange resulting from the settlement of our foreign currency assets and liabilities. Gain on divestitures increased by $3.2 billion from 2017 to 2018. This increase was due to gains on the divestitures of our Russia/CIS and Southeast Asia operations. Unrealized gain on investments increased by $2.0 billion from 2017 to 2018. This increase was primarily due to a gain from a fair value adjustment of our Didi investment. Change in fair value of embedded derivatives decreased by $328 million from 2017 to 2018 as a result of their revaluation. Other increased by $181 million from 2017 to 2018. This increase was primarily due to income of $152 million from the forfeiture of the Didi warrant because of Didi’s breach of a non-compete clause. Provision for (Benefit from) Income Taxes ** Percentage not meaningful. 2019 Compared to 2018 Provision for income taxes decreased by $238 million, primarily driven by the deferred U.S. tax expense related to our investment in Didi and Grab and deferred China tax related to our investment in Didi incurred during the first quarter of 2018. In March 2019, we initiated a series of transactions resulting in changes to our international legal structure, including a redomiciliation of a subsidiary to the Netherlands and a transfer of certain intellectual property rights among our wholly-owned subsidiaries, primarily to align our structure to our evolving operations. The redomiciliation resulted in a step-up in the tax basis of intellectual property rights and a correlated increase in foreign deferred tax assets in an amount of $6.4 billion, net of a reserve for uncertain tax positions of $1.4 billion. Based on available objective evidence, we believe it was not more-likely-than-not that these additional foreign deferred tax assets would be realizable as of December 31, 2019 and, therefore, they were offset by a full valuation allowance to the extent not offset by reserves from uncertain tax positions. 2018 Compared to 2017 Provision for income taxes increased by $825 million. This increase was primarily due to a tax benefit of $722 million recorded in 2017 related to the Tax Cuts and Jobs Act of 2017 (the “Tax Act”), tax expense of $576 million in 2018 related to the revaluation of our Didi investment, and tax expense of $116 million in 2018 related to the divestiture of our Southeast Asia operations. This was partially offset by a tax benefit of $589 million in 2018 primarily related to losses from operations recorded in the United States. Loss from Equity Method Investment, Net of Tax ** Percentage not meaningful. 2019 Compared to 2018 Loss from equity method investment, net of tax decreased by $8 million primarily due to a decrease in our portion of the net loss from our Yandex.Taxi joint venture and amortization expense on intangible assets resulting from the basis difference in this investment. 2018 Compared to 2017 Loss from equity method investment, net of income taxes increased $42 million due to our investment in our Yandex.Taxi joint venture. This amount represents our portion of the net loss of our Yandex.Taxi joint venture and amortization expense on intangible assets resulting from the basis difference in this investment. Segment Results of Operations We operate our business as five operating and reportable segments: Rides, Eats, Freight, Other Bets, and ATG and Other Technology Programs. For additional information about our segments, see Note 14 - Segment Information and Geographic Information in the notes to the consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data”, of this Annual Report on Form 10-K. Adjusted Net Revenue (1) Including previously reported Other Core Platform revenue of $390 million, $255 million and $133 million for the years ended December 31, 2017, 2018 and 2019, respectively. (2) Consists of $42 million collaboration revenue from Toyota recognized for the year ended December 31, 2019. Refer to Note 17 - Non-Controlling Interests of Part II, Item 8, “Financial Statements and Supplementary Data”, of this Annual Report on Form 10-K for further information on collaboration revenue. ** Percentage not meaningful. Segment Adjusted EBITDA Segment Adjusted EBITDA is defined as revenue less the following expenses: cost of revenue, operations and support, sales and marketing, and general and administrative and research and development expenses associated with our segments. Segment adjusted EBITDA also excludes any non-cash items, certain transactions that are not indicative of ongoing segment operating performance and / or items that management does not believe are reflective of our ongoing core operations. Our segment adjusted EBITDA measures replace what was previously reported as contribution profit (loss) and maintains the same definition. Previously reported Core Platform contribution profit (loss) is the sum of Rides adjusted EBITDA and Eats adjusted EBITDA, and previously reported Other Bets contribution profit (loss) is the sum of Freight adjusted EBITDA and Other Bets adjusted EBITDA. (1) Excluding stock-based compensation expense. (2) Includes costs that are not directly attributable to the Company’s reportable segments. Corporate G&A also includes certain shared costs such as finance, accounting, tax, human resources, information technology and legal costs. Platform R&D also includes mapping and payment technologies and support and development of the internal technology infrastructure. The Company’s allocation methodology is periodically evaluated and may change. (3) See the section titled “Reconciliations of Non-GAAP Financial Measures” for more information and reconciliations to the most directly comparable GAAP financial measure. ** Percentage not meaningful. Rides Segment For the year ended December 31, 2019 compared to the same period in 2018, Rides adjusted net revenue increased $1.5 billion (16%) and Rides adjusted EBITDA profit increased $530 million (34%). Rides adjusted net revenue increased primarily attributable to U.S. pricing changes effective in the second and third quarter of 2019 and deeper penetration into international markets, partially offset by a one-time Driver appreciation award. Rides Take Rate decreased to 21.4% from 21.9% compared to the same period in 2018 driven by an increase in incentive spend in Latin America. Rides adjusted EBITDA profit increased primarily attributable to an increase in Rides adjusted net revenue partially offset by an increase in consumer promotions and variable costs attributable to the overall growth of the business. For the year ended December 31, 2018 compared to the same period in 2017, Rides adjusted net revenue increased $2.4 billion (35%) and Rides Adjusted EBITDA profit increased $1.2 billion (297%). Rides adjusted net revenue increased primarily attributable to an increase in gross bookings as a result of higher bookings fees. Rides Take Rate increased to 21.9% from 20.4% in the same period in 2017 driven by a decrease in incentive spend. Rides adjusted EBITDA profit increased primarily attributable to an increase in Rides adjusted net revenue, partially offset by an increase in variable costs related to the overall growth of the business. Eats Segment For the year ended December 31, 2019 compared to the same period in 2018, Eats adjusted net revenue increased $624 million (82%) and Eats adjusted EBITDA loss increased $771 million (128%). Eats adjusted net revenue increased primarily attributable to an increase in gross bookings of 83%, mainly due to changes to our service fees in U.S. and Canada and continued expansion into international markets. These increases were partially offset by a one-time Driver appreciation award as well as higher Delivery People incentive spend, primarily in our international markets. Eats adjusted EBITDA loss increased primarily attributable to an increase in consumer promotions, brand marketing, and employee headcount costs. For the year ended December 31, 2018 compared to the same period in 2017, Eats adjusted net revenue increased $396 million (109%) and Eats adjusted EBITDA loss increased $246 million (69%). Eats adjusted net revenue increased primarily attributable to an increase in gross bookings of 164% as we worked to expand the business. Our Eats Take Rate declined to 9.6% in 2018 compared to 12.1% in 2017 as a result of increased Driver incentives, expansion into new regions, and lower average basket sizes. Eats adjusted EBITDA loss increased on a dollar basis although Eats adjusted EBITDA margin as a percentage of Eats Adjusted Net Revenue improved as we worked to scale the business. Freight Segment For the year ended December 31, 2019 compared to the same period in 2018, Freight revenue increased $375 million (105%) and Freight adjusted EBITDA loss increased $115 million (113%). Freight revenue increased primarily attributable to an increase in load volume over 100% domestically as the business expanded the number of shippers and carriers on the network despite industry-wide conditions that have led to a decline in revenue per load. Freight adjusted EBITDA loss increased attributable to an increase in investment spend in our Freight offerings as we continue to grow the business. For the year ended December 31, 2018 compared to the same period in 2017, Freight revenue increased $289 million and Freight adjusted EBITDA loss increased $63 million (162%). Freight revenue and adjusted EBITDA loss increased primarily attributable to launching our Freight offerings in 2017. Other Bets Segment For the year ended December 31, 2019 compared to the same period in 2018, Other Bets revenue increased $102 million and Other Bets adjusted EBITDA loss increased $201 million. Other Bets revenue increased as we continue to expand the reach of our New Mobility offerings. Other Bets adjusted EBITDA loss increased attributable to an increase in investment spend in our New Mobility offerings as we continue to launch in new cities. For the year ended December 31, 2018 compared to the same period in 2017, Other Bets revenue increased $17 million and Other Bets adjusted EBITDA loss increased $49 million. Other Bets revenue and adjusted EBITDA loss increased as a result of our New Mobility offering that was launched in 2018. ATG and Other Technology Programs Segment For the year ended December 31, 2019 compared to the same period in 2018, ATG and Other Technology Programs revenue increased $42 million and ATG and Other Technology Programs adjusted EBITDA loss decreased $38 million (7%). ATG and Other Technology Programs revenue increased attributable to collaboration revenue related to our three-year joint collaboration agreement with Toyota and DENSO. ATG and Other Technology Programs adjusted EBITDA loss decreased due to an increase in revenue, as noted above, partially offset by an increase in operational expenses. For the year ended December 31, 2018 compared to the same period in 2017, ATG and Other Technology Programs adjusted EBITDA loss decreased $6 million (1%). ATG and Other Technology Programs adjusted EBITDA loss decreased primarily attributable to lower general and administrative spend driven by legal. This is partially offset by increased spend in research and development driven by headcount. Reconciliations of Non-GAAP Financial Measures We collect and analyze operating and financial data to evaluate the health of our business and assess our performance. In addition to revenue, net income (loss), loss from operations, and other results under GAAP, we use Adjusted Net Revenue, Adjusted EBITDA, and Adjusted EBITDA margin as a percentage of Adjusted Net Revenue as well as revenue and ANR growth rates in constant currency, which are described below, to evaluate our business. We have included these non-GAAP financial measures because they are key measures used by our management to evaluate our operating performance. Accordingly, we believe that these non-GAAP financial measures provide useful information to investors and others in understanding and evaluating our operating results in the same manner as our management team and board of directors. Our calculation of these non-GAAP financial measures may differ from similarly-titled non-GAAP measures, if any, reported by our peer companies. These non-GAAP financial measures should not be considered in isolation from, or as substitutes for, financial information prepared in accordance with GAAP. Adjusted Net Revenue We define Adjusted Net Revenue as revenue less (i) excess Driver incentives and (ii) Driver referrals. We define Rides Adjusted Net Revenue as Rides revenue less (i) excess Driver incentives and (ii) Driver referrals. We define Eats Adjusted Net Revenue as Eats revenue less (i) excess Driver incentives and (ii) Driver referrals. We believe that this measure is informative of our top line performance because it measures the total net financial activity reflected in the amount earned by us after taking into account all Driver and restaurant earnings, Driver incentives, and Driver referrals. Adjusted Net Revenue is lower than revenue in all reported periods. Excess Driver incentives refer to cumulative payments, including incentives but excluding Driver referrals, to Drivers that exceed the cumulative revenue that we recognize from Drivers with no future guarantee of additional revenue. Cumulative payments to Drivers could exceed cumulative revenue from Drivers as a result of Driver incentives or when the amount paid to Drivers for a Trip exceeds the fare charged to the consumer. Further, cumulative payments to Drivers for Eats deliveries historically have exceeded the cumulative delivery fees paid by consumers. Excess Driver incentives are recorded in cost of revenue, exclusive of depreciation and amortization. Driver referrals are recorded in sales and marketing expenses. Driver incentives and Driver referrals largely depend on our business decisions based on market conditions. We include the impact of these amounts in Adjusted Net Revenue to evaluate how increasing or decreasing incentives would impact our top line performance, and the overall net financial activity between us and our customers, which ultimately impacts our Take Rate, which is calculated as Adjusted Net Revenue as a percentage of Gross Bookings. For purposes of Take Rate, Gross Bookings include the impact of our 2018 Divested Operations. Management views Driver incentives and Driver referrals as Driver payments in the aggregate, whether they are classified as Driver incentives, excess Driver incentives, or Driver referrals. Adjusted Net Revenue has limitations as a financial measure, should be considered as supplemental in nature, and is not meant as a substitute for revenue prepared in accordance with GAAP. The following tables present reconciliations of Adjusted Net Revenue, Rides Adjusted Net Revenue and Eats Adjusted Net Revenue to the most directly comparable GAAP financial measures for each of the periods indicated. Freight Adjusted Net Revenue, Other Bets Adjusted Net Revenue and ATG and Other Technology Programs Adjusted Net Revenue are equal to GAAP net revenue in all periods presented. The comparability of the results for the periods presented above was impacted by our 2018 Divested Operations. The 2018 Divested Operations decreased Adjusted Net Revenue by $55 million and $4 million during the years ended December 31, 2017 and 2018, respectively, due to excess Driver incentives and Driver referrals for the 2018 Divested Operations being greater than revenue for the 2018 Divested Operations in these periods. Adjusted EBITDA We define Adjusted EBITDA as net income (loss), excluding (i) income (loss) from discontinued operations, net of income taxes, (ii) net income (loss) attributable to non-controlling interests, net of tax, (iii) provision for (benefit from) income taxes, (iv) income (loss) from equity method investment, net of tax, (v) interest expense, (vi) other income (expense), net, (vii) depreciation and amortization, (viii) stock-based compensation expense, (ix) certain legal, tax, and regulatory reserve changes and settlements, (x) asset impairment/loss on sale of assets, (xi) acquisition and financing related expenses, (xii) restructuring charges and (xiii) other items not indicative of our ongoing operating performance. We have included Adjusted EBITDA in this Annual Report on Form 10-K because it is a key measure used by our management team to evaluate our operating performance, generate future operating plans, and make strategic decisions, including those relating to operating expenses. Accordingly, we believe that Adjusted EBITDA provides useful information to investors and others in understanding and evaluating our operating results in the same manner as our management team and board of directors. In addition, it provides a useful measure for period-to-period comparisons of our business, as it removes the effect of certain non-cash expenses and certain variable charges. Adjusted EBITDA has limitations as a financial measure, should be considered as supplemental in nature, and is not meant as a substitute for the related financial information prepared in accordance with GAAP. These limitations include the following: • Adjusted EBITDA excludes certain recurring, non-cash charges, such as depreciation of property and equipment and amortization of intangible assets, and although these are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future, and Adjusted EBITDA does not reflect all cash capital expenditure requirements for such replacements or for new capital expenditure requirements; • Adjusted EBITDA excludes stock-based compensation expense, which has been, and will continue to be for the foreseeable future, a significant recurring expense in our business and an important part of our compensation strategy; • Adjusted EBITDA excludes other items not indicative of our ongoing operating performance; • Adjusted EBITDA does not reflect period to period changes in taxes, income tax expense or the cash necessary to pay income taxes; • Adjusted EBITDA does not reflect the components of other income (expense), net, which includes interest income, foreign currency exchange gains (losses), net, gain on business divestitures, gain (loss) on debt and equity securities, net, and change in fair value of embedded derivatives; and • Adjusted EBITDA excludes certain legal, tax, and regulatory reserve changes and settlements that may reduce cash available to us. The following table presents a reconciliation of net income (loss) attributable to Uber Technologies, Inc., the most directly comparable GAAP financial measure, to Adjusted EBITDA for each of the periods indicated: The comparability of the results for the periods presented above was impacted by our 2018 Divested Operations. During the years ended December 31, 2017 and 2018, the 2018 Divested Operations unfavorably impacted net income (loss) attributable to Uber Technologies, Inc. by $481 million and $127 million, respectively. Adjusted EBITDA Margin as a Percentage of ANR We define Adjusted EBITDA margin as a percentage of ANR as Adjusted EBITDA divided by Adjusted Net Revenue. Constant Currency We compare the percent change in our current period results from the corresponding prior period using constant currency disclosure. We present constant currency growth rate information to provide a framework for assessing how our underlying revenue and ANR performed excluding the effect of foreign currency rate fluctuations. We calculate constant currency by translating our current period financial results using the corresponding prior period’s monthly exchange rates for our transacted currencies other than the U.S. dollar. Selected Quarterly Financial Data The following tables set forth our unaudited selected quarterly financial data for each of the quarters indicated. This unaudited selected quarterly financial data has been prepared 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, the financial data set forth in the tables below reflect all normal recurring adjustments necessary for the fair statement of results of operations for these periods. Our historical results are not necessarily indicative of the results that may be expected in the future and the results of a particular quarter or other interim period are not necessarily indicative of the results for a full year. This financial data should be read in conjunction with the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. Quarterly Consolidated Statements of Operations (1) The three months ended June 30, 2019 includes $3.6 billion of stock-based compensation expense for awards with a performance-based vesting condition satisfied upon our IPO. For additional information on our IPO, see Note 11 - Redeemable Convertible Preferred Stock, Common Stock, and Equity (Deficit) in the notes to the consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data”, of this Annual Report on Form 10-K. The following table sets forth the stock-based compensation expense for each of the quarters indicated: (2) The three months ended March 31, 2018 includes a $2.2 billion gain on the sale of the our Southeast Asia operations, a $2.0 billion unrealized gain on our non-marketable equity securities related to Didi and a $954 million gain on the disposal of our Russia/CIS operations. For additional information, see Note 10 - Supplemental Financial Statement Information to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data”, of this Annual Report on Form 10-K. Quarterly Consolidated Statements of Operations, as a Percentage of Revenue (1) (1) Totals of percentage of revenues may not foot due to rounding. Liquidity and Capital Resources Operating Activities Net cash used in operating activities was $4.3 billion for the year ended December 31, 2019, primarily consisting of $8.5 billion of net loss, adjusted for certain non-cash items, which primarily included $4.6 billion of stock-based compensation expense, $444 million of gain on extinguishment of convertible notes, $58 million of revaluation gain of our derivative liabilities, depreciation and amortization expense of $472 million, $82 million in accretion of discount on our long-term debt, as well as $1.2 billion withdrawal of collateral from restricted cash from James River and a $699 million decrease in cash consumed by working capital. The decrease in cash consumed by working capital was primarily driven by an increase in our insurance reserve, accrued expenses and other liabilities, partially offset by higher accounts receivable and prepaid expenses. Net cash used in operating activities was $1.5 billion for the year ended December 31, 2018, primarily consisting of $1.0 billion of net income, adjusted for certain non-cash items, which primarily included a $3.2 billion gain on business divestitures related to our 2018 Divested Operations, unrealized gain on investment of $2.0 billion related to our investment in Didi, $501 million of revaluation expense of our derivative liabilities, depreciation and amortization expense of $426 million, $318 million in accretion of discount on our long-term debt, impairment of long-lived assets held for sale of $197 million, and $170 million of stock-based compensation expense, as well as an $890 million decrease in cash consumed by working capital primarily driven by an increase in our insurance reserves and accrued expenses, partially offset by higher accounts receivable and prepaid expenses. Net cash used in operating activities was $1.4 billion for the year ended December 31, 2017, primarily consisting of $4.0 billion of net loss, adjusted for certain non-cash items, which primarily included a $762 million change in deferred income taxes, depreciation and amortization expenses of $510 million, impairment of long-lived assets held for sale of $223 million, $244 million in accretion of discount on our long-term debt, $173 million of revaluation expense of our derivative liabilities, and $124 million of stock-based compensation expense, as well as a $1.9 billion decrease in cash consumed by working capital primarily driven by an increase in our insurance and legal reserves offset by higher prepaid expenses and other assets and accounts receivable. Investing Activities Net cash used in investing activities was $790 million for the year ended December 31, 2019, primarily consisting of $588 million in purchases of property and equipment and $441 million in purchases of marketable securities, partially offset by $293 million in proceeds from business disposal, net of cash divested. Net cash used in investing activities was $695 million for the year ended December 31, 2018, primarily consisting of $412 million contributed to equity method investees and $558 million in purchases of property and equipment, partially offset by $369 million of proceeds from sales and disposals of property and equipment. Net cash used in investing activities was $487 million in 2017, primarily consisting of $821 million in purchases of leased vehicles and other property and equipment, partially offset by $342 million of proceeds from the sale of leased vehicles and property and equipment. Financing Activities Net cash provided by financing activities was $8.9 billion for the year ended December 31, 2019, primarily consisting of $8.0 billion of proceeds from issuance of common stock upon our IPO, net of offering costs, $1.2 billion of proceeds from issuance of term loan and senior notes, net of issuance costs, and $500 million of proceeds from issuance of common stock in private placement, partially offset by $1.6 billion taxes paid related to net share settlement of equity awards to satisfy tax withholding requirements and $138 million of principal payments on capital and finance leases. Net cash provided by financing activities was $4.6 billion for the twelve months ended December 31, 2018, primarily consisting of $3.5 billion from issuance of term loan and senior notes, net of issuance costs, $1.8 billion in proceeds from the issuance of redeemable convertible preferred stock, net of issuance costs, partially offset by $491 million of principal repayment on revolving lines of credit. Net cash provided by financing activities was $1.0 billion in 2017, primarily consisting of $1.0 billion in proceeds from the issuance of redeemable convertible preferred stock, net of issuance costs. Other Information As of December 31, 2019, $1.4 billion of our $10.9 billion in cash and cash equivalents was held by our foreign subsidiaries. Cash held outside the United States may be repatriated, subject to certain limitations, and would be available to be used to fund our domestic operations. However, repatriation of funds may result in immaterial tax liabilities. We believe that our existing cash balance in the United States is sufficient to fund our working capital needs in the United States. In November 2019, we began requiring substantially all employees sell a portion of the shares they receive upon the vesting of RSUs in order to cover any required withholding taxes ("sell-to-cover"), rather than our previous approach of net share settlement. We expect this sell-to-cover approach will reduce our cash outflows. We also believe that our sources of funding will be sufficient to satisfy our currently anticipated cash requirements including capital expenditures, working capital requirements, potential acquisitions, and other liquidity requirements through at least the next 12 months. Off-Balance Sheet Arrangements As of December 31, 2019, we did 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 our financial condition, revenue, or expenses, results of operations, liquidity, capital expenditures, or capital resources that are material to investors. Contractual Obligations The following table summarizes our contractual obligations as of December 31, 2019: (1) Refer to Note 8 - Long-Term Debt and Revolving Credit Arrangements of Part II, Item 8, “Financial Statements and Supplementary Data”, of this Annual Report on Form 10-K for further details regarding our long-term debt obligations. (2) Refer to Note 6 - Leases of Part II, Item 8, “Financial Statements and Supplementary Data”, of this Annual Report on Form 10-K for further details regarding our leases. (3) Consists primarily of non-cancelable commitments for network and cloud services, background checks, and other items in the ordinary course of business with varying expiration terms through 2024. The contractual commitment obligations in the table above are associated with agreements that are enforceable and legally binding. As of December 31, 2019, we had recorded liabilities of $70 million related to uncertain tax positions. Due to uncertainties in the timing of potential tax audits, the timing of the resolution of these positions is uncertain and we are unable to make a reasonable estimate of the timing of payments in individual years particularly beyond 12 months. As a result, this amount is not included in the table above. The table above also excludes the purchase price of approximately $1.7 billion of non-interest bearing unsecured convertible notes and approximately $1.4 billion in cash, subject to certain adjustments and holdbacks. For additional discussion on the acquisition of Careem, see Note 20 - Subsequent Events 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 additional discussion on our operating and finance leases as well as purchase commitments, see Note 6 - Leases and Note 15 - Commitments and Contingencies to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data”, of this Annual Report on Form 10-K. Critical Accounting Policies and Estimates We believe that the following accounting policies involve a high degree of judgment and complexity and are critical to understanding and evaluating our consolidated financial condition and results of our operations. An accounting policy is considered to be critical if it requires judgment on a significant accounting estimate to be made based on assumptions about matters that are uncertain at the time the estimate is made, and if different estimates that reasonably could have been used, or changes in the accounting estimates that are reasonably likely to occur periodically, could materially impact the reported amounts of assets, liabilities, revenue and expenses, and related disclosures in our audited consolidated financial statements. We have based our estimates on historical experience and on 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. Although we believe that the estimates we use are reasonable, due to the inherent uncertainty involved in making those estimates, actual results reported in future periods could differ from those estimates. We believe that the following critical accounting policies reflect the more significant judgments, estimates and assumptions used in the preparation of our consolidated financial statements. For additional information, see the disclosure included in Note 1 - Description of Business and Summary of Significant Accounting Policies in the notes to the consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data”, of this Annual Report on Form 10-K. Revenue Recognition We derive our revenue principally from service fees paid by Drivers and Restaurants for the use of our platform in connection with our Rides products and Eats offering provided by Drivers and Restaurants to end-users. Our sole performance obligation in the transaction is to connect Drivers and Restaurants with end-users to facilitate the completion of a successful ridesharing trip or Eats meal delivery. Because end-users access our platform for free and we have no performance obligation to end-users, end-users are not our customers. Further, judgment is required in evaluating the presentation of revenue on a gross versus net basis based on whether we control the service provided to the end-user and are the principal in the transaction (gross), or we arrange for other parties to provide the service to the end-user and are the agent in the transaction (net). We have concluded that we are an agent as we arrange for Drivers and Restaurants to provide the service to the end user in Rides and Eats transactions. The assessment of whether we are considered the principal or the agent in a transaction could impact the accounting for certain incentives provided to Drivers and end-users and change the timing and amount of revenue recognized. In certain markets, consumers have the option to pay Drivers cash for trips, and we generally collect our service fee from Drivers for these trips by offsetting against any other amounts due to Drivers, including Driver incentives. Because we have limited means to collect our service fee for cash trips, and because we cannot control whether Drivers will generate future earnings that we can offset to collect our service fee, we have concluded collectability of such amounts is not probable until collected. As such, uncollected service fees for cash trips are not recognized in our consolidated financial statements until collected. Driver Incentives As Drivers are our customers, Driver incentives are recorded as a reduction of revenue if we do not receive a distinct service or cannot reasonably estimate the fair value of the service received. Driver incentives that are not for a distinct service are evaluated as variable consideration, in the most likely amount to be earned by the Drivers at the time or as they are earned by the Drivers, depending on the type of Driver incentive. We evaluate whether the cumulative amount of Driver incentives that are not in exchange for a distinct service provided to Drivers exceeds the cumulative revenue earned since inception of the Drivers relationship. When the cumulative amount of these Driver incentives exceeds the cumulative revenue earned since inception of the Drivers relationship, the excess Driver incentives are recorded in cost of revenue, exclusive of depreciation and amortization. As a result, Driver incentives provided to Drivers at the beginning of a relationship are typically classified as cost of revenue, exclusive of depreciation and amortization, while Driver incentives provided to Drivers with a more mature relationship are typically classified as a reduction of revenue. Referral incentives offered by us and earned by Drivers for performing marketing services of referring other Drivers to drive on our platform are recorded as sales and marketing expense, as we receive a distinct service. The amount recorded is the lesser of the amount of the Driver incentive paid or the established fair market value of the distinct service received. Fair market value of the distinct service is estimated using amounts paid to vendors for similar services. End-User Discounts and Promotions We offer discounts and promotions to end-users to encourage use of our platform. These are offered in various forms and include: • Targeted end-user discounts and promotions: These discounts and promotions are offered to specific end-users in a market to acquire, re-engage, or generally increase end-users’ use of our platform. An example is an offer providing a discount on a limited number of rides or meal deliveries during a limited time period, and are akin to coupons. We record the cost of these discounts and promotions as sales and marketing expense at the time they are redeemed by the end-user. • End-user referrals: These referrals are earned when an existing end-user (the referring end-user) refers a new end-user (the referred end-user) to the platform and the new end-user takes his or her first ride on the platform. These referrals are typically paid in the form of a credit given to the referring end-user when earned. These referrals are offered to attract new end-users to our platform. We record the liability for these referrals and corresponding expense as sales and marketing expense at the time the referral is earned by the referring end-user. • Market-wide promotions: These promotions are pricing actions in the form of discounts that reduce the end-user fare charged by Drivers to end-users for all or substantially all rides or meal deliveries in a specific market. Accordingly, we record the cost of these promotions as a reduction of revenue at the time the trip is completed. Embedded Derivatives We have issued Convertible Notes that contain embedded features subject to derivative accounting. These embedded features are composed of conversion options that have the economic characteristics of a contingent early redemption feature settled in shares of our stock rather than cash, because the total number of shares of our common stock delivered to settle these embedded features will have a fixed value. These conversion options are bifurcated from the underlying instrument and accounted for and valued separately from the host instrument. Embedded derivatives are recognized as derivative liabilities on our consolidated balance sheet. We measure these instruments at their estimated fair value and recognize changes in their estimated fair value in other income (expense), net in our consolidated statement of operations and comprehensive loss during the period of change. We value these embedded derivatives as the difference between the estimated value of the Convertible Notes with and without the Qualified Initial Public Offering (“QIPO”) conversion option (“QIPO Conversion Option”). The fair value of the Convertible Notes with and without the QIPO Conversion Option is estimated utilizing a discounted cash flow model to discount the expected payoffs at various potential QIPO dates to the valuation date. The key inputs to the valuation model include the probability of a QIPO occurring at various points in time and the discount yield, which was derived by imputing the fair value as equal to the face value on the issuance date of the Convertible Notes. The discount rate is updated during each period to reflect the yield of a comparable instrument issued as of the valuation date. Upon closing of the IPO in May 2019, holders of these Convertible Notes elected to convert all outstanding notes into shares of common stock. For additional information, see to Note 1 - Description of Business and Summary of Significant Accounting Policies and Note 3 - Investments and Fair Value Measurement included in Part II, Item 8, “Financial Statements and Supplementary Data”, of this Annual Report on Form 10-K. Investments-Non-Marketable Equity and Debt Securities We hold investments in privately held companies in the form of equity securities and debt securities without readily determinable fair values and in which we do not have a controlling interest or significant influence. Investments in equity securities without readily determinable fair values are initially recorded at cost and are subsequently adjusted to fair value for impairments and price changes from observable transactions in the same or a similar security from the same issuer. Investments in material available-for-sale debt securities are recorded initially at fair value and subsequently remeasured to fair value at each reporting date with the changes in fair value recognized in other comprehensive income (loss), net of tax. We may elect the fair value option for financial instruments and account for investments in debt and equity securities at fair value with changes reported in net income (loss) from continuing operations. Privately held equity and debt securities are valued using significant unobservable inputs or data in inactive markets. This valuation requires judgment due to the absence of market prices and inherent lack of liquidity and are classified as Level 3 in the fair value hierarchy. In determining the estimated fair value of our investments in privately held companies, we utilize the most recent data available including observed transactions such as equity financing transactions of the investees and sales of the existing shares of the investees’ securities. In addition, the determination of whether an observed transaction is similar to the equity and debt securities held by us requires significant management judgment based on the rights and preferences of the securities. We assess our investment portfolio of privately held equity and debt securities quarterly for impairment. The impairment analysis for investments in equity securities includes a qualitative analysis of factors including the investee’s financial performance, industry and market conditions, and other relevant factors. If an equity investment is considered to be impaired we will establish a new carrying value for the investment and recognize an impairment loss through our consolidated statement of operations. If an investment in debt securities is determined to have an impairment that is other-than-temporary, if we do not intend to sell, and if it is not more likely-than-not that we will be required to sell the debt security, then only credit losses, if any, are recognized in the consolidated statement of operations. The determination of the impairment loss may include the use of various valuation methodologies and estimates. Equity Method Investments We account for investments in the common stock or in-substance common stock of entities in which we have the ability to exercise significant influence, but do not own a controlling financial interest, using the equity method. Investments accounted for under the equity method are initially recorded at cost. Subsequently, we recognize through our consolidated statement of operations, and as an adjustment to the investment balance, our proportionate share of the entities’ net income or loss and reflect the amortization of basis differences. In accounting for these investments, we record our share of the entities’ net income or loss one quarter in arrears. We review our equity method investments for impairment whenever events or changes in business circumstances indicate that the carrying value of the investment may not be fully recoverable. Qualitative and quantitative factors considered as indicators of a potential impairment include financial results and operating trends of the investees, implied values in transactions of the investee’s securities, severity and length of decline in value, and our intention for holding the investment, among other factors. If an impairment is identified, the fair value of the impaired investment would have to be determined and an impairment charge recorded for the difference between the fair value and the carrying value of the investment. The fair value determination, particularly for investments in privately held companies, requires significant judgment to determine appropriate estimates and assumptions. Changes in these estimates and assumptions could affect the calculation of the fair value of the investments and the determination of the impairment charges. Loss Contingencies We are involved in legal proceedings, claims, and regulatory, non-income tax, or government inquiries and investigations that arise in the ordinary course of business. Certain of these matters include claims for substantial or indeterminate amounts of damages. We record a liability when we believe that it is both probable that a loss has been incurred and the amount can be reasonably estimated. If we determine that a loss is reasonably possible and the loss or range of loss can be reasonably estimated, we disclose the possible loss in the accompanying notes to the consolidated financial statements. We review the developments in our contingencies that could affect the amount of the provisions that have been previously recorded, and the matters and related reasonably possible losses disclosed. We make adjustments to our provisions and changes to our disclosures accordingly to reflect the impact of negotiations, settlements, rulings, advice of legal counsel, and updated information. Significant judgment is required to determine both the probability and the estimated amount of loss. These estimates have been based on our assessment of the facts and circumstances at each balance sheet date and are subject to change based on new information and future events. The outcomes of litigation and other disputes are inherently uncertain. Therefore, if one or more of these matters were resolved against us for amounts in excess of management’s expectations, our results of operations and financial condition, including in a particular reporting period in which any such outcome becomes probable and estimable, could be materially adversely affected. Income Taxes We are subject to income taxes in the United States and foreign jurisdictions. We account for income taxes using the asset and liability method. The establishment of deferred tax assets from intra-entity transfers of intangible assets requires management to make significant estimates and assumptions to determine the fair value of such intangible assets. Significant estimates in valuing intangible assets may include, but are not necessarily limited to, internal revenue and expense forecasts, the estimated life of the intangible assets, comparable transaction values, and / or discount rates. The discount rates used to discount expected future cash flows to present value are derived from a weighted-average cost of capital analysis and are adjusted to reflect the inherent risks related to the cash flow. Although we believe the assumptions and estimates we have made are reasonable and appropriate, they are based, in part, on historical experience, internal and external comparable data and are inherently uncertain. Unanticipated events and circumstances may occur that could affect either the accuracy or validity of such assumptions, estimates or actual results. We account for uncertainty in tax positions by recognizing a tax benefit from uncertain tax positions when it is more-likely-than-not that the position will be sustained upon examination. Evaluating our uncertain tax positions, determining our provision for income taxes, and evaluating the ongoing impact of the Tax Act, are inherently uncertain and require making judgments, assumptions, and estimates. While we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes and the effective tax rate in the period in which such determination is made. The provision for income taxes includes the impact of reserve provisions and changes to reserves as well as the related net interest and penalties. In addition, we are subject to the continuous examination of our income tax returns by the IRS and other tax authorities which may assert assessments against us. We regularly assess the likelihood of adverse outcomes resulting from these examinations and assessments to determine the adequacy of our provision for income taxes. Insurance Reserves We use a combination of third-party insurance and self-insurance mechanisms, including a wholly-owned captive insurance subsidiary, to provide for the potential liabilities for certain risks, including auto liability, uninsured and underinsured motorist, auto physical damage, general liability, and workers’ compensation. The insurance reserves is an estimate of our potential liability for unpaid losses and loss adjustment expenses, which represents the estimate of the ultimate unpaid obligation for risks retained by us and includes an amount for case reserves related to reported claims and an amount for losses related to events incurred but not reported as of the balance sheet date. The estimate of the ultimate obligation utilizes generally accepted actuarial methods applied to historical claim and loss experience. In addition, we use assumptions based on actuarial judgment with consideration toward relevant industry claim and loss development patterns, frequency trends, and severity trends. These reserves are continually reviewed and adjusted as experience develops and new information becomes known. Adjustments, if any, relating to accidents that occurred in prior years are reflected in the current year results of operations. All estimates of ultimate losses and allocated loss adjustment expenses, and of resulting reserves, are subject to inherent variability caused by the nature of the insurance claim settlement process. Such variability is increased for us due to limited historical experience and the nature of the coverage provided. Actual results depend upon the outcome of future contingent events and can be affected by many factors, such as claim settlement processes and changes in the economic, legal, and social environments. As a result, the net amounts that will ultimately be paid to settle the liability, and when these amounts will be paid, may vary in the near term from the estimated amounts. While management believes that the insurance reserve amount is adequate, the ultimate liability may be in excess of, or less than, the amount provided. Stock-Based Compensation We have granted stock-based awards consisting primarily of stock options, restricted common stock, RSUs, warrants, and SARs to employees, members of our board of directors, and non-employee advisors. The substantial majority of our stock-based awards have been made to employees. The majority of our outstanding RSUs, as well as certain options, SARs, and shares of restricted common stock, contain both a service-based vesting condition and a liquidity-event based vesting condition. The service-based vesting condition for the majority of these awards is satisfied over four years. The liquidity event-based vesting condition is satisfied upon the occurrence of a qualifying event, which is generally defined as a change in control transaction or the effective date of an initial public offering. Prior to our IPO in May 2019, no qualifying event had occurred, and we did not recognized any stock-based compensation expense for the RSUs and other awards with both a service-based vesting condition and a liquidity event-based vesting condition. We account for stock-based employee compensation under the fair value recognition and measurement provisions, in accordance with applicable accounting standards, which requires compensation expense for the grant-date fair value of stock-based awards to be recognized over the requisite service period. We account for forfeitures when they occur. We have elected to use the Black-Scholes option-pricing model to determine the fair value of stock options, warrants, and SARs on the grant date. The Black-Scholes option-pricing model requires certain subjective inputs and assumptions, including the fair value of our common stock, the expected term, risk-free interest rates, expected stock price volatility, and expected dividend yield of our common stock. These assumptions used in the Black-Scholes option-pricing model, other than the fair value of our common stock (see the section titled “-Common Stock Valuations” below), are estimated as follows: • Expected term. We estimate the expected term based on the simplified method for employees and on the contractual term for non-employees. • 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. • Expected volatility. We estimate the volatility of our common stock on the date of grant based on the weighted-average historical stock price volatility of comparable publicly-traded companies in our industry group. • Expected dividend yield. Expected dividend yield is zero percent, as we have not paid and do not anticipate paying dividends on our common stock. We continue to use judgment in evaluating the expected volatility and expected term utilized in our stock-based compensation expense calculation on a prospective basis. As we continue to accumulate additional data related to our common stock, we may refine our estimates of expected volatility and expected term, which could materially impact our future stock-based compensation expense. Common Stock Valuations Subsequent to our IPO in May 2019, the fair value of common stock was determined on the grant date using the closing price of the Company’s common stock. Prior to our IPO, given the absence of a public trading market for our common stock, and in accordance with 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 exercised its reasonable judgment and considered numerous objective and subjective factors to determine the best estimate of fair value of our common stock, including: • independent third-party valuations of our common stock; • the prices of the recent redeemable convertible preferred stock sales by us to investors in arm’s-length transactions; • the price of sales of our common stock and preferred stock in recent secondary sales by existing stockholders to investors; • our capital resources and financial condition; • the preferences held by our preferred stock classes relative to those of our common stock; • the likelihood and timing of achieving a liquidity event, such as an initial public offering or sale of the company, given prevailing market conditions; • our historical operating and financial performance as well as our estimates of future financial performance; • valuations of comparable companies; • the hiring of key personnel; • the status of our development, product introduction, and sales efforts; • the price paid by us to repurchase outstanding shares; • the relative lack of marketability of our common stock; • industry information such as market growth and volume and macro-economic events; and • additional objective and subjective factors relating to our business. In valuing our common stock prior to our IPO, our board of directors determined the fair value of our common stock using both the income and market approach valuation methods, in addition to giving consideration to recent secondary sales of our common stock. The income approach estimates value based on the expectation of future cash flows that a company will generate. These future cash flows are discounted to their present values using a discount rate based on our weighted-average cost of capital, and is adjusted to reflect the risks inherent in our cash flows. The market approach estimates value based on a comparison of our company to comparable public companies in a similar line of business. From the comparable companies, a representative market value multiple is determined and then applied to our company’s financial forecasts to estimate the value of the subject company. Recent Accounting Pronouncements See Note 1 - Description of Business and Summary of Significant Accounting Policies, to the consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data”, of this Annual Report on Form 10-K.

<s>[INST] In addition to our historical consolidated financial information, the following discussion contains forwardlooking statements that reflect our plans, estimates, and beliefs. Our actual results could differ materially from those discussed in the forwardlooking statements. You should review the sections titled “Special Note Regarding ForwardLooking Statements” for a discussion of forwardlooking statements and in Part I, Item 1A, “Risk Factors”, for a discussion of 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 and elsewhere in this Annual Report on Form 10K. Overview We are a technology platform that uses a massive network, leading technology, operational excellence and product expertise to power movement from point A to point B. We develop and operate proprietary technology applications supporting a variety of offerings on our platform. We connect consumers with providers of ride services, restaurants and food delivery services, public transportation networks, ebikes, escooters and other personal mobility options. We use this same network, technology, operational excellence and product expertise to connect shippers with carriers in the freight industry. We are also developing technologies that provide autonomous driving vehicle solutions to consumers, networks of vertical takeoff and landing vehicles and new solutions to solve everyday problems. Financial and Operational Highlights (1) See the section titled “Reconciliations of NonGAAP Financial Measures” for more information and reconciliations to the most directly comparable GAAP financial measure. (2) See the section titled “Certain Key Metrics and NonGAAP Financial Measures” below for more information. (3) MAPCs presented for annual periods are MAPCs for the fourth quarter of the year. The 2018 MAPCs exclude the impact of our 2018 Divested Operations. (4) Net income (loss) attributable to Uber Technologies, Inc. includes stockbased compensation expense of $137 million, $172 million and $4.6 billion during the years ended December 31, 2017, 2018 and 2019, respectively. ** Percentage not meaningful. Highlights for 2019 In 2019, we crossed the 100 million mark for MAPCs, ending the year with 111 million MAPCs or 22% growth compared to 2018, while also seeing a 68% increase in the number of consumers using both Rides and Eats. Gross Bookings grew over $15 billion for the third consecutive year, up to $65.0 billion or 35%, on a constant currency basis. Revenue and Adjusted Net Revenue grew to $14.1 billion and $12.9 billion, respectively, with quarterly growth rates accelerating throughout 2019 and ending with a fullyear Take Rate of 19.8%. Rides Adjusted EBITDA grew $530 million to $2.1 billion, exiting the year with a record quarter Rides Adjusted EBITDA profit of $742 million which more than covered our Corporate G&A and Platform R&D in the fourth quarter of 2019. Rides Adjusted EBITDA margin as a percentage of Rides revenue and Rides Adjusted Net Revenue improved every quarter in 2019. Eats Gross Bookings grew $6.6 billion to $14.5 billion, growing 83%, or 87% on a constant currency basis. Eats revenue grew 72%, or 76% on a constant currency basis. Eats Adjusted Net Revenue grew 82%, or 86% on a constant currency basis, while Eats fullyear Take Rate was 9.5%. We continued to expand our other offerings, including Freight and Other Bets, resulting in a combined revenue growth of 128%. We ended the year with $11.3 billion in cash, cash equivalents and shortterm investments. 2019 Significant Developments Driver Appreciation Award In April 2019, we paid a $299 million Driver appreciation award to Drivers who met certain criteria. The payment was accounted for as a Driver incentive in the second quarter of 2019. Initial [/INST] Negative. </s>

Personalis, Inc.

2020-03-25

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 consolidated financial statements and the related notes and other financial information included elsewhere in this Annual Report on Form 10-K and our final prospectus filed with the Securities and Exchange Commission (the “SEC”) pursuant to Rule 424(b) under the Securities Act of 1933, as amended, on June 20, 2019 (the “Prospectus”). In addition to historical consolidated financial information, 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. You should review the sections titled “Special Note Regarding Forward-Looking Statements” for a discussion of forward-looking statements and in Part I, Item 1A, “Risk Factors” for a discussion of 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 and elsewhere in this Annual Report on Form 10-K and in our Prospectus. This section of this Form 10-K generally discusses 2019 and 2018 items and year-to-year comparisons between 2019 and 2018. Discussions of 2017 items and year-to-year comparisons between 2018 and 2017 that are not included in this Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Prospectus. Overview We are a growing cancer genomics company transforming the development of next-generation therapies by providing more comprehensive molecular data about each patient’s cancer and immune response. We designed our NeXT Platform to adapt to the complex and evolving understanding of cancer, providing our biopharmaceutical customers with information on all of the approximately 20,000 human genes, together with the immune system, in contrast to many cancer panels that cover roughly 50 to 500 genes. In parallel with the development of our platform technology, we have also provided population sequencing services under contract with the U.S. Department of Veterans Affairs (the “VA”) Million Veteran Program (the “VA MVP”), which has enabled us to innovate, scale our operational infrastructure, and achieve greater efficiencies in our lab. We are also developing a complementary liquid biopsy assay that analyzes all of the approximately 20,000 human genes versus the more narrowly focused liquid biopsy assays that are currently available. By combining technological innovation, operational scale, and regulatory differentiation, our NeXT Platform is designed to help our customers obtain new insights into the mechanisms of response and resistance to therapy as well as new potential therapeutic targets. Our platform enhances the ability of biopharmaceutical companies to unlock the potential of conducting translational research in the clinic rather than with pre-clinical animal models or cancer cell lines. We also announced in January 2020 a diagnostic based on our NeXT Platform that we envision being used initially by both leading clinical cancer centers as well as biopharmaceutical companies. We generated revenues of $65.2 million, $37.8 million, and $9.4 million for the years ended December 31, 2019, 2018, and 2017, respectively. In 2019, 67% of our revenues were generated from the U.S. Department of Veterans Affairs (the “VA”) Million Veteran Program (the “VA MVP”) as compared to 49% in 2018. Non-VA MVP revenues increased by 13% in 2019 compared to 2018. We also incurred net losses of $25.1 million, $19.9 million and $23.6 million for the years ended December 31, 2019, 2018, and 2017, respectively. As of December 31, 2019, we had $128.3 million in cash and cash equivalents, and short-term investments. From inception through December 31, 2019, we have funded our operations primarily through cash from operations, redeemable convertible preferred stock issuances, debt issuances, and proceeds from our initial public offering. We expect that our existing cash and cash equivalents, and short-term investments will provide sufficient funds to sustain operations through at least the next 12 months. We have based these estimates on assumptions that may prove to be wrong, and we could exhaust our available capital resources sooner than we expect. Factors Affecting Our Performance We believe there are several important factors that have impacted, and that we expect will continue to impact, our operating performance and results of operations, including: • The continued development of the market for genomic-based tests. Our performance depends on the willingness of biopharmaceutical customers to continue to seek more comprehensive molecular information to develop more efficacious cancer therapies. • Increasing adoption of our products and solutions by existing customers. Our performance depends on our ability to retain and broaden adoption with existing customers. Because our technology is novel, some customers begin using our platform by initiating pilot studies involving a small number of samples to gain experience with our service. As a result, historically a significant portion of our revenues has come from existing customers. We believe that our ability to convert initial pilots into larger orders from existing customers has the potential to drive substantial long-term revenue. We expect there may be some variation in the number of samples they choose to test each quarter. • Adoption of our products and solutions by new customers. While new customers initially may not account for significant revenues, we believe that they have the potential to grow substantially over the long term as they gain confidence in our service. Our ability to engage new customers is critical to our long-term success. Our publications, posters and presentations at scientific conferences lead to engagement at the scientific level with potential customers who often make the initial decision to gain experience with our platform. Accessing these new customers through scientific engagement and marketing to gain initial buy-in is critical to our success and gives us the opportunity to demonstrate the utility of our platform. • Our revenues and costs are affected by the volume of samples we receive from customers from period to period. The timing and size of sample shipments received after orders have been placed is variable. Since sample shipments can be large, and are often received from a third party, the timing of arrival can be difficult to predict over the short term. Although our long-term performance is not affected, we do see quarter-to-quarter volatility due to these factors. Samples arriving later than expected may not be processed in the quarter proposed and result in revenue the following quarter. Since many of our customers request defined turnaround times, we employ project managers to coordinate and manage the complex process from sample receipt to sequencing and delivery of results. • Investment in product innovation to support commercial growth. Investment in research and development, including the development of new products is critical to establish and maintain our leading position. In particular, we have invested in NeoantigenID, a neoantigen characterization report, ImmunogenomicsID, a broad biomarker report, and ImmunoID NeXT, our universal cancer immunogenomics platform. We are also collaborating with key opinion leaders from academic cancer centers, such as Inova Health System, Stanford Medicine, and the Parker Institute for Cancer Immunotherapy, to support the utility of our platform. We believe this work is critical to gaining customer adoption and expect our investments in these efforts to increase. We believe utility for our product may result in additional expenditures to develop and market new products, including a diagnostic or database. • Leverage our operational infrastructure. We have invested significantly, and will continue to invest, in our sample processing capabilities and commercial infrastructure. With our current operating model and infrastructure, we can increase our production and commercialize new generations of our platform, but as our volumes continue to increase we will ultimately need to invest in additional production capabilities. We expect to grow our revenues and spread our costs over a larger volume of services. In addition, we may invest significant amounts in infrastructure to support new products resulting from our research and development activities. In addition to the factors described above, as our headquarters and laboratory operations are located in San Mateo County, California, our operations have been impacted by the ongoing COVID-19 pandemic. On March 16, 2020, the Health Officer of the County of San Mateo (the “Health Officer”) issued a shelter-in-place order (the “San Mateo Order”), which directed all businesses to cease non-essential operations at physical locations in the county. The San Mateo Order also directed all individuals living in the county to shelter at their place of residence with limited exceptions. The intent of the San Mateo Order is to slow the spread of COVID-19 to the maximum extent possible. The San Mateo Order became effective on March 17, 2020 and will continue to be in effect through April 7, 2020, or until it is extended, rescinded, superseded, or amended in writing by the Health Officer. Similar orders were issued in neighboring counties, including Santa Clara County, such that the substantial majority of our employees are subject to a shelter-in-place order. While the San Mateo Order allows for continued operation of so-called Essential Businesses, which includes certain critical healthcare operations and services, to comply with the San Mateo Order, we are prioritizing the fulfillment of customer orders to those related to time-sensitive healthcare projects, such as in-process clinical trials, and will fulfill other customer orders to the extent we have the ability to do so with limited laboratory staffing. In addition, on March 19, 2020, the Governor of California and the State Public Health Officer and Director of the California Department of Public Health ordered all individuals living in the State of California to stay at their place of residence for an indefinite period of time (subject to certain exceptions to facilitate authorized necessary activities) to mitigate the impact of the COVID-19 pandemic (the “California Order” and, together with the San Mateo Order, the “Orders”). Other states in the United States, including Massachusetts and New York, have followed suit by issuing orders with similar goals and restrictions. Beyond the immediate impact of the Orders to our operations, the ongoing COVID-19 pandemic, the Orders, and similar orders issued by other authorities to impose restrictions intended to mitigate the impact of the COVID-19 pandemic, may disrupt our supply chain, including our ability to acquire raw materials, disrupt customer demand, reduce our ability to receive customer samples on a normal basis, disrupt our customer and vendor relationships, divert management attention, and negatively impact employee productivity due to work-from-home policies. The scope and duration of such impact is highly uncertain. We are unable to predict or quantify the impact of any potential disruption to our supply chain, changes in consumer demand, or any other actions that may become necessary as events unfold. Components of Operating Results Revenues We derive our revenues primarily from sequencing and data analysis services to support the development of next-generation cancer therapies and to support large scale genetic research programs. We support our customers by providing high-accuracy, validated genomic sequencing and advanced analytics. Many of these analytics are related to state-of-the-art biomarkers, including those relevant to immuno-oncology therapeutics such as checkpoint inhibitors. Our revenues are primarily generated through contracts with companies in the pharmaceutical industry, healthcare organizations, and government entities. Our ability to increase our revenues will depend on our ability to further penetrate this market. To do this, we are developing a growing set of additional state-of-the-art products, advancing our operational infrastructure, building our regulatory credentials and expanding our targeted marketing efforts. Unlike diagnostic or therapeutic companies, we have not to date sought reimbursement through traditional healthcare payors. We sell through a small direct sales force. We have one reportable segment from the sale of sequencing and data analysis services. Substantially all of our revenues to date have been derived from sales in the United States. Costs and Expenses Costs of revenues Costs of revenues consist of production material costs, personnel costs (salaries, bonuses, benefits, and stock-based compensation), costs of consumables, laboratory supplies, depreciation and service maintenance on capitalized equipment, and information technology (“IT”) and facility costs. We expect the costs of revenues to increase as our revenues grow, but the cost per unit of data delivered to decrease over time due to economies of scale we may gain as volume increases, automation initiatives, and other cost reductions. Research and development expenses Research and development expenses consist of costs incurred for the development of our products. These expenses consist primarily of payroll and personnel costs (salaries, bonuses, benefits, and stock-based compensation), costs of consumables, laboratory supplies, depreciation and service maintenance on capitalized equipment, and IT and facility costs. These expenses also include costs associated with our collaborations, which we expect to increase over time. We expense our research and development expenses in the period in which they are incurred. We expect to increase our research and development expenses as we continue to develop new products. Selling, general, and administrative expenses Selling expenses consist of personnel costs, customer support expenses, direct marketing expenses, educational and promotional expenses, and market research. Our general and administrative expenses include costs for our executive, accounting, finance, legal, and human resources functions. These expenses consist of personnel costs, audit and legal expenses, consulting costs, and IT and facility costs. We expense all selling, general, and administrative expenses as incurred. We expect our selling expenses will continue to increase in absolute dollars, primarily driven by our efforts to expand our commercial capability and to expand our brand awareness and customer base through targeted marketing initiatives with an increased presence both within and outside the United States. We also expect general and administrative expenses will increase as we scale our operations. Interest Income Interest income consists primarily of interest earned on our cash and cash equivalents, and short-term investments. Interest income increased significantly in 2019 as a result of us investing proceeds from the IPO. We expect a continued higher level of interest income in 2020 for this reason. Interest Expense Interest expense primarily consists of cash and non-cash interest costs related to our term loan, convertible promissory notes, revolving loan, and growth capital loan. We record costs incurred in connection with the issuance of debt as a direct deduction from the debt liability. We amortize these costs over the term of our debt agreements as interest expense in our consolidated statements of operations. After the payoff of our growth capital loan in August 2019, we no longer have any outstanding debt and have not incurred interest expense from that point forward. Loss on Debt Extinguishment We incurred loss on debt extinguishment in 2018 resulting from changes in the maturity dates of the convertible notes issued in 2017. We also incurred loss on debt extinguishment in 2019 upon the payoff of the growth capital loan. See Note 6 to our consolidated financial statements included elsewhere in this annual report. Other (Expense) Income, Net Other (expense) income, net consists of changes in the fair value of the compound derivative instrument, changes in fair value of convertible preferred stock warrant liability, and foreign currency exchange gains and losses. Future periods will not include changes in fair value of the compound derivative instrument, due to extinguishment of the related convertible notes, nor will future periods include changes in fair value of convertible preferred stock warrants, due to the conversion of such warrants to common stock warrants. See Notes 6 and 10 included elsewhere in this annual report for further discussion of these two items. We expect our foreign currency gains and losses to continue to fluctuate in the future due to changes in foreign currency exchange rates. Results of Operations The following table sets forth our consolidated statements of income data (in thousands): Revenues The following table shows revenues by customer type (in thousands): The following table shows our concentration of revenues by customer: VA MVP The increase in 2019 revenues from the VA MVP was driven by an increase in the volume of samples we tested in the period, partially offset by lower prices per sample. All Other Customers The increase in 2019 revenues from all other customers was primarily due to an increase in the volume of samples we tested in relation to the sequencing and data analysis services we provided to our customers. Costs and Expenses Costs of revenues The increase in 2019 was primarily due to the increase in revenues discussed above. The cost components related to the increase in costs of revenues were an $11.7 million increase in production materials, a $2.2 million increase related to personnel costs including salaries, bonuses, benefits, and stock-based compensation expenses, a $1.6 million increase in depreciation and service maintenance on capitalized equipment, a $0.5 million increase in the consumption cost of consumables and laboratory supplies, a $0.9 million increase in IT and facility costs, and a $0.3 million increase in other costs. Research and development The increase in 2019 was primarily due to increased development activities for new product offerings, lab and automation development costs, and IT and facility costs. Research and development expenses increased due to an increase of $4.0 million in personnel-related expenses, including salaries, bonuses, benefits, and stock-based compensation expenses, a $2.8 million increase in laboratory and automation supplies consumed, a $1.2 million increase in depreciation, service maintenance on capitalized equipment, and cost of expensed equipment, and $0.2 million increase in other costs. Selling, general and administrative The increase in 2019 was due to a $7.3 million increase in personnel-related expenses including salaries, bonuses, benefits, and stock-based compensation expenses primarily related to increased headcount, a $3.0 million increase in professional services primarily related to public company-related costs (including corporate insurance, audit fees, and legal expenses), and a $0.5 million increase in other costs. Interest income, interest expense, and loss on debt extinguishment Interest income The increase in 2019 was due to investments of proceeds from our IPO. Interest expense The lower interest expense in 2019 was due to the repayment of the $20 million growth capital loan in August 2019, which resulted in no further outstanding debt for the remainder of the year, as well as 2018 including significant interest expense from the Convertible Notes and Revolving Loan. Loss on debt extinguishment The $1.7 million loss on debt extinguishment in 2019 resulted from the extinguishment of our $20 million Growth Capital Loan facility. The $4.7 million loss on debt extinguishment in 2018 resulted from changes in the maturity dates of the Convertible Notes issues in 2017. Other (expense) income, net Other expenses, net in 2019 were primarily comprised of a $1.4 million increase in the fair values of warrants for Series B and Series C redeemable convertible preferred stock. Other income, net in 2018 was primarily comprised of a $0.6 million decrease in fair value of the compound derivative instrument, partially offset by a $0.4 million increase in the fair values of warrants for Series B and Series C redeemable convertible preferred stock. Liquidity and Capital Resources The following table presents selected financial information and statistics as of and for the years ended December 31, 2019, 2018, and 2017 (in thousands): From our inception through December 31, 2019, we have funded our operations primarily from $144.0 million in net proceeds from our initial public offering in June 2019 and $89.6 million from issuance of redeemable convertible preferred stock, as well as cash from operations and debt financing. On March 22, 2019, we received $20.0 million in gross cash proceeds from a growth capital loan. As of December 31, 2019, we had cash and cash equivalents in the amount of $55.0 million. We have incurred net losses since our inception. We anticipate that our current cash and cash equivalents and marketable securities, together with cash provided by operating activities are sufficient to fund our near-term capital and operating needs for at least the next 12 months. We have based these future funding requirements on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we expect. If our available cash balances, net proceeds from the offering and anticipated cash flow from operations are insufficient to satisfy our liquidity requirements including because of lower demand for our services or other risks described in this annual report, we may seek to sell additional common or preferred equity or convertible debt securities, enter into an additional 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. Additional capital may not be available on reasonable terms, or at all. On March 22, 2019, we entered into a growth capital loan (the “Growth Capital Loan”) with TriplePoint to provide for a $20.0 million growth capital loan facility and as of June 30, 2019, had drawn down the full $20.0 million available under the facility. We used $5.1 million of the Growth Capital Loan to repay, in its entirety, all amounts outstanding under the Revolving Loan. Borrowings under the Growth Capital Loan bore interest at a floating rate of prime, plus 5.00%, for borrowings up to $15.0 million and the prime rate plus 6.50% for borrowings greater than $15.0 million. Under the agreement, we were required to make monthly interest-only payments through April 1, 2020 and required to make 36 equal monthly payments of principal, plus accrued interest, from April 1, 2020 through March 1, 2023, when all unpaid principal and interest was to become due and payable. The agreement allowed voluntary prepayment of all, but not part, of the outstanding principal at any time prior to the maturity date, subject to a prepayment fee of 1.00% of the outstanding balance if prepaid in months one through 12 of the loan term. In addition to the final payment, we paid an amount equal to 2.75% of each principal amount drawn under this growth capital loan facility. In connection with the Growth Capital Loan, we issued a warrant to purchase 65,502 shares of common stock to TriplePoint at an exercise price of $9.16 per share exercisable for seven years from March 22, 2019. We recorded the issuance-date fair value of the warrant of $0.6 million and fees paid to TriplePoint of $0.3 million as a debt discount, which was amortized over the term of the Growth Capital Loan using the effective interest method. Upon issuance, the Growth Capital Loan had an effective interest rate of 15.23% per year. Interest expense for the year ended December 31, 2019 was $1.0 million. On August 14, 2019, we paid off the Growth Capital Loan in its entirety and recorded a $1.7 million loss on extinguishment of debt in the consolidated statements of operations. Our short-term investments portfolio is primarily invested in highly rated securities, with the primary objective of minimizing the potential risk of principal loss. Our investment policy generally requires securities to be investment grade and limits the amount of credit exposure to any one issuer. During 2019, cash used by operating activities of $18.1 million was a result of $25.1 million of net loss and the net negative change in operating assets and liabilities of $7.3 million, partially offset by non-cash negative adjustments to net income of $14.3 million. Cash used by investing activities of $81.6 million during 2019 consisted of purchases of available-for-sale debt securities, net of maturities and sales, of $73.2 million, and cash used to acquire property and equipment of $8.4 million. Cash provided by financing activities of $134.9 million during 2019 consisted primarily of $139.8 million of proceeds from initial public offering, net of underwriting discounts and commissions, $1.4 million of proceeds from issuance of common stock under employee stock plans, and net proceeds from the issuance of a Growth Capital Loan of $20.0 million, partially offset by cash used to repay a revolving loan and issue and repay the Growth Capital Loan of $26.3 million. Investments in property and equipment The Company’s capital expenditures were $8.4 million during 2019, which was primarily related to the acquisition of property and equipment used for our sequencing and data analysis services. Debt We previously entered into various forms of convertible debt and revolving loans to finance our operations prior to our IPO. After our IPO, we paid off all remaining debt and now have zero outstanding debt balances as of 2019. Further information regarding the Company’s debt issuances can be found in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 6, “Borrowings.” Contractual Obligations As a “smaller reporting company”, we are not required to provide this disclosure. Off-balance Sheet Arrangements We did not have any off-balance sheet arrangements as of December 31, 2019. Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with U.S. GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses, and related disclosures. 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. 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 that the assumptions and estimates associated with the accounting policies discussed below have the greatest potential impact on our consolidated financial statements. Therefore, we consider these to be our critical accounting policies and estimates. Revenue Recognition Adoption of ASC Topic 606, “Revenue from Contracts with Customers” On January 1, 2017, we early adopted the new accounting standard ASC Topic 606 using the full retrospective method. Results for reporting periods beginning after January 1, 2017, are presented under ASC Topic 606. The impact of adopting ASC Topic 606 was not material on our consolidated financial statements. Revenue Recognition We generate our revenues from selling sequencing and data analysis services. We agree to provide services to our customers through a contract, which may be in the form of a combination of a signed agreement, statement of work and/or a purchase order. Upon adoption of ASC Topic 606, we have evaluated the performance obligations contained in contracts with customers to determine whether any of the performance obligations are distinct, such that the customers can benefit from the obligations on their own, and whether the obligations can be separately identifiable from other obligations in the contract. For all of our contracts to date, the customer orders a specified quantity of a sequencing; therefore, the delivery of the ordered quantity per the purchase order is accounted for as one performance obligation. Our contracts include only one performance obligation-the delivery of the sequencing and data analysis services to the customer. Fees for our sequencing and data analysis services are predominantly based on a fixed price per sample. The fixed prices identified in the arrangements only change if a pricing amendment is agreed with a customer. In limited cases we provide our customers a discount if samples received are above a certain volume are purchased. In such cases, the discount applies prospectively. We have analyzed such discounts if they represent a material right provided to a customer. We have concluded that such discounts do not represent a material right provided to a customer since they are not deemed to be incremental to the pricing offered to the customer, or are not enforceable options to acquire additional goods. As a result, these discounts do not constitute a material right and do not meet the definition of a separate performance obligation. We do not offer retrospective discounts or rebates. Accordingly, all of the transaction price, net of any discounts, is allocated to one performance obligation. Therefore, upon delivery of the services, there are no remaining performance obligations. Contracts that contain multiple distinct performance obligations would require an allocation of the transaction price to each performance obligation based on a relative stand-alone selling price basis. Sometimes we deliver sequencing results in two or more batches; however, since the quantity delivered per batch of each individual test per sales order in these instances is in the same ratio as in the original sales order, allocating the transaction price on a relative stand-alone selling price basis would have no impact on the revenue recognized in any period presented. We recognize revenue when control of the promised services is transferred to our customers. Management applies judgment in evaluating when a customer obtains control of the promised service, which is when the sequencing and data analysis service results are delivered to customers, at an amount that reflects the consideration to which we expect to be entitled to in exchange for those services. Revenue is recorded net of sales or other transaction taxes collected from clients and remitted to taxing authorities. A customer contract liability will arise when we have received payments from its customers in advance, but has not yet provided genome and exome sequencing and data analysis services to a customer and satisfied its performance obligations. We record a customer contract liability for performance obligations outstanding related to payments received in advance for customer deposits. We expect to satisfy these remaining performance obligations and recognize the related revenues upon providing sequencing and data analysis services. All of our revenues and trade receivables are generated from contracts with customers and substantially all of our revenues are derived from U.S. domestic operations. The following section describes the accounting policies that we believe have significant judgment, or changes in judgment, as a result of adopting ASC Topic 606. Payment Terms Payment terms and conditions vary by contract and customer. Our standard payment terms are typically less than 90 days from the date of invoice. In instances where the timing of our revenue recognition differs from the timing of its invoicing, we have determined that our contracts do not include a significant financing component. The primary purposes of our invoicing terms are to provide customers with simplified and predictable ways of purchasing our services and provide payment protection for us. Convertible Preferred Stock Warrants We accounted for warrants to purchase shares of our redeemable convertible preferred stock as liabilities at their estimated fair value because the warrants may have obligated us to transfer assets to the holders at a future date upon a deemed liquidation event. The warrants were recorded at fair value upon issuance and were subject to remeasurement to fair value at each period end, with any fair value adjustments recognized in the consolidated statements of operations and comprehensive loss. We adjusted the warrant liability for changes in fair value until the conversion of redeemable convertible preferred stock into common stock. Common Stock Warrants Our common stock warrants are classified as equity as they meet all criteria for equity classification. The common stock warrants were recorded at fair value upon issuance, or conversion to common stock warrants in the case of our convertible preferred stock warrants, as additional paid-in-capital in the consolidated balance sheets. The common stock warrants are not subsequently remeasured. Convertible Instruments We evaluate and account for conversion options embedded in convertible instruments in accordance with ASC Topic 815, Derivatives and Hedging Activities. Applicable GAAP requires companies to bifurcate conversion options from their host instruments and account for them as freestanding derivative financial instruments according to certain criteria. The criteria include circumstances in which (a) the economic characteristics and risks of the embedded derivative instrument are not clearly and closely related to the economic characteristics and risks of the host contract, (b) the hybrid instrument that embodies both the embedded derivative instrument and the host contract is not remeasured at fair value under other GAAP with changes in fair value reported in earnings as they occur, and (c) a separate instrument with the same terms as the embedded derivative instrument would be considered a derivative instrument. Stock-Based Compensation We account for stock-based compensation arrangements with employees, using a fair value-based method, for costs related to all stock-based payments including stock options and stock awards. Our determination of the fair value of stock options on the date of grant utilizes the Black-Scholes option-pricing model. The fair value of the option granted is recognized over the period during which an optionee is required to provide services in exchange for the option award, known as the requisite service period which usually is the vesting period, on a straight-line basis. Estimating the fair value of equity-settled 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. 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. • Expected Term-The expected term assumption represents the weighted-average period that the stock-based awards are expected to be outstanding. We have elected to use the “simplified method” for estimating the expected term of the options, whereby the expected term equals the arithmetic average of the vesting term and the original contractual term of the option. • Expected Volatility-For all stock options granted to date, the volatility data was estimated based on a study of publicly traded industry peer companies. For purposes of identifying these peer companies, we considered the industry, stage of development, size, and financial leverage of potential comparable companies. • Expected Dividend Yield-The Black-Scholes option-pricing valuation model calls for a single expected dividend yield as an input. We currently have no history or expectation of paying cash dividends on our common stock. • Risk-Free Interest Rate-The risk-free interest rate is based on the yield available on U.S. Treasury zero-coupon issues similar in duration to the expected term of the equity-settled award. We estimated the fair value of the time-based employee stock options using the Black-Scholes option-pricing model based on the date of grant with the following assumptions: Common Stock Valuations The estimated fair value of the common stock underlying our stock options was determined at each grant date by our board of directors, with input from management. All options to purchase shares of our common stock are 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. In the absence of a public trading market for our common stock prior to our IPO, on each grant date, we developed an estimate of the fair value of our common stock based on the information known to us on the date of grant, upon a review of any recent events and their potential impact on the estimated fair value per share of the common stock, and in part on input from an independent third-party valuation firm. As provided in Section 409A of the U.S. Internal Revenue Code of 1986, as amended (the “Code”), we generally relied on our valuations for up to 12 months unless we experienced a material event that would have affected the estimated fair value per common share. Our valuations of our common stock were determined in accordance with the guidelines outlined in the American Institute of Certified Public Accountants Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation (the “Practice Aid”). The methodology to determine the fair value of our common stock included estimating the fair value of the enterprise using the “backsolve” method, which estimates the fair value of our company by reference to the value and preferences of our last round of financing, as well as our capitalization. The assumptions used to determine the estimated fair value of our common stock were based on numerous objective and subjective factors, combined with management’s judgment, including external market conditions affecting the pharmaceutical and biotechnology industry and trends within the industry: • our stage of development; • the rights, preferences, and privileges of our redeemable convertible preferred stock relative to those of our common stock; • the prices at which we sold shares of our redeemable convertible preferred stock; • our financial condition and operating results, including our levels of available capital resources; • the progress of our research and development efforts, our stage of development, and business strategy; • equity market conditions affecting comparable public companies; and • general U.S. market conditions and the lack of marketability of our common stock. 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, we considered the following methods: • Income approach. The income approach attempts to value an asset or security by estimating the present value of the future economic benefits it is expected to produce. These benefits can include earnings, cost savings, tax deductions, and disposition proceeds from the asset. An indication of value may be developed in this approach by discounting expected cash flows to their present value at a rate of return that incorporates the risk-free rate for the use of funds, the expected rate of inflation over the asset’s holding period, and the risks associated with realizing the cash flows in the amounts and at the times projected. The discount rate selected is typically based on rates of return available from alternative investments of similar type and quality as of the valuation date. The most commonly employed income approach to valuation is the discounted cash flow analysis. • Market Approach. The market approach attempts to value an asset or security by examining observable market values for similar assets or securities. Sales and offering prices for comparable assets are adjusted to reflect differences between the asset being valued and the comparable assets, such as, location, time and terms of sale, utility, and physical characteristics. When applied to the valuation of equity, the analysis may include consideration of the financial condition and operating performance of the company being valued relative to those of publicly traded companies or to those of companies acquired in a single transaction, which operate in the same or similar lines of business. • Cost Approach. The cost approach to valuation is based upon the concept of replacement cost as an indicator of value and the notion that an investor would pay no more for an asset than what it would cost to replace the asset with one of equal utility. The cost approach estimates value based upon the estimated cost of replacing or reproducing the asset, less adjustments for physical deterioration and functional obsolescence, if relevant. When applied to an enterprise, a type of cost approach referred to as the Net Asset Method is sometimes employed. This method measures the value of equity as the sum of the values of its assets reduced by the sum of the values of its liabilities. The resulting equity is reflective of a 100% ownership interest in the business. This approach is frequently used in valuing holding companies. Based on our early stage of development and other relevant factors, we considered all three approaches and chose to apply both income and market approaches in our analyses. We determined these approaches were the most appropriate methods for allocating our enterprise value to determine the estimated fair value of our common stock for valuations performed for periods up to our IPO. 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. The estimated fair value of our common stock at each grant date reflected a non-marketability discount partially based on the anticipated likelihood and timing of a future liquidity event. Following our IPO, our board of directors determines the fair value of our common stock based on the closing quoted market price of our common stock on the date of grant. Income Taxes We account for income taxes under the asset and liability method. Deferred 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 50% likely of being realized upon ultimate settlement. We have elected to account for the tax on Global Intangible Low-Taxed Income, enacted as part of the Tax Cuts and Jobs Act as a component of tax expense in the period in which the tax is incurred. JOBS Act Accounting Election We are an emerging growth company, as defined in the Jumpstart Our Business Startups Act (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 irrevocably elected not to avail ourselves of this exemption from 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. Recent Accounting Pronouncements See the sections titled “Summary of Significant Accounting Policies-Recent Accounting Pronouncements” and “-Recent Accounting Pronouncements Not Yet Adopted” in Note 2 to our consolidated financial statements for additional information.

<s>[INST] This section of this Form 10K generally discusses 2019 and 2018 items and yeartoyear comparisons between 2019 and 2018. Discussions of 2017 items and yeartoyear comparisons between 2018 and 2017 that are not included in this Form 10K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Prospectus. Overview We are a growing cancer genomics company transforming the development of nextgeneration therapies by providing more comprehensive molecular data about each patient’s cancer and immune response. We designed our NeXT Platform to adapt to the complex and evolving understanding of cancer, providing our biopharmaceutical customers with information on all of the approximately 20,000 human genes, together with the immune system, in contrast to many cancer panels that cover roughly 50 to 500 genes. In parallel with the development of our platform technology, we have also provided population sequencing services under contract with the U.S. Department of Veterans Affairs (the “VA”) Million Veteran Program (the “VA MVP”), which has enabled us to innovate, scale our operational infrastructure, and achieve greater efficiencies in our lab. We are also developing a complementary liquid biopsy assay that analyzes all of the approximately 20,000 human genes versus the more narrowly focused liquid biopsy assays that are currently available. By combining technological innovation, operational scale, and regulatory differentiation, our NeXT Platform is designed to help our customers obtain new insights into the mechanisms of response and resistance to therapy as well as new potential therapeutic targets. Our platform enhances the ability of biopharmaceutical companies to unlock the potential of conducting translational research in the clinic rather than with preclinical animal models or cancer cell lines. We also announced in January 2020 a diagnostic based on our NeXT Platform that we envision being used initially by both leading clinical cancer centers as well as biopharmaceutical companies. We generated revenues of $65.2 million, $37.8 million, and $9.4 million for the years ended December 31, 2019, 2018, and 2017, respectively. In 2019, 67% of our revenues were generated from the U.S. Department of Veterans Affairs (the “VA”) Million Veteran Program (the “VA MVP”) as compared to 49% in 2018. NonVA MVP revenues increased by 13% in 2019 compared to 2018. We also incurred net losses of $25.1 million, $19.9 million and $23.6 million for the years ended December 31, 2019, 2018, and 2017, respectively. As of December 31, 2019, we had $128.3 million in cash and cash equivalents, and shortterm investments. From inception through December 31, 2019, we have funded our operations primarily through cash from operations, redeemable convertible preferred stock issuances, debt issuances, and proceeds from our initial public offering. We expect that our existing cash and cash equivalents, and shortterm investments will provide sufficient funds to sustain operations through at least the next 12 months. We have based these estimates on assumptions that may prove to be wrong, and we could exhaust our available capital resources sooner than we expect. Factors Affecting Our Performance We believe there are several important factors that have impacted, and that we expect will continue to impact, our operating performance and results of operations, including: The continued development of the market for genomicbased tests. Our performance depends on the willingness of biopharmaceutical customers to continue to seek more comprehensive molecular information to develop more efficacious cancer therapies. Increasing adoption of our products and solutions by existing customers. Our performance depends on our ability to retain and broaden adoption with existing customers. Because our technology is novel, some customers begin using our platform by initiating pilot studies involving a small number of samples to gain experience with our service. As a result, historically [/INST] Positive. </s>

NextCure, 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 the financial statements and the related notes appearing elsewhere in this Annual Report. This discussion contains forward-looking statements that are based on management’s current expectations, estimates, and projections about our business and operations, and involve risks and uncertainties. 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 the sections entitled “Risk Factors” and “Special Note Regarding Forward-Looking Statements” and elsewhere in this Annual Report. Overview We are a clinical-stage biopharmaceutical company committed to discovering and developing novel, first-in-class immunomedicines to treat cancer and other immune-related diseases by restoring normal immune function. We view the immune system holistically and, rather than target one specific immune cell type, we focus on understanding biological pathways, the interactions of cells and the role each interaction plays in an immune response. Through our proprietary Functional, Integrated, NextCure Discovery in Immuno-Oncology, or FIND-IO, platform, we study various immune cells to discover and understand targets and structural components of immune cells and their functional impact in order to develop immunomedicines. We are focused on patients who do not respond to current therapies, patients whose cancer progresses despite treatment and patients with cancer types not adequately addressed by available therapies. We are committed to discovering and developing first-in-class immunomedicines, which are immunomedicines that use new or unique mechanisms of action to treat a medical condition, for these patients. Our lead product candidate, NC318, is a first-in-class immunomedicine against a novel immunomodulatory receptor called Siglec-15, or S15. In October 2018, we initiated a Phase 1/2 clinical trial of NC318 in patients with advanced or metastatic solid tumors. We completed enrollment of the Phase 1 portion of this trial in August 2019 and preliminary data from the Phase 1 portion was presented at the Society for Immunotherapy of Cancer annual meeting in November 2019. We began enrolling patients in the Phase 2 portion of the trial in October 2019 and expect to announce initial data from the Phase 2 portion by the end of 2020. We intend to initiate an additional Phase 2 clinical trial to evaluate NC318 in combination with standard of care chemotherapies in patients with advanced or metastatic solid tumors in mid-2020. Our second product candidate, NC410, is a novel immunomedicine designed to block immune suppression mediated by an immune modulator called Leukocyte-Associated Immunoglobulin-like Receptor 1. The U.S. Food and Drug Administration, or the FDA, accepted our investigational new drug application, or IND, for NC410 in the first quarter of 2020 and we intend to initiate a Phase 1/2 clinical trial in patients with advanced or metastatic solid tumors in the second quarter of 2020. Financial Overview Since commencing operations in 2015, we have devoted substantially all of our efforts and financial resources to organizing and staffing our company, identifying business development opportunities, raising capital, securing intellectual property rights related to our product candidates, building and optimizing our manufacturing capabilities and conducting discovery, research and development activities for our product candidates, discovery programs and FIND-IO platform. We have not generated any revenue from product sales and only limited revenue from other sources and, as a result, we have never been profitable and have incurred net losses since the commencement of our operations. Our net losses for the years ended December 31, 2019 and 2018 were $33.7 million and $22.8 million, respectively. As of December 31, 2019, we had an accumulated deficit of $81.0 million primarily as a result of research and development and general and administrative expenses. We do not expect to generate product revenue unless and until we obtain marketing approval for and commercialize a product candidate, and we cannot assure you that we will ever generate significant revenue or profits. We have funded our operations to date primarily with proceeds from public offerings of our common stock, private placements our preferred stock and upfront fees received under our former research collaboration and development agreement with Eli Lilly and Company, or Lilly. From our inception through December 31, 2019, we received gross proceeds of $164.4 million through private placements of preferred stock and an upfront payment of $25.0 million in connection with our agreement with Lilly, or the Lilly Agreement. In April 2018, we received gross proceeds of $31.0 million from the sale and issuance of shares of our Series A-3 Preferred Stock, and in November 2018, we received gross proceeds of $93.4 million from the sale and issuance of shares of our Series B Preferred Stock, including $15.0 million from Lilly as described below. In November 2018, we entered into the Lilly Agreement, to use our FIND-IO platform to identify novel oncology targets for additional collaborative research and drug discovery by us and Lilly. We received an upfront payment of $25.0 million in cash and an equity investment of $15.0 million from Lilly upon entering into the Lilly Agreement, and we were eligible for quarterly research and development support payments during a portion of the term of the Lilly Agreement. Effective March 3, 2020, Lilly terminated the Lilly Agreement. On May 13, 2019, we closed our initial public offering, or IPO, in which we sold 5,750,000 shares of common stock, at a public offering price of $15.00 per share, for aggregate gross proceeds of $86.3 million. The net offering proceeds to us were approximately $76.9 million after deducting underwriting discounts and commissions of $6.0 million and offering expenses of $3.4 million. See Note 1 to our audited financial statements included elsewhere in this Annual Report for more information. On November 19, 2019, we completed an underwritten public offering, in which we issued and sold 4,077,192 shares of common stock at a public offering price of $36.75 per share. On December 2, 2019, the underwriters exercised in full their option to purchase an additional 611,578 shares of common stock at the public offering price of $36.75, for total net proceeds to us of approximately $160.9 million after deducting underwriting discounts and commissions of approximately $10.3 million and offering expenses of approximately $1.0 million. As of December 31, 2019, we had cash, cash equivalents and marketable securities, excluding restricted cash, of $334.6 million. We believe that our existing cash, cash equivalents and marketable securities will be sufficient to fund our planned operations into the first half of 2023. We have based this estimate on assumptions that may prove to be incorrect, and we could use our available capital resources sooner than we currently expect. We expect to incur substantial expenditures in the foreseeable future as we advance our product candidates through clinical development, the regulatory approval process and, if approved, commercialization, and as we expand our pipeline through research and development activities related to our FIND-IO platform and discovery programs. Specifically, in the near term, we expect to incur substantial expenses relating to our ongoing Phase 1/2 clinical trial and planned Phase 2 clinical trial of NC318, our planned Phase 1/2 clinical trial of NC410 and other research and development activities. We expect to incur significantly increased costs as a result of operating as a public company, including significant legal, accounting, investor relations and other expenses that we did not incur as a private company. We will need substantial additional funding to support our continuing operations and to pursue our development strategy. Until such time as we can generate significant revenue from sales of our product candidates, if ever, we expect to finance our operations through a combination of public and private equity offerings, debt financings, marketing and distribution arrangements, other collaborations, strategic alliances and licensing arrangements. 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 be required to delay, limit, reduce or terminate preclinical studies, clinical trials, or other research and development activities or one or more of our development programs. Components of Our Results of Operations Revenue For the year ended December 31, 2019, we recognized $6.3 million in revenue under the Lilly Agreement. Through December 31, 2019, we have not generated any revenue from product sales. Through December 31, 2018, we had not generated any revenue from product sales or otherwise. For additional information about our revenue recognition policy, see Note 2 to our audited financial statements included elsewhere in this Annual Report. Operating Expenses Research and Development Expenses Research and development expenses consist primarily of costs incurred for our discovery efforts, research activities, development and testing of our product candidates as well as for clinical trials, including: · salaries, benefits and other related costs, including stock-based compensation, for personnel engaged in research and development functions; · expenses incurred under agreements with third parties, including agreements with third parties that conduct research, preclinical activities or clinical trials on our behalf, such as our corporate sponsored research agreement, or the SRA, and our license agreement with Yale University, or Yale; · costs of outside consultants, including their fees, stock-based compensation and related travel expenses; · the costs of laboratory supplies and acquiring, developing and manufacturing preclinical study and clinical trial materials; and · facility-related expenses, which include direct depreciation costs and allocated expenses for rent and maintenance of facilities and other operating costs. We expense research and development costs as incurred. Our expenses related to clinical trials are based on actual costs incurred and estimates of other incurred costs. These estimated costs are based on several factors, including patient enrollment and related expenses at clinical investigator sites, contract services received, consulting agreement costs and efforts expended under contracts with research institutions and third-party contract research organizations that conduct and manage clinical trials on our behalf. We generally accrue estimated costs related to clinical trials based on contracted amounts applied to the level of patient enrollment and other activity according to the protocol. If future timelines or contracts are modified based on changes in the clinical trial protocol or scope of work to be performed, we would modify our estimates of accrued expenses accordingly on a prospective basis. Historically, any such modifications have not been material. Due to the early-stage nature of our programs and the discovery-related nature of our efforts, we do not track costs on a program-by-program basis other than costs incurred for the Lilly Agreement. However, as our current and future product candidates proceed along a development path further in clinical trials, we intend to track the costs of each program. We measure costs incurred under the Lilly Agreement as an input to recording revenue from the Lilly Agreement. 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 advance our product candidates through development, including conducting our ongoing Phase 1/2 clinical trial of NC318, our planned Phase 2 clinical trial in combination with standard of care chemotherapies and preclinical studies and a Phase 1/2 clinical trial of NC410, as we develop a complementary diagnostic for NC318 if we determine it is advisable, and as we expand our current good manufacturing practice, or cGMP, manufacturing capacity, including to provide drug supply of NC318 for future clinical trials, and as we expand our pipeline through research and development activities related to our FIND-IO platform and discovery programs. We cannot determine with certainty the duration and costs of future clinical trials of NC318, NC410 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 may obtain marketing approval. We may never succeed in obtaining marketing approval for any product candidate. The duration, costs and timing of clinical trials and development of NC318, NC410 and any other product candidate we may develop will depend on a variety of factors, including: · the scope, progress, results and costs of clinical trials of NC318 and NC410, as well as of any future clinical trials of other product candidates and other research and development activities that we may conduct; · uncertainties in selection of indications, clinical trial design and patient enrollment rates; · the probability of success for our product candidates, including safety and efficacy, early clinical data, competition, ease and ability of manufacturing and commercial viability; · significant and changing government regulation and regulatory guidance; · the timing and receipt of any development or marketing approvals; and · the expense of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights. A change in the outcome of any of these variables with respect to the development of a product candidate could lead to 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 to complete clinical development for any such product candidate. General and Administrative Expenses General and administrative expenses consist primarily of personnel-related costs, including payroll and stock-based compensation, for personnel in executive, finance, human resources, business and corporate development and other administrative functions, professional fees for legal, intellectual property, consulting and accounting services, rent and other facility-related costs, depreciation and other general operating expenses not otherwise classified as research and development expenses. General and administrative expenses also include all patent-related costs incurred in connection with filing and prosecuting patent applications, which are expensed as incurred. We anticipate that our general and administrative expenses will increase substantially during the next few years as a result of staff expansion and additional occupancy costs, as well as costs associated with being a public company, including higher legal and accounting fees, investor relations costs, higher insurance premiums and other compliance costs associated with being a public company. Other Income, Net Other income, net consists primarily of interest income earned on U.S. Treasury obligations and payment of interest on our term loan with a commercial bank, or the Term Loan. Results of Operations Comparison of the Years Ended December 31, 2019 and 2018 The following table summarizes our results of operations for the periods indicated (in thousands): Revenue from Research and Development Arrangement Revenue was $6.3 million and $0 for the years ended December 31, 2019 and 2018, respectively. The 2019 revenue is related to the recognition of a portion of the upfront consideration under the Lilly Agreement and the premium on the proceeds from Lilly’s investment in shares of our Series B-3 Preferred Stock. We expect to record as revenue the remaining deferred revenue balance of $22.4 million at December 31, 2019 in the first quarter of 2020 as a result of the termination of the Lilly Agreement in March 2020. Research and Development Expenses Research and development expenses for the year ended December 31, 2019 increased by $14.4 million to $34.2 million compared to $19.8 million for the year ended December 31, 2018. The increase was driven primarily by $4.4 million increase in lab supplies and services for NC318, NC410, other early-stage programs and discovery activities. Other significant components of the increase in research and development expenses included $4.1 million in personnel-related costs due to an increase in headcount, $3.0 million in clinical research costs related to advancing NC318, $0.7 million payments pursuant to the SRA and other sponsored research agreements and $0.6 million in research and development license costs. General and Administrative Expenses General and administrative expenses for the year ended December 31, 2019 increased by $6.2 million to $9.6 million as compared to $3.4 million for the year ended December 31, 2018. The increase was driven primarily by increases, largely in connection with our IPO and operating as a public company, of $2.8 million for professional fees related to legal, finance and audit services, public relations, compensation and investor relations support, $1.2 million in insurance expenses and $0.7 million in personnel-related costs due to an increase in headcount. Other Income, Net Other income, net for the year ended December 31, 2019 increased by $3.3 million to $3.7 million from $0.4 million for the year ended December 31, 2018. The increase was driven primarily by interest income earned on higher cash and marketable securities balances, partially offset by interest expense related to an increase in the outstanding principal balance of our term loan from $1.0 million to $5.0 million in January 2019. Liquidity and Capital Resources We have financed our operations primarily with proceeds from public offerings of our common stock, private placements of our preferred stock and upfront fees received under the Lilly Agreement. On May 13, 2019, we closed our IPO in which we sold 5,750,000 shares of common stock, at a public offering price of $15.00 per share, for aggregate gross proceeds of $86.3 million. The net offering proceeds to us were approximately $76.9 million after deducting underwriting discounts and commissions and offering expenses. On November 19, 2019, we completed an underwritten public offering, in which we sold 4,077,192 shares of common stock at a public offering price of $36.75 per share. On December 2, 2019, the underwriters exercised in full their option to purchase an additional 611,578 shares of common stock at the public offering price of $36.75. The total gross proceeds to us were $172.2 million and the total net offering proceeds to us were approximately $160.9 million after deducting underwriting discounts and commissions and offering expenses. Since inception, we have received aggregate gross proceeds of $164.4 million from the sale and issuance of shares of our preferred stock. In addition, in November 2018, we received an upfront payment of $25.0 million in cash from Lilly pursuant to the Lilly Agreement. Our cash and cash equivalents are held in money market funds. As of December 31, 2019, we had cash, cash equivalents and marketable securities, excluding restricted cash, of $334.6 million. We believe that our existing cash, cash equivalents and marketable securities will be sufficient to fund our planned operations into the first half of 2023. In addition, in April 2016, we entered into a term loan to finance laboratory equipment purchases. In January 2019, we amended the term loan to increase our borrowing capacity from $1.0 million to $5.0 million. As amended, the term loan matures in January 2023. Our obligations under the term loan are secured by a security interest in our certificates of deposit, money market accounts, cash, securities, investment property and deposit or investment accounts. The term loan bears interest at a rate equal to the greater of (i) the prime rate less 1.0% and (ii) 4.25% and is subject to mandatory prepayment upon the occurrence of specified events, including failure to pay the term loan when due, uncured breach, bankruptcy or dissolution. Under the term loan, we will make interest-only payments through January 2020 and 36 equal monthly payments of principal plus accrued interest thereafter through January 2023. As of December 31, 2019, our outstanding borrowings under this term loan were $5.0 million. We will continue to require additional capital to develop our product candidates and fund operations for the foreseeable future. We may seek to raise capital through sale of equity, debt financings, strategic alliances and licensing arrangements. Adequate additional 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 of our product candidates or delay our efforts to expand our pipeline of product candidates. Our need to raise additional capital will depend on many factors, including: · the scope, progress, results and costs of researching and developing NC318, NC410 and our other programs, including targets identified through our FIND-IO platform, and of conducting preclinical studies and clinical trials; · the timing of, and the costs involved in, obtaining marketing approvals for NC318, NC410 and any future product candidates we develop, if clinical trials are successful; · the costs of manufacturing NC318, NC410 and any future product candidates we develop for preclinical studies and clinical trials in preparation for marketing approval and commercialization; · the costs of commercialization activities, including marketing, sales and distribution costs, for NC318, NC410 and any future product candidates we develop, whether alone or with a collaborator, if any such product candidates are approved for sale, including marketing, sales and distribution costs; · the success of the SRA with Yale; · our ability to establish and maintain additional collaborations, licenses or other arrangements on favorable terms, if at all; · the costs involved in preparing, filing, prosecuting, maintaining, expanding, defending and enforcing patent claims, including litigation costs and the outcome of any such litigation; · our current collaboration and license agreements remaining in effect and our achievement of milestones and the timing and amount of milestone payments we are required to make, or that we may be eligible to receive, under those agreements; · the timing, receipt and amount of sales of, or royalties on, our future products, if any; and · the emergence of competing therapies and other adverse developments in the oncology market. Adequate additional financing may not be available to us on acceptable terms, or at all. 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 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 future revenue streams, product candidates or research programs or to 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, reduce or terminate some or all of our development programs and clinical trials. We may also be required to sell or license to others rights to our product candidates in certain territories or indications that we would prefer to retain for ourselves. See the section entitled "Risk Factors" for additional risks associated with our substantial capital requirements. Cash Flows The following table sets forth the primary sources and uses of cash and cash equivalents for each of the periods presented below (in thousands): Cash Used in/Provided by Operating Activities Net cash used in operating activities was $35.6 million for the year ended December 31, 2019, which was primarily due to our net loss of $33.7 million. Net cash provided by operating activities was $8.0 million for the year ended December 31, 2018, which was primarily due to deferred revenue, including the $25.0 million upfront payment pursuant to the Lilly Agreement, as well as a non-cash charge for depreciation and amortization and the timing of cash payments, partially offset by our net loss of $22.8 million as we continued our research and development activities. The amount of cash used in operating activities in any period is influenced by the timing of cash payments for research-related expenses. Cash Used in Investing Activities Cash used in investing activities for the year ended December 31, 2019 was $303.9 million, which was primarily due to the purchase of marketable securities. Cash used in investing activities for the year ended December 31, 2018 was $3.1 million, which consisted primarily of purchases of laboratory equipment. Cash Provided by Financing Activities Cash provided by financing activities was $243.0 million for the year ended December 31, 2019, which consisted primarily of net proceeds from the Company’s public offering. Cash provided by financing activities was $121.4 million for the year ended December 31, 2018, which consisted of gross proceeds from the sale and issuance of shares of our Series A and B Preferred Stock, partially offset by issuance costs, deferred offering costs and payments under the Term Loan. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2019 (in thousands): We had operating lease obligations consisting of two operating leases for our corporate headquarters for a total of approximately 50,000 square feet as of December 31, 2019. The terms of the leases expire in August 2025 and March 2030. Under the terms of the leases, we will have lease obligations aggregating $8.8 million through 2025. The contractual obligations table does not include any potential contingent payments upon the achievement by us of clinical, regulatory and commercial events, as applicable, or royalty payments that we may be required to make under license agreements we have entered into with various entities pursuant to which we have in-licensed intellectual property, including, our license agreement with Yale and the SRA with Yale. We excluded the contingent payments given that the timing and amount (if any) of any such payments cannot be reasonably estimated at this time. See “Business-Our Collaboration Agreements” for additional information. We enter into contracts in the normal course of business with third-party contract organizations for clinical trials, non-clinical studies and testing, manufacturing and 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 financial statements have been prepared in accordance with U.S. generally accepted accounting principles, or 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. The most significant assumptions used in the financial statements are the underlying assumptions used in revenue recognition and valuing share-based compensation, including the fair value of our common stock in periods before our IPO. 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. We evaluate our estimates and assumptions on an ongoing basis. 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, we believe that the following critical accounting policies are most important to understanding and evaluating our reported financial results, as these policies relate to the more significant areas involving management’s judgments and estimates. Research and Development Expenses, Including Clinical Trial Accruals Research costs consist of employee-related costs, contractor expenses, laboratory supplies and facility costs, for research and development of product candidates are expensed as incurred. Development costs, including clinical trial-related expenses, incurred by third parties, such as CROs, are expensed as the contracted work is performed. Where contingent milestone payments are due to third parties under research and development arrangements, the milestone payment obligations are expensed when the milestone results are probable of being achieved. When evaluating the adequacy of the accrued liabilities, we analyze progress of the studies, including the phase or completion of events, invoices received and contracted costs. For further discussion of research and development expenses, see Note 2 to our audited financial statements included elsewhere in this Annual Report. Revenue Recognition We account for revenue in accordance with ASC Topic 606, Revenue from Contracts with Customers (“ASC 606”). 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 the appropriate amount of revenue to be recognized for arrangements determined to be within the scope of ASC 606, we perform the following five 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; and (v) recognition of revenue when (or as) we satisfy each performance obligation. We only apply the five-step model to contracts when it is probable that we will collect consideration to which we are entitled in exchange for the goods or services we transfer to the customer. For further discussion of revenue recognition, see Note 2 to our audited financial statements included elsewhere in this Annual Report. Stock-Based Compensation We account for stock-based compensation, including stock options and restricted stock units, based on the fair value of the award as of the grant date. We utilize the Black-Scholes option-pricing model as the method for estimating the fair value of our stock option grants. The Black-Scholes option-pricing model requires the use of highly subjective and complex assumptions, including the options’ expected term and the price volatility of the underlying stock. The fair value of the portion of the award that is ultimately expected to vest is recognized as compensation expense over the award’s requisite service period. We recognize stock-based compensation to expense using the straight-line method. If there are any modifications or cancelations of stock-based awards, we may be required to accelerate, increase or decrease any remaining unrecognized stock-based compensation expense. Stock-based compensation expense, net of estimated forfeitures, is reflected in the statements of operations and comprehensive loss as follows: As of December 31, 2019, total unamortized stock-based compensation was $6.9 million. The intrinsic value of all outstanding stock options as of December 31, 2019 was $113.3 million. Common Stock Valuation Before our IPO, there was no public market for our common stock to date and 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 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 and which may have changed from the date of the most recent 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 common stock valuations were prepared using an option pricing method, or OPM, which used market approaches to estimate our enterprise value. The OPM treats common stock and preferred stock 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 stock has value only if the funds available for distribution to stockholders exceeded the value of the preferred stock liquidation preferences at the time of the liquidity event, such as a strategic sale or a merger. A discount for lack of marketability of the common stock is then applied to arrive at an indication of value for the common stock. Since the closing of our IPO, our board of directors has determined the fair value of our common stock based on the closing price of our common stock on the Nasdaq Global Select Market as reported on the date of grant. For further discussion of our accounting for stock-based compensation, see Note 2 to our audited financial statements included elsewhere in this Annual Report. 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 Securities and Exchange Commission. JOBS Act Accounting Election 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. We have elected to take advantage of this extended transition period to enable us to comply 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. For so long as we remain an emerging growth company, we are permitted and intend to rely on certain exemptions from various public company reporting requirements, including not being required to have our internal control over financial reporting audited by our independent registered public accounting firm pursuant to Section 404(b) of the Sarbanes-Oxley Act of 2002. We will remain an emerging growth company until the earliest of (i) December 31, 2024, (ii) the last day of the first fiscal year in which we have total annual gross revenues of at least $1.07 billion, (iii) the last day of the first fiscal year in which the market value of our common stock that is held by non-affiliates exceeds $700.0 million on June 30th and (iv) 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 audited financial statements included elsewhere in this Annual Report for a discussion of recent accounting pronouncements that have impacted or may impact our financial position and results of operations.

<s>[INST] those discussed in these forwardlooking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in the sections entitled “Risk Factors” and “Special Note Regarding ForwardLooking Statements” and elsewhere in this Annual Report. Overview We are a clinicalstage biopharmaceutical company committed to discovering and developing novel, firstinclass immunomedicines to treat cancer and other immunerelated diseases by restoring normal immune function. We view the immune system holistically and, rather than target one specific immune cell type, we focus on understanding biological pathways, the interactions of cells and the role each interaction plays in an immune response. Through our proprietary Functional, Integrated, NextCure Discovery in ImmunoOncology, or FINDIO, platform, we study various immune cells to discover and understand targets and structural components of immune cells and their functional impact in order to develop immunomedicines. We are focused on patients who do not respond to current therapies, patients whose cancer progresses despite treatment and patients with cancer types not adequately addressed by available therapies. We are committed to discovering and developing firstinclass immunomedicines, which are immunomedicines that use new or unique mechanisms of action to treat a medical condition, for these patients. Our lead product candidate, NC318, is a firstinclass immunomedicine against a novel immunomodulatory receptor called Siglec15, or S15. In October 2018, we initiated a Phase 1/2 clinical trial of NC318 in patients with advanced or metastatic solid tumors. We completed enrollment of the Phase 1 portion of this trial in August 2019 and preliminary data from the Phase 1 portion was presented at the Society for Immunotherapy of Cancer annual meeting in November 2019. We began enrolling patients in the Phase 2 portion of the trial in October 2019 and expect to announce initial data from the Phase 2 portion by the end of 2020. We intend to initiate an additional Phase 2 clinical trial to evaluate NC318 in combination with standard of care chemotherapies in patients with advanced or metastatic solid tumors in mid2020. Our second product candidate, NC410, is a novel immunomedicine designed to block immune suppression mediated by an immune modulator called LeukocyteAssociated Immunoglobulinlike Receptor 1. The U.S. Food and Drug Administration, or the FDA, accepted our investigational new drug application, or IND, for NC410 in the first quarter of 2020 and we intend to initiate a Phase 1/2 clinical trial in patients with advanced or metastatic solid tumors in the second quarter of 2020. Financial Overview Since commencing operations in 2015, we have devoted substantially all of our efforts and financial resources to organizing and staffing our company, identifying business development opportunities, raising capital, securing intellectual property rights related to our product candidates, building and optimizing our manufacturing capabilities and conducting discovery, research and development activities for our product candidates, discovery programs and FINDIO platform. We have not generated any revenue from product sales and only limited revenue from other sources and, as a result, we have never been profitable and have incurred net losses since the commencement of our operations. Our net losses for the years ended December 31, 2019 and 2018 were $33.7 million and $22.8 million, respectively. As of December 31, 2019, we had an accumulated deficit of $81.0 million primarily as a result of research and development and general and administrative expenses. We do not expect to generate product revenue unless and until we obtain marketing approval for and commercialize a product candidate, and we cannot assure you that we will ever generate significant revenue or profits. We have funded our operations to date primarily with proceeds from public offerings of our common stock, private placements our preferred stock and upfront fees received under our former research collaboration and development agreement with Eli Lilly and Company, or Lilly. From our inception through December 31, 2019, we received gross proceed [/INST] Negative. </s>

New Providence Acquisition Corp.

2020-03-30

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 Report including, without limitation, statements under “Item 7. 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 Report, 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 formed under the laws of the State of Delaware on May 28, 2019 for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or other similar business combination with one or more businesses. We intend to effectuate our business combination using cash from the proceeds of the initial public offering and the sale of the private placement warrants, 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 in our initial public offering; ● may subordinate the rights of holders of common stock if preferred stock is issued with rights senior to those afforded our common stock; ● 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 carry forwards, if any, and could result in the resignation or removal of our present officers and directors; and ● may adversely affect prevailing market prices for our units, Class A common stock and/or warrants. Similarly, if we issue debt securities, 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 disadvantages compared to our competitors who have less debt. As indicated in the accompanying financial statements, at December 31, 2019, we had $493,128 in cash and working capital of $456,362. We expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete our initial 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 May 28, 2019 (inception) through December 31, 2019 were organizational activities, those necessary to prepare for the initial public offering, described below, and, after our initial public offering, 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. For the period from May 28, 2019 (inception) through December 31, 2019, we had net income of $655,679, which consisted of interest income on marketable securities held in the trust account of $1,197,637 and an unrealized gain on marketable securities held in our trust account of $17,194, offset by operating and formation costs of $384,857 and a provision for income taxes of $174,295. Liquidity and Capital Resources On September 13, 2019, 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 5,500,000 private placement warrants to the Sponsor at a price of $1.00 per warrant, generating gross proceeds of $5,500,000. On September 19, 2019, in connection with the underwriters’ full exercise of their over-allotment option, we consummated the sale of an additional 3,000,000 units and the sale of an additional 600,000 private placement warrants, generating total gross proceeds of $30,600,000. Following the initial public offering, the exercise of the over-allotment option and the sale of the private placement warrants, a total of $230,000,000 was placed in the trust account. We incurred $13,260,927 in transaction costs, including $4,600,000 of underwriting fees, $8,050,000 of deferred underwriting fees and $610,927 of other costs. As of December 31, 2019, we had marketable securities held in the trust account of $231,214,831 (including $1,215,000 of interest income and unrealized gains) consisting of U.S. Treasury Bills with a maturity of 180 days or less. Interest income on the balance in the trust account may be used by us to pay taxes. Through December 31, 2019, we did not withdraw any interest earned on the trust account. For the period from May 28, 2019 (inception) through December 31, 2019, cash used in operating activities was $420,945. Net income of $655,679 was affected by interest earned on marketable securities held in the trust account of $1,197,637, an unrealized gain on marketable securities held in our trust account of $17,194, a deferred tax provision of $3,611 and changes in operating assets and liabilities, which provided $134,596 of cash. 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 and income taxes payable), 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 $493,128 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 initial stockholders or their affiliates 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 warrants identical to the private placement warrants, at a price of $1.00 per warrant 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 did not have any off-balance sheet arrangements as of December 31, 2019. 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 $10,000 for office space, administrative and support services to the Company. We began incurring these fees on September 11, 2019 and will continue to incur these fees monthly until the earlier of the completion of the business combination and the Company’s liquidation. The underwriters are entitled to a deferred fee of $0.35 per unit, or $8,050,000 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 identified the following critical accounting policies: 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. Net loss per share of common stock We apply the two-class method in calculating earnings per share. Common stock subject to possible redemption which is not currently redeemable and is not redeemable at fair value, has been excluded from the calculation of basic net loss per common 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 standards Management does not believe that any other recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on our financial statements. Emerging Growth Company 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 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, 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 our 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.

<s>[INST] All statements other than statements of historical fact included in this Report including, without limitation, statements under “Item 7. 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 Report, 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 formed under the laws of the State of Delaware on May 28, 2019 for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or other similar business combination with one or more businesses. We intend to effectuate our business combination using cash from the proceeds of the initial public offering and the sale of the private placement warrants, 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 in our initial public offering; may subordinate the rights of holders of common stock if preferred stock is issued with rights senior to those afforded our common stock; 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 carry forwards, if any, and could result in the resignation or removal of our present officers and directors; and may adversely affect prevailing market prices for our units, Class A common stock and/or warrants. Similarly, if we issue debt securities, 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 disadvantages compared to our competitors who have less debt. As indicated in the accompanying financial statements, at December 31, 2019, we had $493,128 in cash and working capital of $456,362. We expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete our initial 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 May 28, 2019 (inception) through December 31, 2019 were organizational activities, those [/INST] Negative. </s>

Health Catalyst, 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 of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the accompanying notes included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those forward-looking statements below. Factors that could cause or contribute to those differences include, but are not limited to, those identified below and those discussed in the sections titled “Risk Factors” and "Special Note Regarding Forward-Looking Statements" included elsewhere in this Annual Report on Form 10-K. A discussion regarding our financial condition and results of operations for the year ended December 31, 2019 compared to the year ended December 31, 2018 is presented below. A discussion regarding our financial condition and results of operations for the year ended December 31, 2018 compared to the year ended December 31, 2017 is included under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our prospectus filed pursuant to Rule 424(b) on July 25, 2019. Overview We are a leading provider of data and analytics technology and services to healthcare organizations. Our Solution comprises a cloud-based data platform, analytics software, and professional services expertise. Our customers, which are primarily healthcare providers, use our Solution to manage their data, derive analytical insights to operate their organizations, and produce measurable clinical, financial, and operational improvements. We envision a future where all healthcare decisions are data informed. Health Catalyst was founded in 2008 by healthcare analytics industry pioneers. Our founders and team developed the initial version of our Solution, consisting of an early version of our data platform, select analytics accelerators, and professional services expertise. From the beginning, our Solution has been focused on enabling our mission: to be the catalyst for massive, measurable, data-informed healthcare improvement. We currently employ more than 900 team members. For the years ended December 31, 2019, 2018, and 2017, our total revenue was $154.9 million, $112.6 million, and $73.1 million, respectively. For the years ended December 31, 2019, 2018, and 2017, we incurred net losses of $60.1 million, $62.0 million, and $47.0 million, respectively. For the years ended December 31, 2019, 2018, and 2017, our Adjusted EBITDA was $(27.4) million, $(38.1) million, and $(35.4) million, respectively. See “Selected Consolidated Financial and Other Data-Reconciliation of Non-GAAP Financial Measures” for more information about this financial measure, including the limitations of such measure and a reconciliation to the most directly comparable measure calculated in accordance with GAAP. See “Key Factors Affecting Our Performance” for more information about important opportunities and challenges related to our business. On July 29, 2019, we closed our IPO in which we issued and sold 8,050,000 shares of common stock at a price to the public of $26.00 per share for aggregate net proceeds of $190.0 million after deducting underwriting discounts and commissions and offering expenses payable by us. Our Business Model We offer our Solution to a variety of healthcare organizations, primarily in the United States, including academic medical centers, integrated delivery networks, community hospitals, large physician practices, ACOs, health information exchanges, health insurers, and other risk-bearing entities. We categorize our customer count into two primary categories: DOS Subscription Customers and Other Customers. DOS Subscription Customers are defined as customers who access our DOS platform via a technology subscription contract. Other Customers generally include DOS non-subscription customers and Medicity interoperability customers. As of December 31, 2019, 2018, and 2017, we had 65, 50, and 34 DOS Subscription Customers with active subscriptions, respectively. As of December 31, 2019, 2018, and 2017, we had 65, 76, and 12 active Other Customers, respectively. The significant increase in Other Customers from 2017 to 2018 was primarily due to our acquisition of Medicity on June 29, 2018. We derive substantially all of our revenue through subscriptions for use of our technology and professional services on a recurring basis. In 2019, greater than 90% of our total revenue was recurring in nature. Customers pay for our technology primarily on a subscription basis for our entire technology suite or for pieces of our technology (e.g., DOS-only). We generally provide access to our technology and deliver professional services to customers on a recurring basis, with our technology invoiced upfront annually or quarterly and our professional services invoiced monthly. Most of our technology and professional services contracts have up to a three-year term, of which the vast majority are terminable after one year upon 90 days' notice. As we increase the use cases we address at a given customer, we have the opportunity to upsell incremental technology and services. We have demonstrated an ability to upsell technology and services to our customer base over time as evidenced by a Dollar-based Retention Rate of 109% for the year ended December 31, 2019. The primary costs incurred to deliver our technology are hosting fees and headcount-related costs associated with our cloud services and support teams. Hosting fees are related to providing our technology through a cloud-based environment hosted primarily by Microsoft Azure. However, we also operate a private data center where certain customers are hosted and have deployed DOS on-premise to a small number of customers. Over time, we plan to migrate our on-premise and private data center customers to Azure-hosted environments, increasing our technology cost of revenue. We have experienced and expect to continue to experience operational inefficiencies associated with managing multiple hosting providers, resulting in a headwind against Adjusted Technology Gross Margin. The primary costs incurred to deliver our professional services are the salaries, benefits, and other headcount-related costs of our team members. We delineate our sales organization by new customer acquisition and existing customer retention and expansion. Selling efforts to new customers vary. Many of our new customers engage with us broadly for multiple use cases, requiring buy-in during the sales cycle across the C-suite. Alternatively, in some instances, we engage with a customer in a single-use case. After we demonstrate measurable improvements, we work with our customers to expand the utilization of our Solution to other use cases or enterprise-wide. The average sales cycle for a new customer is approximately 11 months and generally ranges from 4 to 17 months. Because of our vertical focus on the healthcare industry, we believe our sales and marketing resources can be deployed more efficiently than at horizontally-focused companies that provide technology and services to multiple industries. Over the past few years, we have invested heavily in growth infrastructure by adding to our sales operations and marketing teams, which are built to help us scale over the long term. We have demonstrated a consistent track record of innovation through research and development over time as evidenced by our new product features and new product offerings. This innovation is driven by feedback we glean from our customers, professional services teams, and the market generally. Our investments in product development have been focused on increasing the capabilities of our Solution and expanding the number of use cases we address for our customers. Key Business Metrics We regularly review a number of metrics, including the following key financial metrics, to manage our business and evaluate our operating performance compared to that of other companies in our industry: We monitor the key metrics set forth in the preceding table to help us evaluate trends, establish budgets, measure the effectiveness and efficiency of our operations, and determine employee incentives. We discuss Adjusted Gross Profit, Adjusted Gross Margin, and Adjusted EBITDA in more detail below. Adjusted Gross Profit and Adjusted Gross Margin Adjusted Gross Profit is a non-GAAP financial measure that we define as revenue less cost of revenue, excluding depreciation and amortization and excluding stock-based compensation, tender offer payments deemed compensation, and post-acquisition restructuring costs. We define Adjusted Gross Margin as our Adjusted Gross Profit divided by our revenue. We believe Adjusted Gross Profit and Adjusted Gross Margin are useful to investors as they eliminate the impact of certain non-cash expenses and allow a direct comparison of these measures between periods without the impact of non-cash expenses and certain other non-recurring operating expenses. We believe these non-GAAP measures are useful in evaluating our operating performance compared to that of other companies in our industry, as these metrics generally eliminate the effects of certain items that may vary from company to company for reasons unrelated to overall profitability. See above for information regarding the limitations of using our Adjusted Gross Profit and Adjusted Gross Margin as financial measures and for a reconciliation of revenue to our Adjusted Gross Profit, the most directly comparable financial measure calculated in accordance with GAAP. Adjusted EBITDA Adjusted EBITDA is a non-GAAP financial measure that we define as net loss adjusted for interest and other expense, net, loss on debt extinguishment, income tax provision (benefit), depreciation and amortization, stock-based compensation, tender offer payments deemed compensation, and post-acquisition restructuring costs. We believe Adjusted EBITDA provides investors with useful information on period-to-period performance as evaluated by management and comparison with our past financial performance. We believe Adjusted EBITDA is useful in evaluating our operating performance compared to that of other companies in our industry, as this metric generally eliminates the effects of certain items that may vary from company to company for reasons unrelated to overall operating performance. See “Selected Consolidated Financial and Other Data - Reconciliation of Non-GAAP Financial Measures” for information regarding the limitations of using our Adjusted EBITDA as a financial measure and for a reconciliation of our net loss to Adjusted EBITDA, the most directly comparable financial measure calculated in accordance with GAAP. Other Key Metrics We also regularly monitor and review the number of DOS Subscription Customers and Dollar-based Retention Rate as shown in the following tables: DOS Subscription Customers Since 2016, our primary contracting model is a subscription-based contract to our DOS platform, analytics applications, and professional services. Given how fundamental DOS is to our Solution and because the vast majority of our total revenue is derived from DOS Subscription Customers, we believe our DOS Subscription Customer count, which represents customers with active subscriptions at period end, is the best representation of our market penetration and the growth of our business. Dollar-based Retention Rate We calculate our Dollar-based Retention Rate as of a period end by starting with the sum of the Annual Recurring Revenue (ARR) from customers as of the date 12 months prior to such period end (prior period ARR). We then calculate the sum of the ARR from these same customers as of the current period end (current period ARR). Current period ARR includes any upsells and also reflects contraction or attrition over the trailing twelve months but excludes revenue from new customers added in the current period. We then divide the current period ARR by the prior period ARR to arrive at our Dollar-based Retention Rate. We calculate ARR for each customer as the expected monthly recurring revenue of our customers as of the last day of a period multiplied by 12. Because we acquired Medicity in 2018, and because our primary business model is to contract for our DOS platform, analytics applications, and professional services, Medicity customers are not included in the Dollar-based Retention Rate metrics. Key Factors Affecting Our Performance We believe that our future growth, success, and performance are dependent on many factors, including those set forth below. While these factors present significant opportunities for us, they also represent the challenges that we must successfully address in order to grow our business and improve our results of operations. • Add new customers. We believe that our ability to increase our customer base will enable us to drive growth. Our potential customer base is generally in the early stages of data and analytics adoption and maturity. We expect to further penetrate the market over time as potential customers invest in commercial data and analytics solutions. As one of the first data platform and analytics vendors focused specifically on healthcare organizations, we have an early-mover advantage and strong brand awareness. Our customers are large, complex organizations who typically have long procurement cycles which may lead to declines in the pace of our new customer additions. • Leverage recent product and services offerings to drive expansion. We believe that our ability to expand within our customer base will enable us to drive growth. Over the last few years, we have developed and deployed several new analytics applications including CORUS, Touchstone, Patient Safety Monitor, Population Builder, and others. Because we are in the early stages of certain of our applications’ lifecycles and maturity, we do not have enough information to know the impact on revenue growth by upselling these applications and associated services to current and new customers. • Impact of Medicity acquisition on growth. Our customer base includes over 50 health systems and regional healthcare information exchanges added in the Medicity acquisition, representing an opportunity for us to cross-sell our Solution to Medicity customers. We are in the early phases of that cross-selling initiative and do not have full visibility into the incremental growth opportunities from that effort. Historically, Medicity customers have generated a lower Dollar-based Retention Rate than DOS Subscription Customers and we expect flat to declining revenue from Medicity customers in the foreseeable future. If our cross-sell efforts and technology integration strategies are successful, this could offset revenue declines from Medicity customers. Overall, the impact of the Medicity acquisition could negatively impact our revenue growth rates over time. • Changing revenue mix. Our technology and professional services offerings have materially different gross margin profiles. While our professional services help our customers achieve measurable improvements and make them stickier, they have lower gross margins than technology revenue. In 2019, our technology revenue and professional services revenue represented 54% and 46% of total revenue, respectively. Changes in our revenue mix between the two offerings would impact future Total Adjusted Gross Margin. Furthermore, changes within the types of professional services we offer over time can have a material impact on our Adjusted Professional Services Gross Margin, impacting our future Total Adjusted Gross Margin. See “Selected Consolidated Financial and Other Data-Reconciliation of Non-GAAP Financial Measures” for more information. • Transitions to Microsoft Azure as DOS hosting provider. We incur hosting fees related to providing DOS through a cloud-based environment hosted by Microsoft Azure. We also operate a private data center where we host DOS for certain customers and we maintain a small number of customers that have deployed DOS on-premise. We are in the process of transitioning customers we host in our private data center and who deployed DOS on-premise to Azure-hosted environments. The Azure cloud provides customers with more advanced DOS product functionality and a more seamless customer experience; however, hosting customers in Azure is more costly than our private data center and on-premise deployments on a per-customer basis. This transition will result in higher cost of technology revenue and provide a headwind against increases in Adjusted Technology Gross Margin. • Refinement of pricing for our Solution. In the past, we have adjusted our prices as a result of offering new applications and services and customer demand. In the fourth quarter of 2018, we began to introduce new pricing for our Solution for new customers to account for the addition of new analytics applications and associated services. We expect to realize fully the effect of this pricing adjustment in future years as new customers renew their technology and services subscription contracts. Because these price adjustments were primarily related to new applications and services added to our Solution, our prior experience pricing these offerings is limited. As we gain more experience marketing and delivering these new analytics applications and associated services, we may need to further refine our pricing, which could result in either increases or decreases to the price of our Solution. During the years ended December 31, 2019 and 2018, there were no material revenue increases from the pricing adjustments made in 2018 as the increase in technology revenue from current customers is primarily attributable to contractual, annual escalators as opposed to pricing changes. Medicity Acquisition In June 2018, we acquired 100% of the LLC interests in Medicity from Aetna, Inc. (Aetna). The acquisition of Medicity was one element of an integrated transaction whereby we also issued 707,613 shares of our Series E redeemable convertible preferred stock to Aetna in exchange for $15.0 million in cash. The acquisition was accounted for as a business combination as specified under ASC 805, Business Combinations. As part of the post-acquisition activities, we agreed to pay $2.6 million in cash as involuntary termination payments to certain Medicity team members. The termination expense was recognized as compensation expense when management committed to the plan and the severance terms were communicated to the team members. Medicity’s customer base is comprised of large health systems and regional healthcare information exchanges. We have invested in sales and marketing resources tasked with cross-selling our Solution to the Medicity customer base. We are in the early phases of that cross-selling initiative and do not have full visibility into additional revenue growth opportunities from that customer base. Medicity’s technology platform also included significant technical functionality related to real-time interoperability with transactional software systems like EHRs. We plan to integrate portions of Medicity’s technology into the DOS platform and are currently in the process of that technical integration. In addition, Medicity’s technology platform houses data that can be added to DOS to leverage in the future. Components of Our Results of Operations Revenue We derive our revenue from sales of technology and professional services. For the years ended December 31, 2019, 2018, and 2017, technology revenue represented 54%, 51%, and 43% of total revenue, respectively, and professional services revenue represented 46%, 49%, and 57% of total revenue, respectively. Technology revenue. Technology revenue primarily consists of subscription fees charged to customers for access to use our data platform and analytics applications. We provide customers access to our technology through either an all-access or limited-access, modular subscription. Most of our subscription contracts are cloud-based and have up to a three-year term, of which the vast majority are terminable after one year upon 90 days' notice. A majority of our DOS Subscription Customers access our technology through all-access subscriptions, which in the vast majority of cases have built-in annual escalators for technology access fees. Also included in technology revenue is the maintenance and support we provide, which generally includes updates and support services. Professional services revenue. Professional services revenue primarily includes analytics services, domain expertise services, outsourcing services, and implementation services. Professional services arrangements typically include a fee for making full-time equivalent (FTE) services available to our customers on a monthly basis. FTE services generally consist of a blend of analytic engineers, analysts, and data scientists based on the domain expertise needed to best serve our customers. Deferred revenue Deferred revenue consists of customer billings in advance of revenue being recognized from our technology and professional services arrangements. We primarily invoice our customers for technology arrangements annually or quarterly in advance. Amounts anticipated to be recognized within one year of the balance sheet date are recorded as deferred revenue and the remaining portion is recorded as deferred revenue, net of current portion on the consolidated balance sheets. Cost of revenue, excluding depreciation and amortization Cost of technology revenue. Cost of technology revenue primarily consists of costs associated with hosting and supporting our technology, including third-party cloud computing and hosting costs, contractor costs, and salary and related personnel costs for our cloud services and support teams. Although we expect cost of technology revenue to increase in absolute dollars as we transition customers to third-party hosted data centers with Microsoft Azure and increase headcount to accommodate growth, we anticipate cost of technology revenue as a percentage of technology revenue will generally decrease over the long term. We expect cost of technology revenue as a percentage of technology revenue to fluctuate and potentially increase in the near term, primarily due to additional costs associated with transitioning customers from on-premise and our managed data centers to Microsoft Azure. Cost of professional services revenue. Cost of professional services revenue consists primarily of costs related to delivering our team’s expertise in analytics, strategic advisory, improvement, and implementation services. These costs primarily include salary and related personnel costs, travel-related costs, and outside contractor costs. We expect cost of professional services revenue to increase in absolute dollars as we increase headcount to accommodate growth. Operating expense Sales and marketing. Sales and marketing expenses primarily include salary and related personnel costs for our sales, marketing, and account management teams, lead generation, marketing events, including our Healthcare Analytics Summit (HAS), marketing programs, and outside contractor costs associated with the sale and marketing of our offerings. We plan to continue to invest in sales and marketing to grow our customer base, expand in new markets, and increase our brand awareness. The trend and timing of sales and marketing expenses will depend in part on the timing of our expansion into new markets and marketing campaigns. We expect that sales and marketing expenses will increase in absolute dollars in future periods, but decrease as a percentage of our revenue over the long term. Our sales and marketing expenses may fluctuate as a percentage of our revenue from period to period due to the timing and extent of these expenses. Research and development. Research and development expenses primarily include salary and related personnel costs for our data platform and analytics applications teams, subscriptions, and outside contractor costs associated with the development of products. We have developed an open, flexible, and scalable data platform. We plan to continue to invest in research and development to develop new solutions and enhance our applications library. We expect that research and development expenses will increase in absolute dollars in future periods, but decrease as a percentage of our revenue over the long term. Our research and development expenses may fluctuate as a percentage of our revenue from period to period due to the timing and extent of these expenses. General and administrative. General and administrative expenses primarily include salary and related personnel costs for our legal, finance, people operations, IT, and other administrative teams, including certain executives. General and administrative expenses also include facilities, subscriptions, corporate insurance, outside legal, accounting, and directors' fees. Due to the closing of our IPO on July 29, 2019, we incurred and expect to continue to incur additional costs as a result of operating as a public company, including costs related to compliance and reporting obligations of public companies, and increased costs for insurance, investor relations, and corporate governance. As a result, we expect our general and administrative expenses to increase in absolute dollars for the foreseeable future, but decrease as a percentage of our revenue over the long term. Our general and administrative expenses may fluctuate as a percentage of our revenue from period to period due to the timing and extent of these expenses. Depreciation and amortization. Depreciation and amortization expenses are primarily attributable to our capital investment and consist of fixed asset depreciation, amortization of intangibles considered to have definite lives, and amortization of capitalized internal-use software costs. Interest and other expense, net Interest and other expense, net primarily consists of interest income from our investment holdings and interest expense. Interest expense is primarily attributable to our revolving line of credit, term loan, and imputed interest on acquisition-related consideration payable. It also includes the amortization of discounts on debt and amortization of deferred financing costs related to our various debt arrangements. Income tax provision (benefit) Income tax provision (benefit) consists of U.S. federal, state, and foreign income taxes. Because of the uncertainty of the realization of the deferred tax assets, we have a full valuation allowance for deferred tax assets, including net operating loss carryforwards (NOLs) and tax credits related primarily to research and development. As of December 31, 2019, we had federal and state NOLs of $269.1 million and $215.2 million, respectively, which will begin to expire for federal and state tax purposes in 2032 and 2024, respectively. Our existing NOLs may be subject to limitations arising from ownership changes and, if we undergo an ownership change, our ability to utilize our NOLs and tax credits could be further limited by Sections 382 and 383 of the Code. Future changes in our stock ownership, many of which are outside of our control, could result in an ownership change under Sections 382 and 383 of the Code. Our NOLs and tax credits may also be limited under similar provisions of state law. Results of Operations The following tables set forth our consolidated results of operations data and such data as a percentage of total revenue for each of the periods indicated: __________________ (1) Includes stock-based compensation expense, as follows: (2)Includes tender offer payments deemed compensation expense, as follows: (3)Includes post-acquisition restructuring costs, as follows: Discussion of the Years Ended December 31, 2019 and 2018 Revenue Total revenue was $154.9 million for the year ended December 31, 2019, compared to $112.6 million for the year ended December 31, 2018, an increase of $42.4 million, or 38%. Technology revenue was $84.0 million, or 54% of total revenue, for the year ended December 31, 2019, compared to $57.2 million, or 51% of total revenue, for the year ended December 31, 2018. The increase in technology revenue was partially due to the year ended December 31, 2018 only including approximately six months of Medicity revenue as a result of the Medicity acquisition closing on June 29, 2018. There was $12.2 million of technology revenue from Medicity during the six months ended June 30, 2019, with no corresponding revenue in the comparative prior-year period. The remaining technology revenue growth was from new DOS Subscription Customers and existing customers paying higher technology access fees from contractual, annual escalators, and new offerings of expanded support services. The revenue growth amounts presented are net of a $1.8 million decrease in one-time technology revenue. Professional services revenue was $71.0 million, or 46% of total revenue, for the year ended December 31, 2019, compared to $55.4 million, or 49% of total revenue, for the year ended December 31, 2018. The professional services revenue growth is primarily due to implementation, analytics, and improvement services being provided to new DOS Subscription Customers and expanded services with existing customers. Cost of revenue, excluding depreciation and amortization Cost of technology revenue, excluding depreciation and amortization, was $27.8 million for the year ended December 31, 2019, compared to $19.4 million for the year ended December 31, 2018, an increase of $8.4 million, or 43%. The increase in cost of technology revenue was primarily due to an increase of $6.4 million in salary and related personnel costs from an increase in cloud services and support headcount, an increase of $4.9 million in cloud computing and hosting costs largely from the expanded use of Microsoft Azure, and an increase of $1.4 million in subscription costs to serve existing and new customers. These increases in cost of technology revenue were partially offset by a $4.1 million decrease in outside contractor fees. Cost of professional services revenue was $47.5 million for the year ended December 31, 2019, compared to $40.4 million for the year ended December 31, 2018, an increase of $7.1 million, or 18%. This increase is primarily due to an increase in salary and related personnel costs from an increase in our professional services headcount. Operating Expenses Sales and marketing Sales and marketing expenses were $47.3 million for the year ended December 31, 2019, compared to $44.1 million for the year ended December 31, 2018, an increase of $3.2 million, or 7%. This increase was primarily due to an increase of $3.7 million in salary and related personnel costs from additional sales, marketing, and account management headcount. There was a $2.3 million increase in stock-based compensation, including a cumulative catch-up of $0.4 million related to two-tier stock options upon the closing of the IPO, and a $1.1 million increase in travel-related costs. These increases were partially offset by $4.0 million of tender offer payments deemed compensation expense during the year ended December 31, 2018 that did not recur in the year ended December 31, 2019. Sales and marketing expense as a percentage of total revenue decreased from 39% in the year ended December 31, 2018 to 31% in the year ended December 31, 2019. Research and development Research and development expenses were $46.3 million for the year ended December 31, 2019, compared to $38.6 million for the year ended December 31, 2018, an increase of $7.7 million, or 20%. The increase was primarily due to an increase of $4.1 million in stock-based compensation, including a cumulative catch-up of $2.1 million related to two-tier stock options upon the closing of the IPO. There was also an increase of $2.6 million in salary and related personnel costs from additional development team headcount largely as a result of the Medicity acquisition and an increase of $1.5 million in third-party hosting costs. These increases were partially offset by $0.9 million of tender offer payments deemed compensation during the year ended December 31, 2018 that did not recur in the year ended December 31, 2019. Research and development expense as a percentage of revenue decreased from 34% in the year ended December 31, 2018 to 30% in the year ended December 31, 2019. General and administrative General and administrative expenses were $31.7 million for the year ended December 31, 2019, compared to $22.7 million for the year ended December 31, 2018, an increase of $9.0 million, or 40%. The increase was primarily due to an increase of $6.7 million in stock-based compensation, including a cumulative catch-up of $3.5 million related to two-tier stock options upon the closing of the IPO and an increase of $2.2 million in salary and related personnel costs from additional general and administrative headcount. Other increases included increased contractor costs of $0.9 million, insurance costs of $0.6 million, and subscription costs of $0.6 million. These increases were partially offset by $3.1 million of tender offer payments deemed compensation expense during the year ended December 31, 2018 that did not recur in the year ended December 31, 2019. General and administrative expense as a percentage of revenue remained consistent at 20% in both of the years ended December 31, 2019 and 2018. Depreciation and amortization Depreciation and amortization expenses were $9.2 million for the year ended December 31, 2019, compared to $7.4 million for the year ended December 31, 2018, an increase of $1.8 million, or 24%. This increase was primarily due to the amortization of capitalized internal-use software costs and additional depreciation and amortization on property, equipment, and intangibles from the Medicity acquisition and current year capital expenditures. Depreciation and amortization expense as a percentage of revenue decreased from 7% in the year ended December 31, 2018 to 6% in the year ended December 31, 2019. Loss on extinguishment of debt __________________ (1) Not meaningful. On February 6, 2019, we entered into the OrbiMed Credit Facility that established a senior term loan facility of up to $80.0 million under certain conditions and we simultaneously borrowed $50.0 million. The use of proceeds from the OrbiMed senior term loan included an immediate repayment of our $20.0 million term loan from SVB that required a prepayment premium of $0.5 million and the write-off of deferred debt issuance costs of $1.2 million, resulting in a $1.7 million loss on extinguishment of debt. Interest and other expense, net Interest and other expense, net increased $1.4 million, or 69%, for the year ended December 31, 2019 compared to the year ended December 31, 2018. This increase is primarily due to an increase in interest expense of $3.7 million from an increase in net borrowings under the OrbiMed Credit Facility, which was partially offset by an increase in interest income of $2.2 million due to the increase in cash equivalents and short-term investments from the IPO proceeds received in July 2019. Income tax provision (benefit) __________________ (1) Not meaningful. Income tax provision (benefit) consists of current and deferred taxes for U.S. federal, state, and foreign income taxes. On December 22, 2017, federal tax legislation was enacted that included lowering the U.S. corporate income tax rate to 21% effective in 2018. We remeasured certain deferred tax assets and liabilities based on the tax rates at which they are expected to reverse in the future, which is generally 21%. As we had a full valuation allowance on deferred tax assets, the allowance was adjusted accordingly based on the remeasured deferred tax asset and liability position. As a result, the federal tax legislation had a limited impact on our income tax provision (benefit). Quarterly Results of Operations The following table sets forth our unaudited quarterly consolidated statements of operations data for each of the eight quarters in the period ended December 31, 2019. The unaudited consolidated statements of operations data set forth below has been prepared on the same basis as our audited consolidated financial statements and, in the opinion of management, reflect all adjustments, consisting only of normal recurring adjustments, that are necessary for the fair presentation of such data. Our historical results are not necessarily indicative of the results that may be expected in the future and the results for any quarter are not necessarily indicative of results to be expected for a full year or any other period. The following quarterly financial data should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K. __________________ (1) Includes stock-based compensation expense, as follows: (2)Includes tender offer payments deemed compensation expense, as follows: (3)Includes post-acquisition restructuring costs, as follows: 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. Quarterly revenue trends Our quarterly technology revenue increased sequentially in all but one of the periods presented due primarily to increases in the number of customers as well as the expansion of technology offerings to existing customers. Contracting activity can vary quarterly as a result of large healthcare provider buying patterns, though this seasonality is sometimes not apparent in our technology revenue because we generally recognize technology revenue over the term of the contract. The significant increase in quarterly technology revenue beginning in the third quarter of 2018 was primarily attributable to the acquisition of Medicity as of June 29, 2018. Our quarterly professional services revenue generally increased over the periods presented due to increases in the number of customers as well as the expansion of professional services arrangements with existing customers. The increase in the fourth quarter of 2018 was primarily due to performance-based revenue arrangements whereby performance was measured and achieved. In 2019, performance-based revenue arrangements represented a smaller portion of our overall revenue base. The increase in the fourth quarter of 2019 was primarily due to increased professional services revenue from Medicity, which is now referred to as Health Catalyst Interoperability or HCI. Quarterly cost of revenue, excluding depreciation and amortization trends Our quarterly cost of revenue, excluding depreciation and amortization, has generally increased over the quarterly periods due to increased cloud computing and hosting costs and an increase in technology and professional services headcount to serve existing and new customers. The significant increase in quarterly technology cost of revenue, excluding depreciation and amortization, beginning in the third quarter of 2018 was primarily attributable to the Medicity acquisition. Quarterly operating expenses trends Total operating expenses fluctuate from quarter to quarter, but have generally increased for the periods presented, primarily due to the addition of personnel in connection with the expansion of our business. The significant increase in the second quarter of 2018 is primarily attributable to deemed compensation expense associated with a tender offer for the repurchase of common stock at a price in excess of its estimated fair value. The additional increase in total operating expenses beginning in the third quarter of 2018 is primarily attributable to the Medicity acquisition. Total operating expenses increased significantly again in the third quarter of 2019, partially due to a cumulative catch-up of $6.0 million related to two-tier stock-based awards upon the closing of the IPO. Sales and marketing expenses generally grew sequentially over the periods, due to the continued expansion of our sales, marketing, and account management teams. Sales and marketing expenses are higher in the third quarter due to our Healthcare Analytics Summit which is typically held in September. Research and development expenses have generally increased sequentially for the periods presented, due to continued investment in developing our Solution. Sales and marketing expenses and research and development expenses decreased slightly during the fourth quarter of 2018 and the first quarter of 2019 compared to the third quarter of 2018 primarily as a result of HCI operational synergies achieved after closing the acquisition. General and administrative expenses generally increased over the periods presented due primarily to the expansion of the legal, finance, and IT teams and due to increased costs for accounting, legal, and outside contractors. Our quarterly results of operations may fluctuate due to various factors affecting our performance. As noted above, we generally recognize revenue from technology ratably over the term of the contract. Therefore, changes in our contracting activity in the near term may not be apparent as a change to our reported revenues 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 contracting activity. Liquidity and Capital Resources As of December 31, 2019, we had cash, cash equivalents, and short-term investments of $228.3 million, which were held primarily for working capital purposes. Our cash equivalents and short-term investments are comprised primarily of money market funds, U.S. treasury notes, commercial paper, corporate bonds, and asset-backed securities. Since inception, we have financed our operations primarily from the proceeds we received through private sales of equity securities, payments received from customers under technology and professional services arrangements, borrowings under our loan and security agreements, and our recent IPO. Our future capital requirements will depend on many factors, including our pace of new customer growth and expanded customer relationships, technology and professional services renewal activity, and the timing and extent of spend to support the expansion of sales, marketing, and development activities. 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, results of operations, and financial condition would be adversely affected. SVB Debt Agreements and OrbiMed Financings In October 2017, we entered into the Amended Loan and Security Agreement and the Mezzanine Loan and Security Agreement (the SVB Debt Agreements) with SVB. The SVB Debt Agreements originally established a revolving line of credit and a term loan facility of up to $20.0 million under certain conditions and $20.0 million, respectively. SVB Revolving Line of Credit As of January 1, 2019, the Amended Loan and Security Agreement allowed us to borrow up to $20.0 million in advances on the revolving line of credit with a contractual interest rate of prime plus 0.5% and a maturity date of December 2019. On February 6, 2019, the Amended Loan and Security Agreement was further amended to reduce the revolving line of credit from up to $20.0 million to $5.0 million with an obligation to maintain a minimum of $5.0 million cash or cash equivalents on deposit with SVB to maintain the assurance of future credit availability, as well as extend the maturity date to February 6, 2021. The line may be increased by $5.0 million upon request and approval by SVB. The revolving line of credit is subject to certain covenants and, as of both December 31, 2019 and 2018, we were in compliance with these covenants. As of December 31, 2019, the interest rate was 5.25% and we had not drawn any amounts under this revolving line of credit. SVB Term Loan As of December 31, 2018, the SVB Debt Agreements allowed us to borrow up to $20.0 million in term loans with a contractual interest rate of prime plus 6.25%. We were contractually allowed to prepay all outstanding principal and accrued interest at any time together with a prepayment penalty of $0.5 million. As of December 31, 2019, we had repaid the full $20.0 million previously borrowed under this term loan. OrbiMed Financings On February 6, 2019, we entered into the OrbiMed Credit Facility that established a senior term loan facility of up to $80.0 million under certain conditions with a maturity date of February 6, 2024. The contractual interest rate is the higher of LIBOR plus 7.5% and 10.0%. On February 6, 2019, we borrowed $50.0 million under the OrbiMed Debt Agreement with principal payments due beginning in 2023, and we simultaneously repaid our term loan and revolver from SVB in full. The OrbiMed Credit Facility was subject to certain covenants and, as of December 31, 2019, we were in compliance with these covenants. As of December 31, 2019, the interest rate was 10.0% and we owed $50.0 million under the OrbiMed Credit Facility. In addition, on February 6, 2019, we sold 437,787 shares of our Series F redeemable convertible preferred stock for a purchase price of $12.2 million. The effect of the OrbiMed debt proceeds, the Series F stock issuance, and the repayment of the SVB term loan resulted in a net increase in cash, cash equivalents, and short-term investments of $38.7 million, net of fees and debt prepayment premiums. Initial Public Offering On July 29, 2019, we closed our IPO in which we issued and sold 8,050,000 shares (inclusive of the underwriters’ over-allotment option to purchase 1,050,000 shares, which was exercised on July 25, 2019) of common stock at $26.00 per share. We received net proceeds of $194.6 million after deducting underwriting discounts and commissions and before deducting offering costs of $4.6 million. We believe our existing cash, cash equivalents, and marketable securities and amounts available under our credit facilities will be sufficient to meet our working capital and capital expenditure needs over at least the next 12 months, though we may require additional capital resources in the future. Cash Flows The following table summarizes our cash flows for the years ended December 31, 2019, 2018, and 2017: Operating Activities Our largest source of operating cash flows is cash collections from our customers for technology and professional services arrangements. Our primary uses of cash from operating activities are for employee-related expenses, marketing expenses, and technology costs. For the year ended December 31, 2019, net cash used in operating activities was $32.2 million, which included a net loss of $60.1 million. Non-cash charges primarily consisted of $9.2 million in depreciation and amortization of property, equipment, and intangible assets, $17.8 million in stock-based compensation, $1.7 million of loss from the extinguishment of debt, and $1.1 million in amortization of debt discount and issuance costs. For the year ended December 31, 2018, net cash used in operating activities was $40.3 million, which included a net loss of $62.0 million. Non-cash charges primarily consisted of $4.2 million in stock-based compensation and $7.4 million in depreciation and amortization of property, equipment, and intangible assets. The 2018 net loss also included an $8.3 million charge that was paid in association with the repurchase of common stock at a price in excess of its estimated fair value as part of the 2018 tender offer that is further described in Note 12 to the audited consolidated financial statements. The tender offer cash payments are not expected to be recurring in future periods. For the year ended December 31, 2017, net cash used in operating activities was $36.8 million, which included a net loss of $47.0 million. Non-cash charges primarily consisted of $4.2 million in stock-based compensation and $5.9 million in depreciation and amortization of property, equipment, and intangible assets. Investing Activities Net cash used in investing activities for the year ended December 31, 2019 of $209.6 million was primarily due to $256.0 million in purchases of short-term investments and $4.3 million in purchases of property, equipment, and intangible assets, reduced by the $50.7 million sale and maturity of short-term investments. Net cash provided by investing activities for the year ended December 31, 2018 of $21.4 million was primarily due to $37.9 million provided from the sale and maturity of short-term investments, reduced by $14.0 million used to purchase short-term investments and $2.5 million in purchases of property, equipment, and intangible assets. Net cash provided by investing activities for the year ended December 31, 2017 of $22.4 million primarily was due to $72.1 million provided from the sale and maturity of short-term investments, reduced by $46.4 million used to purchase short-term investments and $3.3 million in purchases of property, equipment, and intangible assets. Financing Activities Net cash provided by financing activities for the year ended December 31, 2019 of $231.4 million was primarily the result of $194.6 million in IPO proceeds, net of underwriters’ discounts and commissions, $47.2 million in net proceeds drawn under the OrbiMed Credit Facility, $12.1 million in net proceeds from the sale and issuance of Series F redeemable convertible preferred stock, $2.7 million in stock option exercise proceeds, and $3.0 million in proceeds from our ESPP, reduced by the $21.8 million payoff of the SVB debt, $4.6 million in payments of deferred offering costs, and $1.7 million in payments of acquisition-related obligations. Net cash provided by financing activities for the year ended December 31, 2018 of $24.3 million was primarily the result of $34.0 million in proceeds from the issuance of Series E redeemable convertible preferred stock, $10.0 million in proceeds drawn under the SVB Debt Agreements and $3.0 million in stock option exercise proceeds, reduced by an $8.7 million repurchase of our common stock, and $13.9 million in payments of acquisition-related obligations. Net cash provided by financing activities for the year ended December 31, 2017 of $24.9 million was primarily the result of $23.8 million in proceeds from the issuance of Series E redeemable convertible preferred stock and $9.8 million in proceeds drawn under the SVB Debt Agreements, reduced by $8.8 million in payments of acquisition-related obligations. Contractual Obligations and Commitments The following table presents a summary of our payments due under contractual arrangements as of December 31, 2019: __________________ (1) On February 6, 2019, we borrowed $50.0 million under the OrbiMed Debt Agreement, and simultaneously repaid our $20.0 million term loan from SVB in full. We also repaid in full our $1.3 million SVB revolving line of credit. The contractual commitment amounts above include interest payments of $18.5 million and a 5% exit fee. (2) We lease our facilities under long-term operating leases, which expire at various dates through 2024. The contractual commitment amounts in the table above are associated with agreements that are enforceable and legally binding and that specify all significant terms, including fixed or minimum services to be used, fixed, minimum or variable price provisions and the approximate timing of the transaction. In the ordinary course of business, we enter into agreements of varying scope and terms pursuant to which we agree to indemnify customers or business partners and other parties with respect to certain matters, including, but not limited to, losses arising out of the breach of such agreements, services to be provided by us or from data breaches, or intellectual property infringement claims made by third parties. No demands have been made upon us to provide indemnification under such agreements and there are no claims that we are aware of that could have a material effect on our consolidated financial statements. Off-Balance Sheet Arrangements As of December 31, 2019, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities that would 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 these consolidated financial statements requires management to make estimates, assumptions, and judgments 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 revenue and expenses during the applicable periods. We base our estimates, assumptions, and judgments on our knowledge and experience about past and current events and on various other factors that we believe to be reasonable under the circumstances. Different assumptions and judgments would change the estimates used in the preparation of our consolidated financial statements, which, in turn, could change the results from those reported. We evaluate our estimates, assumptions, and judgments on an ongoing basis. The critical accounting estimates, assumptions, and judgments that we believe have the most significant impact on our consolidated financial statements are described below. Revenue Recognition We derive our revenues primarily from technology subscriptions and professional services. We determine revenue recognition by applying the following steps: • Identification of the contract, or contracts, with a customer; • Identification of the performance obligations in the contract; • Determination of the transaction price; • Allocation of the transaction price to the performance obligations in the contract; and • Recognition of revenue when, or as, we satisfy the performance obligation. We recognize revenue net of any taxes collected from customers and subsequently remitted to governmental authorities. Technology Revenue Technology revenue primarily consists of subscription fees charged to customers for access to use our technology. We provide customers access to our technology through either an all-access or limited-access, modular subscription. The majority of our subscription arrangements are cloud-based and do not provide customers the right to take possession of the technology or contain a significant penalty if the customer were to take possession of the technology. Revenue from cloud-based subscriptions is recognized ratably over the contract term beginning on the date that the service is made available to the customer. Most of our subscription contracts have up to a three-year term, of which the vast majority are terminable after one year upon 90 days notice. Subscriptions that allow the customer to take software on-premise without significant penalty are treated as time-based licenses. These arrangements generally include access to technology, access to unspecified future products and maintenance and support. Revenue for upfront access to the technology library is recognized at a point in time when the technology is made available to the customer. Revenue for access to unspecified future products included in time-based license subscriptions is recognized ratably over the contract term beginning on the date that the access is made available to the customer. We also have certain perpetual license arrangements. Revenue from these arrangements is recognized at a point in time upon delivery of the software. Technology revenue also includes maintenance and support revenue which generally includes bug fixes, updates, and support services. Revenue related to maintenance and support is recognized over the contract term beginning on the date that the service is made available to the customer. Professional Services Revenue Professional services revenue primarily includes data and analytics services, domain expertise services, outsourcing services, and implementation services. Professional services arrangements typically include a fee for making FTE services available to our customers on a monthly basis. FTE services generally consist of a blend of analytic engineers, analysts, and data scientists based on the domain expertise needed to best serve our customers. Professional services are typically considered distinct from the technology offerings and revenue is generally recognized as the service is provided using the “right to invoice” practical expedient. Contracts with Multiple Performance Obligations Many of our contracts include multiple performance obligations. We account for performance obligations separately if they are capable of being distinct and distinct within the context of the contract. In these circumstances, the transaction price is allocated to separate performance obligations on a relative standalone selling price basis. We determine standalone selling prices based on the observable price a good or service is sold for separately when available. In cases where standalone selling prices are not directly observable, based on information available, we utilize the expected cost plus a margin, adjusted market assessment, or residual estimation method. We consider all information available including our overall pricing objectives, market conditions, and other factors, which may include the value of contracts, customer demographics, and the types of users. Standalone selling prices are not directly observable for our all-access and limited-access technology arrangements, which are composed of cloud-based subscriptions, time-based licenses, and perpetual licenses. For these technology arrangements, we use the residual estimation method due to the limited number of standalone transactions and/or prices that are highly variable. Variable Consideration We have also entered into at-risk and shared savings arrangements with certain customers whereby we receive variable consideration based on the achievement of measurable improvements which may include cost savings or performance against metrics. For these arrangements, we estimate revenue using the most likely amount that we will receive. Estimates are based on our historical experience and best judgment at the time to the extent it is probable that a significant reversal of revenue recognized will not occur. Due to the nature of our arrangements, certain estimates may be constrained until the uncertainty is further resolved. Stock-Based Compensation Stock-based awards, including stock options and RSUs, are measured and recognized in the consolidated financial statements based on the fair value of the award on the grant date. For awards subject to performance conditions, we record expense when the performance condition becomes probable. We record forfeitures of stock-based awards as the actual forfeitures occur. We have issued two types of employee stock-based awards, standard and two-tier. Our standard stock-based awards vest solely on a service-based condition. For these awards, we recognize stock-based compensation expense on a straight-line basis over the vesting period. Two-tier employee stock-based awards contain both a service-based condition and performance condition, defined as the earlier of (i) an acquisition or change in control of the company or (ii) upon the occurrence of an initial public offering by the Company. A change in control event and effective registration event are not deemed probable until consummated; accordingly, no expense is recorded related to two-tier stock-based awards until the performance condition becomes probable of occurring. Awards that contain both service-based and performance conditions are recognized using the accelerated attribution method once the performance condition is probable of occurring. The service-based condition is generally a service period of four years. Upon closing our IPO, we recorded cumulative share-based compensation expense of approximately $6.0 million using the accumulated attribution method for two-tier employee stock-based awards for which the service condition had been satisfied at that date. The grant date fair value of RSUs is determined using the market closing price of our common stock on the date of grant. We estimate the fair value of our stock option awards on the grant date using the Black-Scholes option-pricing model. This requires the input of highly subjective assumptions, including the expected term of stock options, the expected volatility of the price of our common stock, risk-free interest rates, and the expected dividend yield of our common stock. The assumptions used in our option-pricing model represent our best estimates. These estimates involve inherent uncertainties and the application of management’s judgment. If factors change and different assumptions are used, our stock-based compensation expense could be materially different in the future. The resulting fair value, net of actual forfeitures, is recognized on a straight-line basis over the period during which an employee is required to provide service in exchange for the award. Stock-based compensation expense related to purchase rights issued under the 2019 Health Catalyst Employee Stock Purchase Plan (ESPP) is based on the Black-Scholes option-pricing model fair value of the estimated number of awards as of the beginning of the offering period. Stock-based compensation expense is recognized using the straight-line method over the offering period. These assumptions used in the Black-Scholes option-pricing model, other than the fair value of our common stock, are estimated as follows: • Expected volatility. Since a public market for our common stock did not exist prior to our IPO and, therefore, we did not have a sufficient trading history of our common stock, we estimated the expected volatility based on the volatility of similar publicly-held entities (guideline companies) over a period equivalent to the expected term of the pre-IPO awards. In evaluating the similarity of guideline companies to us, we considered factors such as industry, stage of life cycle, size, and financial leverage. We intend to primarily use the volatility history of the share price of our common stock as it becomes available. • Expected term. We estimate the expected term using the simplified method, as we do not have sufficient historical exercise activity to develop reasonable expectations about future exercise patterns and post-vesting employment termination behavior. The simplified method calculates the average period the stock options are expected to remain outstanding as the midpoint between the vesting date and the contractual expiration date 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 maturities corresponding with the expected term of the award. • Expected dividend yield. We have never declared or paid any dividends and do not presently plan to pay dividends in the foreseeable future. Consequently, we use an expected dividend yield of zero. Prior to the adoption of ASU No. 2018-07, Compensation - Stock Compensation (ASU 2018-17), which simplifies the accounting for non-employee share-based payment transactions, the fair value measurement date for non-employee awards was the date the performance of services was completed. Upon adoption of ASU 2018-07 on January 1, 2019, the measurement date for non-employee awards is the date of grant. The compensation expense for non-employees is recognized, without changes in the fair value of the award, in the same period and in the same manner as though we had paid cash for the services, which is typically the vesting period of the respective award. 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. JOBS Act Accounting Election We are an emerging growth company, as defined in 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 irrevocably elected not to avail ourselves of this exemption from 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. Recent Accounting Pronouncements See “Description of Business and Summary of Significant Accounting Policies” in Note 1 to our audited consolidated financial statements included within Item 8 in this Annual Report on Form 10-K for more information.

<s>[INST] A discussion regarding our financial condition and results of operations for the year ended December 31, 2019 compared to the year ended December 31, 2018 is presented below. A discussion regarding our financial condition and results of operations for the year ended December 31, 2018 compared to the year ended December 31, 2017 is included under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our prospectus filed pursuant to Rule 424(b) on July 25, 2019. Overview We are a leading provider of data and analytics technology and services to healthcare organizations. Our Solution comprises a cloudbased data platform, analytics software, and professional services expertise. Our customers, which are primarily healthcare providers, use our Solution to manage their data, derive analytical insights to operate their organizations, and produce measurable clinical, financial, and operational improvements. We envision a future where all healthcare decisions are data informed. Health Catalyst was founded in 2008 by healthcare analytics industry pioneers. Our founders and team developed the initial version of our Solution, consisting of an early version of our data platform, select analytics accelerators, and professional services expertise. From the beginning, our Solution has been focused on enabling our mission: to be the catalyst for massive, measurable, datainformed healthcare improvement. We currently employ more than 900 team members. For the years ended December 31, 2019, 2018, and 2017, our total revenue was $154.9 million, $112.6 million, and $73.1 million, respectively. For the years ended December 31, 2019, 2018, and 2017, we incurred net losses of $60.1 million, $62.0 million, and $47.0 million, respectively. For the years ended December 31, 2019, 2018, and 2017, our Adjusted EBITDA was $(27.4) million, $(38.1) million, and $(35.4) million, respectively. See “Selected Consolidated Financial and Other DataReconciliation of NonGAAP Financial Measures” for more information about this financial measure, including the limitations of such measure and a reconciliation to the most directly comparable measure calculated in accordance with GAAP. See “Key Factors Affecting Our Performance” for more information about important opportunities and challenges related to our business. On July 29, 2019, we closed our IPO in which we issued and sold 8,050,000 shares of common stock at a price to the public of $26.00 per share for aggregate net proceeds of $190.0 million after deducting underwriting discounts and commissions and offering expenses payable by us. Our Business Model We offer our Solution to a variety of healthcare organizations, primarily in the United States, including academic medical centers, integrated delivery networks, community hospitals, large physician practices, ACOs, health information exchanges, health insurers, and other riskbearing entities. We categorize our customer count into two primary categories: DOS Subscription Customers and Other Customers. DOS Subscription Customers are defined as customers who access our DOS platform via a technology subscription contract. Other Customers generally include DOS nonsubscription customers and Medicity interoperability customers. As of December 31, 2019, 2018, and 2017, we had 65, 50, and 34 DOS Subscription Customers with active subscriptions, respectively. As of December 31, 2019, 2018, and 2017, we had 65, 76, and 12 active Other Customers, respectively. The significant increase in Other Customers from 2017 to 2018 was primarily due to our acquisition of Medicity on June 29, 2018. We derive substantially all of our revenue through subscriptions for use of our technology and professional services on a recurring basis. In 2019, greater than 9 [/INST] Positive. </s>

Tortoise Acquisition Corp.

2020-03-23

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. 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 (the “initial business combination”). On the Closing Date, we completed our Initial Public Offering of 23,300,917 Units, including 800,917 Units that were issued pursuant to the underwriters’ partial exercise of their over-allotment option. The Units were sold at a price of $10.00 per unit, generating gross proceeds to us of approximately $233.0 million. We incurred offering costs of approximately $13.36 million, inclusive of approximately $8.13 million in deferred underwriting commissions. On March 4, 2019, simultaneously with the consummation of the Initial Public Offering, we completed the private sale of 6,660,183 Private Placement Warrants to Tortoise Borrower at a purchase price of $1.00 per warrant, generating gross proceeds to us of approximately $6.66 million. Approximately $233.0 million of the net proceeds from our Initial Public Offering and the sale of the Private Placement Warrants has been deposited in the Trust Account. Our amended and restated certificate of incorporation provides that, other than the withdrawal of interest to pay franchise and income taxes, none of the funds held in the Trust Account will be released until the earliest of: (i) the completion of the initial business combination; (ii) the redemption of any public shares that have been properly tendered in connection with a stockholder vote to amend our amended and restated certificate of incorporation to affect the substance or timing of our obligation to redeem 100% of such public shares if we have not consummated an initial business combination within 24 months from the closing of our Initial Public Offering; and (iii) the redemption of 100% of the public shares if we are unable to complete an initial business combination within 24 months from the closing of our Initial Public Offering, or March 4, 2021 (the “Combination Period”). The proceeds deposited in the Trust Account could become subject to the claims of our creditors, if any, which could have priority over the claims of our public stockholders. In connection with our Initial Public Offering, we entered into a Forward Purchase Agreement pursuant to which Atlas Point Fund agreed to purchase up to an aggregate maximum amount of $150,000,000 of either (i) a number of Forward Purchase Units for $10.00 per unit or (ii) a number of Forward Purchase Shares for $9.67 per share, in a private placement that will close simultaneously with the closing of our initial business combination. Whether we will issue Atlas Point Fund Forward Purchase Units valued at $10.00 per unit or Forward Purchase Shares valued at $9.67 per share will be determined at our election, and in our sole discretion, at least 10 business days prior to the closing of our initial business combination. The Forward Purchase Agreement is subject to conditions, including Atlas Point Fund giving us its irrevocable written consent to purchase the Forward Purchase Securities no later than five days after we notify Atlas Point Fund of our intention to meet to consider entering into a definitive agreement for a proposed initial business combination. Atlas Point Fund may grant or withhold its consent to the purchase entirely within its sole discretion. Accordingly, if Atlas Point Fund does not consent to the purchase, it will not be obligated to purchase the Forward Purchase Securities. We are currently in the process of locating suitable targets for an initial business combination. We intend to effectuate an initial business combination using cash from the proceeds of our Initial Public Offering, the sale of the Private Placement Warrants, the private placement of Forward Purchase Securities, and from additional issuances, if any, of 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 may enter into non-binding letters of intent, but we are currently not subject to any definitive merger or acquisition (or similar) agreement with respect to any business combination. However, we cannot assure you that we will identify any suitable target candidates or, if identified, that we will 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 to date. Our only activities from inception through the Closing Date related to our formation and our Initial Public Offering. Although we have not generated operating revenue, we have generated non-operating income in the form of investment income from investments held in the Trust Account. We expect to incur increased expenses as a result of being a public company, as well as costs in the pursuit of our acquisition plans. For the period from November 7, 2018 (inception) through December 31, 2018, we had a net loss of approximately $600, which consisted of approximately $600 in general and administrative expenses. For the year ended December 31, 2019, we had net income of approximately $2.3 million, which consisted of approximately $3.9 million in investment income, offset by approximately $465,000 in general and administrative expenses, $100,000 in related-party administrative expenses, $200,000 in franchise tax expense and approximately $768,000 in income tax expense. Going Concern Consideration Until the consummation of our Initial Public Offering, our only source of liquidity was an initial sale of Founder Shares to our Sponsor. Additionally, our Sponsor advanced us funds totaling approximately $580,000 pursuant to an unsecured promissory note (the “Note”) to cover expenses related to our Initial Public Offering and certain operating expenses. On March 29, 2019, we repaid the Note to our Sponsor in full. Subsequent to the Closing Date, our liquidity needs have been satisfied through the net proceeds from the sale of the Private Placement Warrants not held in the Trust Account and an aggregate of $812,000 of interest income released from the Trust Account since inception to fund income tax payments. As of December 31, 2019, we had approximately $916,000 of cash in our operating account and approximately $3.0 million of investment income earned from investments held in the Trust Account that may be released to us to pay our franchise and income taxes (less up to $100,000 of such net interest to pay dissolution expenses). In connection with our assessment of going concern considerations in accordance with Financial Accounting Standards Board (the “FASB”) Accounting Standards Update (“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 March 4, 2021. Related Party Transactions Founder Shares In November 2018, our Sponsor paid $25,000 in offering expenses on our behalf in exchange for the issuance of 5,750,000 Founder Shares. In February 2019, we effected a stock dividend of 718,750 Founder Shares, resulting in our Sponsor holding an aggregate of 6,468,750 Founder Shares (up to 843,750 shares of which were subject to forfeiture to the extent the underwriters did not exercise their over-allotment option). On March 4, 2019, the underwriters partially exercised their over-allotment option and on March 7, 2019, the underwriters waived the remainder of their over-allotment option. In connection therewith, our Sponsor forfeited 643,520 Founder Shares for cancellation by us. The Founder Shares are identical to the shares of Class A common stock included in the Units sold in our Initial Public Offering except that the Founder Shares are shares of Class B common stock which automatically convert into shares of Class A common stock at the time of the initial business combination and are subject to certain transfer restrictions, as described in more detail below. The holders of the Founder Shares have agreed, subject to limited exceptions, not to transfer, assign or sell any of their Founder Shares until the earlier to occur of: (i) one year after the completion of the initial business combination and (ii) subsequent to the initial business combination, (a) if the last reported sale price of our Class A 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 consummation of the initial business combination, and (b) the date on which we complete a liquidation, merger, 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 Simultaneously with the consummation of our Initial Public Offering, we completed the sale of the Private Placement Warrants to Tortoise Borrower, generating gross proceeds of approximately $6.66 million. Each Private Placement Warrant is exercisable for one share of the Company’s Class A common stock at an exercise price of $11.50 per share. A portion of the purchase price of the Private Placement Warrants was added to the proceeds from our Initial Public Offering held in the Trust Account. If the initial business combination is not completed within the Combination Period, the proceeds from the sale of the Private Placement Warrants held in the Trust Account will be used to fund the redemption of the public shares (subject to the requirements of applicable law) and the Private Placement Warrants will expire worthless. The Private Placement Warrants will be non-redeemable for cash and exercisable on a cashless basis so long as they are held by Tortoise Borrower or its permitted transferees. Tortoise Borrower agreed, subject to limited exceptions, not to transfer, assign or sell any of its Private Placement Warrants until 30 days after the completion of the initial business combination. Note Payable to Our Sponsor On November 7, 2018, our Sponsor agreed to advance us funds to cover expenses related to our Initial Public Offering pursuant to the Note. This Note was non-interest bearing and payable on the earlier of 180 days and the closing of our Initial Public Offering. The Company borrowed approximately $580,000 under the Note, and repaid the Note in full on March 29, 2019. Administrative Services Agreement Pursuant to an administrative services agreement between us and our Sponsor dated February 27, 2019, we agreed to pay our Sponsor a total of $10,000 per month for office space, utilities, secretarial support and administrative services. Upon completion of the initial business combination or our liquidation, the agreement will terminate. We incurred $100,000 for expenses in connection with the administrative services agreement for the year ended December 31, 2019, which is reflected in the accompanying statement of operations. On March 29, 2019, our Sponsor assigned all of its rights, interests and obligations under the administrative services agreement to Tortoise Capital Advisors, L.L.C. Critical Accounting Policies and Estimates Investments Held in Trust Account Our portfolio of investments held in the Trust Account are comprised solely of an investment in a money market fund that comprises only U.S. treasury securities 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 the Trust Account in our statement of operations. The fair value for trading securities is determined using quoted market prices in active markets. Class A Common Stock Subject to Possible Redemption We account for the Class A common stock subject to possible redemption in accordance with FASB ASC 480, “Distinguishing Liabilities from Equity.” Shares of Class A common stock subject to mandatory redemption (if any) are classified as a liability and measured at fair value. Shares of conditionally redeemable Class A common stock (including shares of 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, shares of Class A common stock are classified as stockholders’ equity. Our Class A common stock features certain redemption rights that are considered to be outside of our control and subject to the occurrence of uncertain future events. We recognize 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 value amount of redeemable shares of Class A common stock are affected by charges against additional paid-in capital. Accordingly, as of December 31, 2019, 22,366,276 shares of Class A common stock subject to conditional redemption are presented as temporary equity, outside of the stockholders’ equity section of our balance sheet. Recent Accounting Pronouncements In December 2019, the FASB issued ASU No. 2019-12, “Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes” (“ASU 2019-12”), which is intended to simplify various aspects related to accounting for income taxes. ASU 2019-12 removes certain exceptions to the general principles in Topic 740 and also clarifies and amends existing guidance to improve consistent application. This guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020, with early adoption permitted. The Company is currently evaluating the impact of this standard on its financial statements and related disclosures. We do not believe that any other 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. Contractual Obligations As of December 31, 2019, we did not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities. On February 27, 2019, we entered into an administrative services agreement with our Sponsor, pursuant to which we have agreed to pay our Sponsor a total of $10,000 per month for office space, utilities, secretarial support and administrative services. Upon completion of the initial business combination or our liquidation, the agreement will terminate. On March 29, 2019, our Sponsor assigned all of its rights, interests and obligations under the administrative services agreement to Tortoise Capital Advisors, L.L.C. The underwriters of our Initial Public Offering were entitled to underwriting discounts and commissions of 5.5%, of which 2.0% (approximately $4.64 million) was paid at the closing of our Initial Public Offering and 3.5% (approximately $8.13 million) was deferred. The deferred underwriting discounts and commissions will become payable to the underwriters upon the consummation of the initial business combination and will be paid from the amounts held in the Trust Account. The underwriters are not entitled to any interest accrued on the deferred underwriting discounts and commissions. JOBS Act 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 of the Sarbanes-Oxley Act, (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 our 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] 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 (the “initial business combination”). On the Closing Date, we completed our Initial Public Offering of 23,300,917 Units, including 800,917 Units that were issued pursuant to the underwriters’ partial exercise of their overallotment option. The Units were sold at a price of $10.00 per unit, generating gross proceeds to us of approximately $233.0 million. We incurred offering costs of approximately $13.36 million, inclusive of approximately $8.13 million in deferred underwriting commissions. On March 4, 2019, simultaneously with the consummation of the Initial Public Offering, we completed the private sale of 6,660,183 Private Placement Warrants to Tortoise Borrower at a purchase price of $1.00 per warrant, generating gross proceeds to us of approximately $6.66 million. Approximately $233.0 million of the net proceeds from our Initial Public Offering and the sale of the Private Placement Warrants has been deposited in the Trust Account. Our amended and restated certificate of incorporation provides that, other than the withdrawal of interest to pay franchise and income taxes, none of the funds held in the Trust Account will be released until the earliest of: (i) the completion of the initial business combination; (ii) the redemption of any public shares that have been properly tendered in connection with a stockholder vote to amend our amended and restated certificate of incorporation to affect the substance or timing of our obligation to redeem 100% of such public shares if we have not consummated an initial business combination within 24 months from the closing of our Initial Public Offering; and (iii) the redemption of 100% of the public shares if we are unable to complete an initial business combination within 24 months from the closing of our Initial Public Offering, or March 4, 2021 (the “Combination Period”). The proceeds deposited in the Trust Account could become subject to the claims of our creditors, if any, which could have priority over the claims of our public stockholders. In connection with our Initial Public Offering, we entered into a Forward Purchase Agreement pursuant to which Atlas Point Fund agreed to purchase up to an aggregate maximum amount of $150,000,000 of either (i) a number of Forward Purchase Units for $10.00 per unit or (ii) a number of Forward Purchase Shares for $9.67 per share, in a private placement that will close simultaneously with the closing of our initial business combination. Whether we will issue Atlas Point Fund Forward Purchase Units valued at $10.00 per unit or Forward Purchase Shares valued at $9.67 per share will be determined at our election, and in our sole discretion, at least 10 business days prior to the closing of our initial business combination. The Forward Purchase Agreement is subject to conditions, including Atlas Point Fund giving us its irrevocable written consent to purchase the Forward Purchase Securities no later than five days after we notify Atlas Point Fund of our intention to meet to consider entering into a definitive agreement for a proposed initial business combination. Atlas Point Fund may grant or withhold its consent to the purchase entirely within its sole discretion. Accordingly, if Atlas Point Fund does not consent to the purchase, it will not be obligated to purchase the Forward Purchase Securities. We are currently in the process of locating suitable targets for an initial business combination. We intend to effectuate an initial business combination using cash from the proceeds of our Initial Public Offering, the sale of the Private Placement Warrants, the private placement of Forward Purchase Securities, and from additional issuances, if any, of 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 may enter [/INST] Negative. </s>

Tenzing Acquisition Corp.

2019-05-22

2019-02-28

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 March 20, 2018 in the British Virgin Islands with limited liability (meaning our shareholders have no liability, as members of the Company, for the liabilities of the Company over and above the amount already paid for their shares) formed for the purpose of acquiring, engaging in a share exchange, share reconstruction and amalgamation with, purchasing all or substantially all of the assets of, or engaging in any other similar Business Combination with one or more businesses or entities. We intend to effectuate our Business Combination using cash from the proceeds of our Initial Public Offering and the sale of the Private Units that occurred simultaneously with the completion of our Initial Public Offering, our shares, debt or a combination of cash, shares and debt. The issuance of additional shares in a Business Combination: · may significantly dilute the equity interest of investors who would not have pre-emption rights in respect of any such issue; · may subordinate the rights of holders of ordinary shares if the rights, preferences, designations and limitations attaching to the preferred shares are created by amendment of our memorandum and articles of association by resolution of the board of directors and preferred shares are issued with rights senior to those afforded our ordinary shares; · could cause a change in control if a substantial number of ordinary shares 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 share ownership or voting rights of a person seeking to obtain control of us; and · may adversely affect prevailing market prices for our ordinary shares. 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 our 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 any document governing such debt contains covenants restricting our ability to obtain such financing while the debt security is outstanding; · our inability to pay dividends on our ordinary shares; · 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 ordinary shares 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. We cannot assure you that our plans to complete a Business Combination will be successful. We are not prohibited from pursuing an initial Business Combination with a company that is affiliated with our Sponsor, officers or directors (such affiliates including New Silk Route Partners Ltd). In the event we seek to complete our initial business combination with a company that is affiliated with our Sponsor, officers or directors, we, or a committee of independent directors, will obtain an opinion from an independent investment banking firm which is a member of the Financial Industry Regulatory Authority or a qualified independent accounting firm that our initial Business Combination is fair to our company from a financial point of view. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities from inception through February 28, 2019 were organizational activities, those necessary to prepare for and consummate the Initial Public Offering as described below, and seeking to identify a target company for a Business Combination. Following the Initial Public Offering, we do not expect to generate any operating revenues until after the completion of our Business Combination. We expect to generate non-operating income in the form of interest income on marketable securities held after the Initial Public Offering. We expect that we will 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 in connection with completing a Business Combination. For the period from March 20, 2018 (inception) through February 28, 2019, we had net income of $574,131, consisting of interest income on marketable securities held in our Trust Account of $729,499, offset by operating costs of $152,789 and an unrealized loss on marketable securities held in our Trust Account of $2,579. Liquidity and Capital Resources On August 23, 2018, we consummated the Initial Public Offering of 5,500,000 Units at a price of $10.00 per Unit, generating gross proceeds of $55,000,000. Simultaneously with the closing of the Initial Public Offering, we consummated the sale of 323,750 Private Units to the Sponsor and the underwriter of our Initial Public Offering at a price of $10.00 per unit, generating gross proceeds of $3,237,500. On August 30, 2018, in connection with the underwriters’ election to fully exercise their over-allotment option, we consummated the sale of an additional 825,000 Units and the sale of an additional 35,063 Private Placement Units, generating total gross proceeds of $8,600,630. Following the Initial Public Offering and the sale of the Private Units, a total of $64,515,000 was placed in the Trust Account. We incurred $4,027,962 in transaction costs, including $1,423,125 of underwriting fees, $2,213,750 of deferred underwriting fees and $391,087 of other costs. For the period from March 20, 2018 (inception) through February 28, 2019, cash used in operating activities amounted to $220,869. Net income of $574,131 was affected by interest earned on marketable securities held in the Trust Account of $729,499 and an unrealized loss on securities held in the Trust Account of $2,579. Changes in our operating assets and liabilities used cash of $68,080. At February 28, 2019, we had marketable securities held in the Trust Account of $65,241,920 (including approximately $727,000 of interest income, net of unrealized losses), 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 not withdrawn interest income from the Trust Account. We intend to use substantially all of the funds held in the Trust Account (excluding deferred underwriting fees and interest to pay taxes) to acquire a target business or businesses and to pay our expenses relating thereto. To the extent that our capital stock is used in whole or in part as consideration to effect our Business Combination, the remaining proceeds held in the Trust Account as well as any other net proceeds not expended will be used as working capital to finance the operations of the target business or businesses. 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 Private Units, at a price of $10.00 per unit at the option of the lender. As of February 28, 2019, we had $313,049 in cash and working capital of $381,129. We have not generated operating revenues, nor do we expect to generate operating revenues until the consummation of a Business Combination. Until the consummation of a Business Combination, we will be using the funds not held in the Trust Account primarily to identify and evaluate prospective acquisition candidates, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses, review corporate documents and material agreements of prospective target businesses, select the target business to acquire and structure, negotiate and complete a Business Combination. Our Sponsor or an affiliate of our Sponsor or certain of our officers and directors are not under any obligation to advance us funds, or to invest in us. Accordingly, we may not be able to obtain additional financing. 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, suspending the pursuit of a potential transaction. We cannot provide any assurance that new financing will be available to us on commercially acceptable terms, if at all. These conditions raise 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 February 28, 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. 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: Ordinary shares subject to 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 not 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, ordinary shares subject to possible redemption are presented at redemption value as temporary equity, outside of the shareholders’ equity section of our balance sheet. Net loss per ordinary share We apply the two-class method in calculating earnings per share. Ordinary shares 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 ordinary 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 ordinary shares subject to 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 March 20, 2018 in the British Virgin Islands with limited liability (meaning our shareholders have no liability, as members of the Company, for the liabilities of the Company over and above the amount already paid for their shares) formed for the purpose of acquiring, engaging in a share exchange, share reconstruction and amalgamation with, purchasing all or substantially all of the assets of, or engaging in any other similar Business Combination with one or more businesses or entities. We intend to effectuate our Business Combination using cash from the proceeds of our Initial Public Offering and the sale of the Private Units that occurred simultaneously with the completion of our Initial Public Offering, our shares, debt or a combination of cash, shares and debt. The issuance of additional shares in a Business Combination: · may significantly dilute the equity interest of investors who would not have preemption rights in respect of any such issue; · may subordinate the rights of holders of ordinary shares if the rights, preferences, designations and limitations attaching to the preferred shares are created by amendment of our memorandum and articles of association by resolution of the board of directors and preferred shares are issued with rights senior to those afforded our ordinary shares; · could cause a change in control if a substantial number of ordinary shares 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 share ownership or voting rights of a person seeking to obtain control of us; and · may adversely affect prevailing market prices for our ordinary shares. 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 our 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 any document governing such debt contains covenants restricting our ability to obtain such financing while the debt security is outstanding; · our inability to pay dividends on our ordinary shares; · 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 ordinary shares 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 [/INST] Positive. </s>

Karuna Therapeutics, Inc.

2020-03-24

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 “Selected Financial Data” section of this Annual Report on Form 10-K and our consolidated financial statements and the related notes included at the end of 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 risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. 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 an innovative clinical-stage biopharmaceutical company committed to developing novel therapies with the potential to transform the lives of people with disabling and potentially fatal neuropsychiatric disorders and pain. Our pipeline is built on the broad therapeutic potential of our lead product candidate, KarXT, an oral modulator of muscarinic receptors that are located both in the central nervous system, or CNS, and various peripheral tissues. KarXT is our proprietary product candidate that combines xanomeline, a novel muscarinic agonist, with trospium, an approved muscarinic antagonist, to preferentially stimulate muscarinic receptors in the CNS. We recently announced topline results from our Phase 2 clinical trial of KarXT for the treatment of acute psychosis in patients with schizophrenia, in which KarXT met the trial’s primary endpoint and was observed to be well tolerated. We are also developing KarXT as a potential treatment for dementia-related psychosis, or DRP, and pain. In the fourth quarter of 2019, we initiated two Phase 1b clinical trials of KarXT. One trial is evaluating the safety and tolerability of KarXT in healthy elderly volunteers as a precursor to KarXT’s development in a DRP patient population. The second trial is evaluating the effect of KarXT on experimentally induced pain in healthy volunteers. We have assembled a team whose members have extensive expertise in the research, development and commercialization of numerous CNS agents, as well as deep familiarity with the biology of neuropsychiatric disorders, such as schizophrenia and DRP, including the role of muscarinic receptors in potential treatment of these diseases. We plan to leverage this expertise to develop a pipeline of product candidates targeting a broad range of psychiatric and neurological conditions. Since our inception in 2009, we have focused substantially all of our efforts and financial resources on organizing and staffing our company, acquiring and developing our technology, raising capital, building our intellectual property portfolio, undertaking preclinical studies and clinical trials and providing general and administrative support for these activities. On June 27, 2019, our registration statement on Form S-1 relating to our initial public offering, or IPO, of our common stock was declared effective by the Securities and Exchange Commission, or SEC. In the IPO, which closed on July 2, 2019, we issued and sold 6,414,842 shares of our common stock, including full exercise of the underwriters’ over-allotment option to purchase an additional 836,718 shares, at a public offering price of $16.00 per share. The aggregate net proceeds to us from the IPO, inclusive of proceeds from the over-allotment exercise, were approximately $93.0 million after deducting underwriting discounts and commissions of $7.2 million and offering expenses of approximately $2.4 million. On November 20, 2019, our registration statement on Form S-1 relating to our follow-on public offering of our common stock was declared effective by the SEC. In this offering, which closed on November 25, 2019, we issued and sold 2,600,000 shares of our common stock at a public offering price of $96.00 per share. The aggregate net proceeds to us from the follow-on offering were approximately $234.2 million after deducting underwriting discounts and commissions of $15.0 million and offering expenses of approximately $0.4 million. Prior to the initial and follow-on public offerings, we have funded our operations primarily with proceeds from the sales of redeemable convertible preferred stock and the issuance of convertible notes. We have never generated revenue and have incurred significant net losses since inception. Our net losses were $44.0 million and $17.5 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $75.5 million. Our net losses may fluctuate significantly from quarter to quarter and year to year. We expect to incur significant expenses and increasing operating losses for the foreseeable future. We anticipate that our operating expenses and capital expenditures will increase substantially, particularly as we: • invest significantly to further develop KarXT for our current and future indications; • advance additional product candidates into preclinical and clinical development; • seek regulatory approvals for any product candidates that successfully complete clinical trials; • require the manufacture of larger quantities of our product candidates for clinical development and potential commercialization; • hire additional clinical, scientific, management and administrative personnel; • maintain, expand and protect our intellectual property portfolio; • acquire or in-license other assets and technologies; and • add additional operational, financial and management information systems and processes to support our ongoing development efforts, any future manufacturing or commercialization efforts and our transition to operating as a public company. We do not expect to generate revenue from product sales unless and until we successfully complete development and obtain regulatory approval for a product candidate or enter into collaborative agreements with third parties, which we expect will take a number of years, if ever, and the outcome of which is subject to significant uncertainty. Additionally, we currently use third parties such as contract research organizations, or CROs, and contract manufacturing organizations, or CMOs, to carry out our preclinical and clinical development activities, and we do not yet have a sales organization. If we obtain regulatory approval for any product candidates, we expect to incur significant commercialization expenses related to product sales, marketing, manufacturing and distribution. 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 private and public equity offerings, debt financings, collaborations, strategic alliances and marketing, distribution or licensing arrangements with third parties. 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. As of December 31, 2019, we had cash, cash equivalents and short-term investments of $389.4 million. We believe that our existing cash, cash equivalents and short-term investments will be sufficient to meet our anticipated operating and capital expenditure requirements through at least the next 36 months. 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.” Components of Our Results of Operations Revenue To date, we have not generated any revenue and do not expect to generate any revenue in the foreseeable future, if at all. 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. If we enter into license or collaboration agreements for any of our product candidates or intellectual property, we may generate revenue in the future from payments as a result of such license or collaboration agreements. We cannot predict if, when, or to what extent we will generate revenue from the commercialization and sale of our product candidates. We may never succeed in obtaining regulatory approval for any of our product candidates. Operating Expenses Research and Development Expenses Research and development expenses consist primarily of costs incurred for the development of our product candidates and our drug discovery efforts, which include: • personnel costs, including salaries and the related costs, 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 CROs; • expenses incurred in connection with CMOs that manufacture drug products for use in our preclinical and clinical trials; • formulation costs and chemistry, manufacturing and controls, or CMC, costs; and • expenses incurred under agreements with consultants who supplement our internal capabilities. 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 and third-party service providers. We do not track our internal research and development expenses on an indication-by-indication 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, such as fees paid to consultants, central laboratories, contractors, CMOs and CROs in connection with our clinical development activities, which costs we do track on an indication-by-indication basis. Formulation costs and CMC costs and preclinical expenses consist of external costs associated with activities to support our current and future clinical programs, but are not allocated on an indication-by-indication basis due to the overlap of the potential benefit of those efforts across multiple indications that utilize KarXT. The following table summarizes our research and development expenses: 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, including investments in manufacturing, as our programs advance into later stages of development and we continue to conduct 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. Because of the numerous risks and uncertainties associated with conducting product development, we cannot determine with certainty the duration and completion costs of our current or future preclinical studies and clinical trials or if, when, or to what extent we will generate revenues from the commercialization and sale of our product candidates. We may never succeed in achieving regulatory approval for our product candidates. The duration, costs and timing of preclinical studies and clinical trials and development of our product candidates will depend on a variety of factors, if and as we: • continue to develop and conduct clinical trials for KarXT for our current and future indications; • initiate and continue research, preclinical and clinical development efforts for future product candidates; • seek to identify additional product candidates; • seek regulatory approvals for KarXT for our current and future indications as well as any other product candidates that successfully complete clinical development; • add operational, financial and management information systems and personnel, including personnel to support our product development and help us comply with our obligations as a public company; • hire and retain additional personnel, such as clinical, quality control, scientific, commercial and administrative personnel; • maintain, expand and protect our intellectual property portfolio; • establish sales, marketing, distribution, manufacturing, supply chain and other commercial infrastructure in the future to commercialize various products for which we may obtain regulatory approval, if any; • add equipment and physical infrastructure to support our research and development; and • acquire or in-license other product candidates and technologies. 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 may never succeed in obtaining regulatory approval for any of our product candidates. We do not believe that it is possible at this time to accurately project total indication-specific expenses through commercialization. There are numerous factors associated with the successful commercialization of any of our product candidates, including future trial design and various regulatory requirements, many of which cannot be determined with accuracy at this time based on our stage of development. Additionally, future commercial and regulatory factors beyond our control will impact our clinical development programs and plans. General and Administrative Expenses General and administrative expenses consist primarily of employee-related costs for personnel in executive, finance and administrative functions, costs related to maintenance and filing of intellectual property, facility-related costs, insurance costs, and other expenses for outside professional services, including legal, human resources, data management, audit and accounting services. Personnel costs consist of salaries, benefits, travel expense and stock-based compensation expense. 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 and director and officer insurance costs as well as investor and public relations expenses associated with operating as a public company. Other Income (Expense) Interest Income (Expense). Interest income (expense) consists of interest accrued, net of any interest forgiven, on the principal balance of convertible notes that were issued and outstanding during 2019 and 2018. In August 2018, March 2019, and April 2019 all outstanding convertible notes were converted into redeemable convertible preferred stock. A portion of the accrued interest was forgiven with respect to certain convertible notes upon their conversion into redeemable convertible preferred stock, and the forgiven interest was recorded as a reduction to interest expense in the years ended December 31, 2019 and 2018. Interest Income. Interest income consists of interest income from our cash equivalents and short-term investments. Accretion of Debt Discount. Upon issuance of our convertible notes, each note was recorded at cost, net of the derivative liability (see “-Critical Accounting Polices and Estimates”). This discount on each outstanding note, if any, was amortized as interest expense to the date such note was expected to convert using the effective interest rate method and is reflected in the statements of operations as accretion of debt discount. Change in Fair Value of Derivatives. Our convertible notes contained conversion options at a significant premium that were deemed to be embedded derivatives that are required to be bifurcated and accounted for separately from the convertible note. We remeasured the derivative liability to fair value at each reporting date, and we recognized changes in the fair value of the derivative liabilities in our statements of operations. As part of the conversion of outstanding convertible notes into redeemable convertible preferred stock, all derivatives were settled in 2019. Results of Operations Comparison of the Years Ended December 31, 2019 and 2018 Research and Development Expenses Expenses related to our schizophrenia clinical trials increased by $5.3 million due to the progress of our Phase 2 clinical trial, for which topline data was announced in November 2019. The $0.6 million and $0.4 million in expenses related to pain and dementia-related psychosis clinical trials, respectively, consist of study preparation and startup costs for Phase 1b clinical trials incurred in the year ended December 31, 2019. Formulation and CMC expenses increased by $0.7 million due to an increase in formulation development activities. Preclinical expenses increased by $1.4 million due to the initiation and execution of toxicology studies. The increase of $2.5 million in personnel-related costs was primarily a result of an increase in headcount. The increase of $2.0 million in consultant fees and other expenses was due to a combination of an increase in consulting activities as well as costs associated with our discovery programs. General and Administrative Expenses The increase of $14.2 million in personnel-related costs was primarily due to an increase in stock-based compensation of $11.2 million, which was primarily attributable to certain grants near or at the time of our IPO that fully vested in 2019 on an accelerated schedule. The increase of $1.1 million in professional and consultant fees was primarily due to an increase in audit fees, legal costs, public relations consulting fees, and recruiting costs related to our preparations to be, and our ongoing business activities as, a public company. The increase of $2.6 million in other costs was primarily due to insurance costs and our facility lease in Boston, Massachusetts. Other Income (Expense), Net Interest income (expense) for the year ended December 31, 2019 reflects the excess of interest forgiven upon conversion of all outstanding convertible notes at the time of our Series B convertible preferred stock financing over interest expense accrued on such convertible notes during the period. Interest income (expense) for the year ended December 31, 2018 represents the excess of interest expense accrued on convertible notes that were outstanding during the period over interest forgiven upon conversion of all convertible notes outstanding at the time of our Series A convertible preferred stock financing. Interest income is attributable to interest earned on our cash equivalents and short-term investments, which were purchased beginning in November 2018. The accretion of debt discount for the year ended December 31, 2019 was attributable to convertible notes that were outstanding prior to the conversion of the associated notes in March 2019 into shares of our Series B convertible preferred stock. The accretion of debt discount for the year ended December 31, 2018 was attributable to convertible notes that were outstanding prior to the conversion of the associated notes in August 2018 into shares of our Series A convertible preferred stock, and convertible notes that were issued after such conversion. All related debt discounts were fully accreted at the time of each respective conversion. The change in fair value of derivative for the year ended December 31, 2019 reflects the mark-to-market of the convertible note derivative liabilities prior to the conversion of the associated notes in March 2019 into shares of our Series B convertible preferred stock. The change in fair value of derivative for the year ended December 31, 2018 reflects the mark-to-market of the convertible note derivative liabilities prior to the conversion of the associated notes in August 2018 into shares of our Series A convertible preferred stock, and the mark-to-market of the convertible note derivative liabilities for associated notes that were issued after such conversion. 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. At December 31, 2019, we had federal net operating loss carryforwards totaling $51.8 million, of which $9.7 million begin to expire in 2029 and $42.1 million can be carried forward indefinitely. At December 31, 2019, we had state net operating loss carryforwards totaling $51.6 million which begin to expire in 2030. The federal and state operating loss carryforwards may be available to offset future income tax liabilities. As of December 31, 2019, we also had federal and state research and development tax credit carryforwards of $2.8 million and $0.3 million, respectively, which begin to expire in 2038 and 2033, respectively. Through December 31, 2019, we had recorded a full valuation allowance against our net deferred tax assets at each balance sheet date. We filed federal and state taxes as part of a controlled group with PureTech Health LLC, or PureTech Health, a related party, until the closing of our Series A financing in August 2018. Following the financing, we no longer met the requirements to be included in the controlled group filing, as PureTech Health no longer held 80% of our outstanding voting securities, thereby requiring us to file a separate U.S. federal income tax return for the period beginning on that date going forward. On July 2, 2019, PureTech no longer held 50% of the outstanding shares of the Company and therefore, beginning on this date, we will file separate state income tax returns. 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 primarily with proceeds from the sale of redeemable convertible preferred stock, issuance of convertible notes, and sales of our common stock. Through December 31, 2019, our operations have been financed by gross proceeds of $24.1 million from the issuance of convertible notes, $91.0 million from the sale of shares of our redeemable convertible preferred stock, $93.0 million from the sale of our common stock in our initial public offering, and $234.2 million from the sale of our common stock in a follow-on public offering. As of December 31, 2019, we had $389.4 million in cash, cash equivalents and short-term investments, and an accumulated deficit of $75.5 million. Our primary use of cash has been to fund operating expenses, which consist of research and development and 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. Cash Flows The following table summarizes our sources and uses of cash for each of the periods presented: Cash Flows from Operating Activities Cash used in operating activities for the year ended December 31, 2019 was $30.9 million, consisting of a net loss of $44.0 million partially offset by noncash items, including stock-based compensation expense of $12.6 million, the accretion of debt discount related to the convertible notes of $0.9 million, and $0.1 million resulting from the change in fair value of the convertible note derivative liabilities. Net loss was also adjusted for $1.3 million of non-cash interest income. The change in our net operating assets and liabilities was due to an increase in accrued expenses of $1.8 million as well as $0.1 million related to an increase in deferred lease obligation and increase to accounts payable of $0.3 million, partially offset by an increase in prepaid expenses and other current assets of $1.6 million due primarily to timing of payment of general and administrative expenses. Cash used in operating activities for the year ended December 31, 2018 was $15.4 million, consisting of a net loss of $17.5 million partially offset by noncash items, including the accretion of debt discount related to the convertible notes of $2.2 million, stock-based compensation expense of $1.0 million, $0.4 million resulting from the change in fair value of the convertible note derivative liabilities and non-cash interest expense of $0.4 million. The change in our net operating assets and liabilities was due primarily to an increase in prepaid expenses of $1.5 million as a result of increased clinical activities and a decrease in accounts payable of $0.5 million primarily due to payment timing, which was partially offset by an increase in accrued expenses of $0.1 million due to timing of payment of general and administrative expenses and an increase in deferred lease obligation of $0.1 million. Cash Flows from Investing Activities Cash used in investing activities for the year ended December 31, 2019 was $174.3 million, consisting primarily of $231.7 million for the purchase of short-term investments with a duration of under one year, partially offset by maturities of short-term investments of $50.0 million and sales of short-term investments of $7.5 million. Cash used in investing activities for the year ended December 31, 2018 was approximately $5.1 million and consisted of $5.0 million for the purchases of short-term investments with a duration of under one year, and $0.1 million for the purchase of property and equipment. Cash Flows from Financing Activities Cash provided by financing activities for the year ended December 31, 2019 was $405.3 million and was related primarily to $234.6 million of proceeds from the sale of our common stock in our follow-on public offering (net of $15.0 million in underwriting discounts and commissions) partially offset by $0.4 million in payments of follow-on offering costs, $95.5 million of proceeds from the sale of our common stock in our initial public offering (net of $7.2 million in underwriting discounts and commissions) partially offset by $2.4 million in payments of initial public offering costs, $74.8 million of net proceeds from the issuance of redeemable convertible preferred stock, as well as $3.1 million related to proceeds from the issuance of convertible notes. Cash provided by financing activities for the year ended December 31, 2018 was $27.6 million and was related to the $15.9 million of proceeds from the issuance of redeemable convertible preferred stock, net of issuance costs and $11.7 million of proceeds from the issuance of convertible notes. 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 through clinical trials. In addition, we expect to incur additional costs associated with operating as a public company. As of December 31, 2019, we had cash and cash equivalents and short-term investments of $389.4 million. Based on our current plans, we believe that our existing cash, cash equivalents and short-term investments will be sufficient to meet our anticipated operating and capital expenditure requirements through at least the next 36 months. 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. 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: • the scope, progress, results and costs of researching and developing KarXT for our current and future indications as well as other product candidates we may develop; • the timing of, and the costs involved in, obtaining marketing approvals for KarXT for our current and future indications as well as future product candidates we may develop and pursue; • the number of future indications and product candidates that we pursue and their development requirements; • if approved, the costs of commercialization activities for KarXT for the approved indication, or any other product candidate that receives regulatory 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 regulatory approval, revenue, if any, received from commercial sales of KarXT for any program or revenues received from any future product candidates; • the extent to which we in-license or acquire rights to other products, product candidates or technologies; • 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 including enforcing and defending intellectual property related claims; and • the costs of operating as a public company. 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 operations through a combination of equity financings, debt financings, collaborations with other companies or other strategic transactions. We do not currently have any committed external source of funds. To the extent that we raise additional capital through the sale of equity or convertible debt securities, our stockholders’ ownership interest will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect your 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 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 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 product candidates that we would otherwise prefer to develop and market ourselves. 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. Contractual Obligations and Other Commitments The following table summarizes our outstanding contractual obligations as of payment due date by period at December 31, 2019. (1) Reflects payments due for our lease of office space in Boston, Massachusetts under an operating lease agreement that expires in February 2023, as amended. 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. These contracts 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 preceding table as the amount and timing of such payments are not known. We are also party to certain license and collaboration agreements with PureTech Health and Eli Lilly and Company. We have not included future payments under these agreements in the table of contractual obligations above since obligations under these agreements are contingent upon future events such as our achievement of specified development, regulatory and commercial milestones, or royalties on net product sales. As of December 31, 2019, we were unable to estimate the timing or likelihood of achieving these milestones or generating future product sales. Critical Accounting Polices and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with United States generally accepted accounting principles, or U.S. GAAP. The preparation of these consolidated 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 consolidated financial statements, as well as the 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 more detail in Note 2 to our consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K, 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. Research and Development Contract Costs and Accruals As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued research and development expenses. We accrue for estimated costs of research and development activities conducted by third-party service providers, which include the conduct of preclinical studies and clinical trials, and contract manufacturing activities. We record the estimated costs of research and development activities based upon the estimated amount of services provided and include these costs in accrued liabilities in the balance sheets and within research and development expense in the statements of operations. When evaluating the adequacy of the accrued liabilities, we analyze progress of the research studies or clinical trials and manufacturing activities, including the phase or completion of events, invoices received and contracted costs. Significant judgments and estimates may be made in determining the accrued balances at the end of any reporting period. Actual results could differ from our estimates. Our historical accrual estimates have not been materially different from the actual costs. Convertible Notes and Derivative Liabilities In June 2018, the Company entered into an agreement with Wellcome Trust to receive up to $8.0 million in gross proceeds from the issuance of convertible notes. The Company received $2.0 million of proceeds in July 2018, $2.7 million in November 2018, $1.6 million in March 2019, and $1.6 million in April 2019. In addition, since inception and through December 31, 2018, the Company has issued $14.0 million of convertible notes to other parties, of which $13.5 million were issued to PureTech Health, a related party (see Note 13 to our consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K). During the year ended December 31, 2018, the Company issued Convertible Notes to PureTech Health with principal totaling $7.0 million. All outstanding convertible notes were converted to Series A convertible preferred stock and Series B convertible preferred stock in August 2018 and March 2019. As of December 31, 2019, there were no convertible notes outstanding. See Note 5 to the consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K for additional detail. The convertible notes issued contained conversion options at a significant discount that we determined to be embedded derivatives, which were recorded as liabilities on our balance sheet and remeasured to fair value at each reporting date until each derivative was settled. Changes in the fair value of the derivative liabilities were recognized as change in fair value of derivative in the statement of operations. The fair value of the derivative liabilities was determined at each period by assessing the likelihood and timing of events that would result in either a conversion or change-of-control feature being triggered, as well as changes in market conditions. Stock-Based Compensation Expense Prior to our IPO, the estimated fair value of our common stock had been determined by our board of directors as of the date of each award grant, 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 and which may have changed from the date of the most recent valuation through the date of the grant. Subsequent to our IPO, the fair value of our common stock is based on quoted market prices. The determination of the fair value of share-based payment awards utilizing the Black-Scholes model is affected by our stock price and a number of assumptions, including expected volatility, expected life, risk-free interest rate and expected dividends. Expected Term-We have opted to use the “simplified method” for estimating the expected term of employee options, whereby the expected term equals the arithmetic average of the vesting term and the original contractual term of the option (generally 10 years). Expected Volatility-Due to our limited operating history 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 data was computed using the daily closing prices for the selected companies’ shares during the equivalent period of the calculated expected term of the stock-based awards. Risk-Free Interest Rate-The risk-free rate assumption is based on the U.S. Treasury instruments with maturities similar to the expected term of our stock options. Expected Dividend-We have not issued any dividends and do not expect to issue dividends over the life of the options. As a result, we have estimated the dividend yield to be zero. The estimated fair value of stock options granted to employees and non-employee service providers are expensed over the requisite service period (generally the vesting term) on a straight-line basis. We account for the impact of forfeitures as they occur. 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 share-based compensation expense could be materially different. 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. 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. Other exemptions and reduced reporting requirements under the JOBS Act for emerging growth companies include presentation of only two years audited financial statements in a registration statement for an initial public offering, an exemption from the requirement to provide an auditor’s report on internal controls over financial reporting pursuant to the Sarbanes-Oxley Act of 2012, an exemption from any requirement that may be adopted by the Public Company Accounting Oversight Board regarding mandatory audit firm rotation, and less extensive disclosure about our executive compensation arrangements. We have elected to use the 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 that (i) we are no longer an emerging growth company or (ii) we affirmatively and irrevocably opt out of the extended transition period provided in the JOBS Act. As a result, our consolidated financial statements may not be comparable to companies that comply with the new or revised accounting pronouncements as of public company effective dates. We would cease to be an emerging growth company upon the earliest of: (1) the last day of the fiscal year ending after the fifth anniversary of our initial public offering; (2) the last day of the fiscal year in which we have more than $1.07 billion in annual revenue; (3) the last day of the fiscal year in which we qualify as a “large accelerated filer,” with at least $700.0 million of equity securities held by non-affiliates as of the prior June 30th; or (4) the issuance, in any three-year period, by our company of more than $1.0 billion in non-convertible debt securities held by non-affiliates. Recently Issued and Adopted 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 elsewhere in this Annual Report on Form 10-K.

<s>[INST] You should read the following discussion and analysis of our financial condition and results of operations together with the “Selected Financial Data” section of this Annual Report on Form 10K and our consolidated financial statements and the related notes included at the end of this Annual Report on Form 10K. This discussion and other parts of this Annual Report on Form 10K contain forwardlooking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. As a result of many factors, including those factors set forth in the “Risk Factors” section of this Annual Report on Form 10K, our actual results could differ materially from the results described in or implied by the forwardlooking statements contained in the following discussion and analysis. Overview We are an innovative clinicalstage biopharmaceutical company committed to developing novel therapies with the potential to transform the lives of people with disabling and potentially fatal neuropsychiatric disorders and pain. Our pipeline is built on the broad therapeutic potential of our lead product candidate, KarXT, an oral modulator of muscarinic receptors that are located both in the central nervous system, or CNS, and various peripheral tissues. KarXT is our proprietary product candidate that combines xanomeline, a novel muscarinic agonist, with trospium, an approved muscarinic antagonist, to preferentially stimulate muscarinic receptors in the CNS. We recently announced topline results from our Phase 2 clinical trial of KarXT for the treatment of acute psychosis in patients with schizophrenia, in which KarXT met the trial’s primary endpoint and was observed to be well tolerated. We are also developing KarXT as a potential treatment for dementiarelated psychosis, or DRP, and pain. In the fourth quarter of 2019, we initiated two Phase 1b clinical trials of KarXT. One trial is evaluating the safety and tolerability of KarXT in healthy elderly volunteers as a precursor to KarXT’s development in a DRP patient population. The second trial is evaluating the effect of KarXT on experimentally induced pain in healthy volunteers. We have assembled a team whose members have extensive expertise in the research, development and commercialization of numerous CNS agents, as well as deep familiarity with the biology of neuropsychiatric disorders, such as schizophrenia and DRP, including the role of muscarinic receptors in potential treatment of these diseases. We plan to leverage this expertise to develop a pipeline of product candidates targeting a broad range of psychiatric and neurological conditions. Since our inception in 2009, we have focused substantially all of our efforts and financial resources on organizing and staffing our company, acquiring and developing our technology, raising capital, building our intellectual property portfolio, undertaking preclinical studies and clinical trials and providing general and administrative support for these activities. On June 27, 2019, our registration statement on Form S1 relating to our initial public offering, or IPO, of our common stock was declared effective by the Securities and Exchange Commission, or SEC. In the IPO, which closed on July 2, 2019, we issued and sold 6,414,842 shares of our common stock, including full exercise of the underwriters’ overallotment option to purchase an additional 836,718 shares, at a public offering price of $16.00 per share. The aggregate net proceeds to us from the IPO, inclusive of proceeds from the overallotment exercise, were approximately $93.0 million after deducting underwriting discounts and commissions of $7.2 million and offering expenses of approximately $2.4 million. On November 20, 2019, our registration statement on Form S1 relating to our followon public offering of our common stock was declared effective by the SEC. In this offering, which closed on November 25, 2019, we issued and sold 2,600,000 shares of our common stock at a public offering price of $96.00 per share. The aggregate net proceeds to us from the followon offering were approximately $234.2 million after deducting underwriting discounts and commissions of $1 [/INST] Negative. </s>

Palomar Holdings, Inc.

2020-02-28

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion of our historical results of operations and our liquidity and capital resources should be read together with the consolidated financial statements and related notes that appear elsewhere in this Annual Report on Form 10-K. In addition to historical financial information, this Annual Report on Form 10-K contains “forward-looking statements.” You should review the “Special Note Regarding Forward-Looking Statements” and “Risk Factors” sections of this Annual Report on Form 10-K for factors and uncertainties that may cause our actual future results to be materially different from those in our forward-looking statements. Forward-looking statements in this Annual Report on Form 10-K are based on information available to us as of the date hereof, and we assume no obligation to update any such forward-looking statements. Overview We are a rapidly growing and profitable company focused on the provision of specialty property insurance. We focus on certain markets that we believe are underserved by other insurance companies, such as the markets for earthquake, wind and flood insurance. We provide specialty property insurance products in our target markets to both individuals and businesses. We use proprietary data analytics and a modern technology platform to offer our customers flexible products with customized and granular pricing on an admitted basis. We distribute our products through multiple channels, including retail agents, program administrators, wholesale brokers, and in partnership with other insurance companies. Our business strategy is supported by a comprehensive risk transfer program with reinsurance coverage that we believe provides both consistency of earnings and appropriate levels of protection in the event of a major catastrophe. Our management team combines decades of insurance industry experience across specialty underwriting, reinsurance, program administration, distribution, and analytics. Founded in 2014, we have significantly grown our business and have generated attractive returns. We have organically increased gross written premiums from $16.6 million for the year ended December 31, 2014, our first year of operations, to $252.0 million for the year ended December 31, 2019, a compound annual growth rate of approximately 72%. For the year ended December 31, 2019, we experienced average monthly premium retention rates above 93% for our Residential Earthquake and Hawaii Hurricane lines and approximately 88% overall across all lines of business, providing strong visibility into future revenue. In February 2014, Palomar Specialty Insurance Company was awarded an “A−” (Excellent) (Outlook Stable) rating from A.M. Best Company (“A.M. Best”), a leading rating agency for the insurance industry. In February 2019, A.M. Best affirmed our “A−” (Excellent) (Outlook Stable) rating for Palomar Specialty Insurance Company and affirmed our “A−” (Excellent) (Outlook Stable) group rating for Palomar Holdings, Inc. This rating reflects A.M. Best’s opinion of our financial strength, operating performance and ability to meet obligations to policyholders and is not an evaluation directed towards the protection of investors. We believe that our market opportunity, distinctive products, and differentiated business model position us to grow our business profitably. On April 22, 2019, we completed our IPO, and the underwriters in the IPO purchased 6,468,750 shares, including the full exercise of their option to purchase additional shares of common stock. The net proceeds were approximately $87.4 million, after deducting underwriting discounts and commissions and offering costs. On September 30, 2019, certain selling stockholders completed the September 2019 Secondary Offering of 6,037,500 shares of our common stock. We did not receive any proceeds from the September 2019 Secondary Offering or incur underwriters’ discounts or commissions on the sale. On January 9, 2020, we, along with certain selling stockholders, completed the January 2020 Secondary Offering of 5,750,000 shares of common stock at a public offering price of $49.00 per share. Of the 5,750,000 shares sold, 750,000 represented the underwriters’ exercise of their option to purchase additional shares. The offering was comprised of 5,000,000 shares sold by certain selling stockholders and 750,000 shares sold by us. Our net proceeds from the January 2020 Secondary Offering were approximately $35.4 million, after deducting underwriting discounts and commissions and offering costs. Components of Our Results of Operations Gross Written Premiums Gross written premiums are the amounts received or to be received for insurance policies written or assumed by us during a specific period of time without reduction for policy acquisition costs, reinsurance costs or other deductions. The volume of our gross written premiums in any given period is generally influenced by: · New business submissions; · Binding of new business submissions into policies; · Renewals of existing policies; and · Average size and premium rate of bound policies. Ceded Written Premiums Ceded written premiums are the amount of gross written premiums ceded to reinsurers. We enter into reinsurance contracts to limit our exposure to potential losses as well as to provide additional capacity for growth. Ceded written premiums are earned over the reinsurance contract period in proportion to the period of risk covered. The volume of our ceded written premiums is impacted by the level of our gross written premiums and any decision we make to increase or decrease limits, retention levels and co-participations. Net Earned Premiums Net earned premiums represent the earned portion of our gross written premiums, less the earned portion that is ceded to third-party reinsurers under our reinsurance agreements. Our insurance policies generally have a term of one year and premiums are earned pro rata over the term of the policy. Commission and Other Income Commission and other income consist of commissions earned on policies written on behalf of third-party insurance companies and where we have no exposure to the insured risk and certain fees earned in conjunction with underwriting policies. Losses and Loss Adjustment Expenses Losses and loss adjustment expenses represent the costs incurred for losses. These expenses are a function of the size and term of the insurance policies we write and the loss experience associated with the underlying coverage. In general, our losses and loss adjustment expenses are affected by: · The occurrence, frequency and severity of catastrophe events such as earthquakes, hurricanes and floods in the areas where we underwrite polices relating to these perils; · Our net reinsurance recoverables; · The volume and severity of non-catastrophe attritional losses; · The mix of business written by us; · The geographic location and characteristics of the policies we underwrite; · Changes in the legal or regulatory environment related to the business we write; · Trends in legal defense costs; and · Inflation in housing and construction costs. Losses and loss adjustment expenses are based on an actuarial analysis of the estimated losses, including losses incurred during the period and changes in estimates from prior periods. Losses and loss adjustment expenses may be paid out over multiple years. Acquisition Expenses Acquisition expenses are principally comprised of the commissions we pay retail agents, program administrators and wholesale brokers, net of ceding commissions we receive on business ceded under certain reinsurance contracts. In addition, acquisition expenses include premium-related taxes. Acquisition expenses related to each policy we write are deferred and amortized to expense in proportion to the premium earned over the policy life. Other Underwriting Expenses Other underwriting expenses represent the general and administrative expenses of our insurance operations including employee salaries and benefits, technology costs, office rent, stock-based compensation, and professional services fees such as legal, accounting, and actuarial services. In addition, we incurred expense related to the write-off of unamortized debt issuance costs on our surplus notes in September 2018 and expense related to the write off of unamortized debt issuance costs on our $20.0 million floating rate senior secured notes (“Floating Rate Notes”) in May 2019. Interest Expense Interest expense consists primarily of interest expense on our surplus notes through September 2018 and our Floating Rate Notes after September 2018. In addition, we incurred interest expense related to prepayment penalties on the payoff of our surplus notes in September 2018 and related to the redemption premium paid on our Floating Rate Notes in May 2019. Net Investment Income We earn investment income on our portfolio of invested assets. Our invested assets are primarily comprised of fixed maturity securities, and may also include cash and cash equivalents, and equity securities. The principal factors that influence net investment income are the size of our investment portfolio, the yield on that portfolio and expenses due to external investment managers. As measured by amortized cost, which excludes changes in fair value caused by changes in interest rates, the size of our investment portfolio is mainly a function of our invested equity capital along with premium we receive from our insureds, less payments on policyholder claims and other operating expenses. Net Realized and Unrealized Gains and Losses on Investments Net realized and unrealized gains and losses on investments are a function of the difference between the amount received by us on the sale of a security and the security’s cost-basis, mark-to-market adjustments, and any “other-than-temporary” impairments recognized in earnings. In addition, beginning in 2018, we carry our equity securities at fair value with unrealized gains and losses included in this line. Prior to 2018, unrealized gains and losses on equity securities were included in accumulated other comprehensive income as a separate component of stockholders’ equity. Income Tax Expense Currently our income tax expense consists mainly of federal income taxes imposed on our operations offset by the reversal of our U.S. federal deferred tax valuation allowance in March 2019. For 2018 and 2017, our income tax expense consists mainly of refunds of federal AMT credits. Our income tax expense has also been significantly impacted by the value of our deferred tax assets and liabilities, particularly our U.S. federal income net operating loss carryforwards which may or may not be realizable. In addition, tax legislation such as the Tax Cuts and Jobs Act of 2017 (the “Tax Act”) significantly impacts our current and future income tax expense. Among other things, the Tax Act, enacted on December 22, 2017 lowers the U.S. federal corporate tax rate from 35% to 21% starting January 1, 2018. Key Financial and Operating Metrics We discuss certain key financial and operating metrics, described below, which provide useful information about our business and the operational factors underlying our financial performance. Underwriting revenue is a non-GAAP financial measure defined as total revenue, excluding net investment income and net realized and unrealized gains and losses on investments. See “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of total revenue in accordance with GAAP to underwriting revenue. Underwriting income is a non-GAAP financial measure defined as income before income taxes excluding net investment income, net realized and unrealized gains and losses on investments and interest expense. See “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of income before income taxes in accordance with GAAP to underwriting income. Adjusted net income is a non-GAAP financial measure defined as net income excluding the impact of certain items that may not be indicative of underlying business trends, operating results, or future outlook, net of tax impact. We calculate the tax impact only on adjustments which would be included in calculating our income tax expense using the effective tax rate at the end of each period. See “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of net income in accordance with GAAP to adjusted net income. Return on equity is net income expressed on an annualized basis as a percentage of average beginning and ending stockholders’ equity during the period. Adjusted return on equity is a non-GAAP financial measure defined as adjusted net income expressed on an annualized basis as a percentage of average beginning and ending stockholders’ equity during the period. See “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of return on equity in accordance with GAAP to adjusted return on equity. Loss ratio, expressed as a percentage, is the ratio of losses and loss adjustment expenses, to net earned premiums. Expense ratio, expressed as a percentage, is the ratio of acquisition and other underwriting expenses, net of commission and other income to net earned premiums. Combined ratio is defined as the sum of the loss ratio and the expense ratio. A combined ratio under 100% generally indicates an underwriting profit. A combined ratio over 100% generally indicates an underwriting loss. Adjusted combined ratio is a non-GAAP financial measure defined as the sum of the loss ratio and the expense ratio calculated excluding the impact of certain items that may not be indicative of underlying business trends, operating results, or future outlook. See “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of combined ratio in accordance with GAAP to adjusted combined ratio. Diluted adjusted earnings per share - is a non-GAAP financial measure defined as adjusted net income divided by the weighted-average common shares outstanding for the period, reflecting the dilution which could occur if equity-based awards are converted into common share equivalents as calculated using the treasury stock method. See “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of diluted earnings per share in accordance with GAAP to diluted adjusted earnings per share. Tangible stockholders’ equity is a non-GAAP financial measure defined as stockholders’ equity less intangible assets. See “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of stockholders’ equity in accordance with GAAP to tangible stockholders’ equity. Results of Operations Year ended December 31, 2019 compared to year ended December 31, 2018 The following table summarizes our results for the years ended December 31, 2019 and 2018: (1) Indicates non-GAAP financial measure; see “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of the non-GAAP financial measures to their most directly comparable financial measures prepared in accordance with GAAP. Gross Written Premiums Gross written premiums were $252.0 million for the year ended December 31, 2019 compared to $154.9 million for the year ended December 31, 2018, an increase of $97.1 million, or 62.7%. Premium growth was primarily due to an increased volume of policies written across our lines of business which was driven by new business generated with existing partners, strong premium retention rates for existing business, expansion of our products’ geographic and distribution footprint, and new partnerships. The changes in gross written premiums were most notable in the following lines of business: · Residential Earthquake, which represented approximately 51.8% of our gross written premiums for the year ended December 31, 2019, increased by $48.8 million, or 59.7%, for the year ended December 31, 2019 compared to the same period in the prior year. Approximately $19.4 million of this increase was due to a new partnership with a homeowners carrier in which we assumed $6.6 million of unearned premiums and wrote an additional $12.8 million in premiums. · Commercial Earthquake, which represented approximately 15.4% of our gross written premiums for the year ended December 31, 2019, increased by $17.8 million, or 85.0%, for the year ended December 31, 2019 compared to the same period in the prior year. · Specialty Homeowners, which represented approximately 13.0% of our gross written premiums for the year ended December 31, 2019, increased by $5.1 million, or 18.5%, for the year ended December 31, 2019 compared to the same period in the prior year. · Commercial All Risk, which represented approximately 12.0% of our gross written premiums for the year ended December 31, 2019, increased by $16.0 million, or 111.7%, for the year ended December 31, 2019 compared to the same period in the prior year. · Hawaii Hurricane, which represented approximately 4.3% of our gross written premiums for the year ended December 31, 2019, increased by $2.6 million or 32.4%, for the year ended December 31, 2019 compared to the same period in the prior year. · Residential Flood, which represented approximately 2.1% of our gross written premiums for the year ended December 31, 2019 increased by $3.1 million or 146.0%, for the year ended December 31, 2019 compared to the same period in the prior year. Ceded Written Premiums Ceded written premiums increased $25.4 million, or 30.6%, to $108.3 million for the year ended December 31, 2019 from $82.9 million for the year ended December 31, 2018. The increase was primarily due to increased cessions to new quota share reinsurance partners in our Commercial All Risk line. We also incurred increased excess of loss reinsurance expense commensurate with growth in exposure. Ceded written premiums as a percentage of gross written premiums decreased to 43.0% for the year ended December 31, 2019 from 53.6% for the year ended December 31, 2018. The cession percentage was higher in the prior year due to an $11.8 million transfer of unearned premiums in June 2018 related to our entering into a fronting arrangement in our Specialty Homeowners line in the state of Texas. This fronting arrangement terminated in June 2019 in conjunction with the inception of our Specialty Homeowners Facility (“SHF”). Net Written Premiums Net written premiums increased $71.7 million, or 99.6%, to $143.6 million for the year ended December 31, 2019 from $71.9 million for the year ended December 31, 2018. The increase was primarily due to higher gross written premiums, primarily in our residential earthquake, commercial earthquake and commercial all risk lines, offset by increased ceded written premiums. Net Earned Premiums Net earned premiums increased $30.3 million, or 43.4%, to $100.2 million for the year ended December 31, 2019 from $69.9 million for the year ended December 31, 2018 due primarily to the earned portion of the higher gross written premiums offset by the earned portion of the higher ceded written premiums under reinsurance agreements. The table below shows the amount of premiums we earned on a gross and net basis for each period presented: Commission and Other Income Commission and other income increased $0.3 million, or 11.1%, to $2.7 million for the year ended December 31, 2019 from $2.4 million for the year ended December 31, 2018 due primarily to an increase in policy related fees associated with an increased volume of premiums written. Losses and Loss Adjustment Expenses Losses and loss adjustment expenses decreased $0.7 million, or 10.9%, to $5.6 million for the year ended December 31, 2019 from $6.3 million for the year ended December 31, 2018. During the year ended December 31, 2019, losses were primarily attributable to windstorm exposure in Japan through our assumed reinsurance portfolio and attritional losses in our commercial all risk and specialty homeowners lines of business. During the year ended December 31, 2018, losses were primarily attributable to attritional losses in our commercial all risk and specialty homeowners lines of business. Losses decreased during the year ended December 31, 2019 due to a reduction in the severity of weather-related losses. We incurred a loss of $5 million from Hurricane Florence during the year ended December 31, 2018. Acquisition Expenses Acquisition expenses increased $9.1 million, or 32.0%, to $37.3 million for the year ended December 31, 2019 from $28.2 million for the year ended December 31, 2018. The primary reason for the increase was higher earned premiums which resulted in higher commissions and premium-related taxes. Acquisition expenses as a percentage of gross earned premiums were 18.6% for the year ended December 31, 2019 compared to 20.5% for the year ended December 31, 2018. Acquisition expenses as a percentage of gross earned premiums decreased due to higher earned ceding commissions related to our Specialty Homeowners and Commercial All Risk lines. Other Underwriting Expenses Other underwriting expenses increased $33.3 million, or 185.7%, to $51.3 million for the year ended December 31, 2019 from $18.0 million for the year ended December 31, 2018. During the year ended December 31, 2019, we incurred increased payroll, professional fees, technology expenses, stock-based compensation and other expenses necessary to support our growth. During the year ended December 31, 2019, other underwriting expenses included a stock compensation charge of $23.0 million related to the modification of our former parent company’s management incentive plan, $0.4 million of expenses associated with our IPO and tax restructuring, a $0.9 million charge related to the write-off of debt amortization costs upon redemption of our Floating Rate Notes, and $2.6 million of expenses from one-time incentive cash bonuses triggered by the September 2019 Secondary Offering and expenses associated with both Secondary Offerings. During the year ended December 31, 2018, other underwriting expenses included $1.1 million of expenses associated with our IPO and tax restructuring and $0.5 million of expenses related to the repayment of our surplus notes in September 2018. Other underwriting expenses as a percentage of gross earned premiums were 25.6% for the year ended December 31, 2019 compared to 13.0% for the year ended December 31, 2018. Excluding the impact of expenses relating to our IPO, tax restructuring, Secondary Offerings, one-time incentive cash bonuses, stock-based compensation and retirement of debt, other underwriting expenses as a percentage of gross earned premiums were 11.6% for the year ended December 31, 2019 compared to 12.0% for the year ended December 31, 2018. Interest Expense Interest expense decreased $1.2 million, or 53.6%, to $1.1 million for the year ended December 31, 2019 from $2.3 million for the year ended December 31, 2018. Interest expense decreased as we redeemed our Floating Rate Notes in May 2019 and did not have any long-term debt after May 2019 whereas we had outstanding surplus notes and Floating Rate Notes during the entire year ended December 31, 2018. In addition, interest expense for the year ended December 31, 2019 includes a $0.4 million charge incurred upon redemption of our Floating Rate Notes in May 2019. Interest expense for the year ended December 31, 2018 includes a $0.1 million charge incurred upon repayment of our surplus notes in September 2018. Net Investment Income and Net Realized and Unrealized Gains (Losses) on Investments Net investment income increased $2.8 million, or 84.5%, to $6.0 million for the year ended December 31, 2019 from $3.2 million for the year ended December 31, 2018. The increase was primarily due to a higher average balance of investments during the year ended December 31, 2019 due primarily to proceeds from our IPO which were received in April 2019. Net realized and unrealized gains on investments increased $7.0 million, to a $4.4 million gain for the year ended December 31, 2019 from a $2.6 million loss for the year ended December 31, 2018. The primary reason for the increase was an improvement in the performance of our equity securities during the year ended December 31, 2019 compared to the year ended December 31, 2018. We mainly invest in investment grade fixed maturity securities, including U.S. government issues, state government issues, mortgage and asset-backed obligations, and corporate bonds with the remainder of investments in equity securities. Our equity securities are comprised of mutual funds that provide exposure to the U.S. investment grade bond market. The following table summarizes the components of our investment income for each period presented: Income Tax Expense (Benefit) Income tax expense increased to $7.5 million for the year ended December 31, 2019 from an immaterial amount for the year ended December 31, 2018 as a result of positive taxable income during the year ended December 31, 2019 occurring after our U.S. domestication in March 2019 partially offset by the benefit from the reduction of the valuation allowance on our federal deferred tax assets. We are subject to income taxes in certain jurisdictions in which we operate. Our U.S. subsidiaries are subject to federal and state income taxes. We earn income in Bermuda, a non-taxable jurisdiction, primarily as a result of quota share reinsurance agreements between our U.S. insurance subsidiary and PSRE, and the investment income earned in PSRE. Prior to July 1, 2019, our U.S. insurance subsidiary and PSRE were subject to a quota share reinsurance agreement under which the U.S. insurance subsidiary ceded 50% of the earthquake and Hawaii hurricane gross premiums earned as well as losses and loss adjustment expenses to PSRE in exchange for a 25% ceding commission. As a result of our multinational operations our effective tax rate has historically been below that of a fully U.S. based operation. All of our operations became subject to U.S. income tax in 2019 as a result of our domestication to the United States. Year ended December 31, 2018 compared to year ended December 31, 2017 The following table summarizes our results for the years ended December 31, 2018 and 2017: (1) Indicates non-GAAP financial measure; see “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of the non-GAAP financial measures to their most directly comparable financial measures prepared in accordance with GAAP. Gross Written Premiums Gross written premiums were $154.9 million for the year ended December 31, 2018 compared to $120.2 million for the year ended December 31, 2017, an increase of $34.7 million, or 28.8%. Premium growth in 2018 was due primarily to an increased volume of policies written across our lines of business which was driven by expansion of our product, geographic and distribution footprint as well as strong premium retention rates for our existing book of business. The changes in gross written premiums were most notable in the following lines of business: · Residential Earthquake, which represented approximately 52.7% of our gross written premiums in 2018, increased by $24.4 million, or 42.5%, for the year ended December 31, 2018 over the prior year. · Specialty Homeowners, which represented approximately 17.9% of our gross written premiums in 2018, increased by $1.2 million, or 4.4%, for the year ended December 31, 2018 over the prior year. · Commercial Earthquake, which represented approximately 13.5% of our gross written premiums in 2018, decreased by $2.1 million, or 9.2%, for the year ended December 31, 2018 over the prior year. · Commercial All Risk, which represented approximately 9.3% of our gross written premiums in 2018, increased by $7.0 million, or 95.8%, for the year ended December 31, 2018 over the prior year. · Hawaii Hurricane, which represented approximately 5.2% of our gross written premiums in 2018, increased by $2.8 million or 52.7%, for the year ended December 31, 2018 over the prior year. Ceded Written Premiums Ceded written premiums increased $36.0 million, or 76.7%, to $82.9 million for the year ended December 31, 2018 from $46.9 million for the year ended December 31, 2017. The increase was primarily due to increased excess of loss reinsurance cost due to higher exposure from the growth of our portfolio, as well as increased ceding of written premium related to our Specialty Homeowners operations in the state of Texas. As of June 2018, we act as a fronting carrier for these operations and cede substantially all of the risk and premium in exchange for a fronting fee. Ceded written premiums as a percentage of gross written premiums increased to 53.6% for the year ended December 31, 2018 from 39.0% for the year ended December 31, 2017. Net Written Premiums Net written premiums decreased $1.3 million, or 1.8%, to $71.9 million for the year ended December 31, 2018 from $73.3 million for the year ended December 31, 2017. The decrease was primarily due to higher ceded written premiums under reinsurance agreements. Net Earned Premiums Net earned premiums increased $14.4 million, or 25.8%, to $69.9 million for the year ended December 31, 2018 from $55.5 million for the year ended December 31, 2017 due primarily to the earned portion of the higher gross written premiums described above offset by the earned portion of the higher ceded written premiums described above under reinsurance agreements for the year ended December 31, 2018. The below table shows the amount of premiums we earned on a gross and net basis: Commission and Other Income Commission and other income increased $1.2 million, or 102.4%, to $2.4 million for the year ended December 31, 2018 from $1.2 million for the year ended December 31, 2017 due primarily to an increase in the volume of REI policies written and resulting increase in associated commission income. Losses and Loss Adjustment Expenses Losses and loss adjustment expenses decreased $5.9 million, or 48.3%, to $6.3 million for the year ended December 31, 2018 from $12.1 million for the year ended December 31, 2017. The decrease primarily relates to lower losses, and favorable prior year loss development, net of reinsurance, during 2018 versus 2017. We incurred $6.5 million of loss due to Hurricane Harvey in 2017. This event increased our loss ratio by 11.7% for the year end December 31, 2017. Acquisition Expenses Acquisition expenses increased $2.7 million, or 10.6%, to $28.2 million for the year ended December 31, 2018 from $25.5 million for the year ended December 31, 2017. The primary reason for the increase was due to higher earned premiums offset by higher earned ceding commissions on ceded business, as well as a change in the overall mix of business produced. Acquisition expenses as a percentage of gross earned premiums were 20.5% for the year ended December 31, 2018 and 25.3% for the year ended December 31, 2017. Other Underwriting Expenses Other underwriting expenses increased $2.8 million, or 18.6%, to $17.9 million for the year ended December 31, 2018 from $15.1 million for the year ended December 31, 2017. The increase was primarily due to increased staffing, professional fees and other expenses necessary to support our growth. Other underwriting expenses as a percentage of gross earned premiums were 13.0% for the year ended December 31, 2018 and 15.0% for the year ended December 31, 2017. Interest Expense Interest expense increased $0.6 million, or 32.0%, to $2.3 million for the year ended December 31, 2018 from $1.7 million for the year ended December 31, 2017. The increase was primarily due to $0.5 million in charges associated with paying off the Surplus Note in September 2018. Net Investment Income and Net Realized and Unrealized Gains (Losses) on Investments Net investment income increased $1.1 million, or 52.4%, to $3.2 million for the year ended December 31, 2018 from $2.1 million for the year ended December 31, 2017. The primary reason for the increase was a higher average balance of investments during the year ended December 31, 2018. Net realized and unrealized gains on investments decreased $3.2 million, or 52.3%, to a $2.5 million loss for the year ended December 31, 2018 from a gain of $0.6 million for the year ended December 31, 2017. The primary reason for the decrease was $6.0 million of unrealized losses on equity securities offset by $3.5 million of net realized investment gains during the year. We mainly invest in investment grade fixed maturity securities, including U.S. government issues, state government issues, mortgage and asset-backed obligations, and corporate bonds with the remainder of investments in equity securities. The following table summarizes the components of our investment income for the years ended December 31, 2018 and 2017: Income Tax (Benefit) Expense Income tax (benefit) expense decreased $1.1 million to an immaterial benefit for the year ended December 31, 2018 from a $1.1 million expense for the year ended December 31, 2017. Income tax expense was higher in the prior year primarily due to the recognition of a $0.9 million valuation allowance on deferred tax assets in 2017. We recorded a valuation allowance in 2017 due to 3-year cumulative losses and a large catastrophe event during 2017. We increased the valuation allowance by $0.7 million in 2018 due to an increase in net deferred tax assets. The amount of our deferred tax assets considered realizable could be adjusted if estimates of future taxable income during the carryforward period are increased or if objective negative evidence in the form of cumulative losses is no longer present. We are subject to income taxes in certain jurisdictions in which we operate. We generate taxable income in our U.S. subsidiaries. We earn income in Bermuda, a non-taxable jurisdiction, primarily as a result of quota share reinsurance agreements between our U.S. insurance subsidiary and Palomar Re, and the investment income earned in Palomar Re. Effective January 1, 2016, our U.S. insurance subsidiary and Palomar Re entered into a quota share reinsurance agreement under which the U.S. insurance subsidiary ceded 35% of the earthquake gross premiums earned as well as losses and loss adjustment expenses to Palomar Re in exchange for a 20% ceding commission. Effective January 1, 2017, the agreement was amended and the cession was decreased to 26.5% with a 25% ceding commission. Effective September 1, 2017, the agreement was amended and the cession was decreased to 0%. Effective January 1, 2018, the agreement was amended, the cession was increased to 50%, and the Hawaii Hurricane gross premiums earned and losses and loss adjustment expenses were added to the lines of business. As a result of our multinational operations our effective tax rate is currently below that of a fully U.S. based operation. Following the domestication transactions, we expect that all of our income will be subject to U.S. income tax. Reconciliation of Non-GAAP Financial Measures Underwriting Revenue We define underwriting revenue as total revenue excluding net investment income and net realized and unrealized gains and losses on investments. Underwriting revenue represents revenue generated by our underwriting operations and allows us to evaluate our underwriting performance without regard to investment income. We use this metric as we believe it gives our management and other users of our financial information useful insight into our underlying business performance. Underwriting revenue should not be viewed as a substitute for total revenue calculated in accordance with GAAP, and other companies may define underwriting revenue differently. Underwriting Income We define underwriting income as income before income taxes excluding net investment income, net realized and unrealized gains and losses on investments, and interest expense. Underwriting income represents the pre-tax profitability of our underwriting operations and allows us to evaluate our underwriting performance without regard to investment income. We use this metric as we believe it gives our management and other users of our financial information useful insight into our underlying business performance. Underwriting income should not be viewed as a substitute for pre-tax income calculated in accordance with GAAP, and other companies may define underwriting income differently. Adjusted Net Income We define adjusted net income as net income excluding the impact of certain items that may not be indicative of underlying business trends, operating results, or future outlook, net of tax impact. We calculate the tax impact only on adjustments which would be included in calculating our income tax expense using the effective tax rate at the end of each period. We use adjusted net income as an internal performance measure in the management of our operations because we believe it gives our management and other users of our financial information useful insight into our results of operations and our underlying business performance. Adjusted net income should not be viewed as a substitute for net income calculated in accordance with GAAP, and other companies may define adjusted net income differently. Adjusted Return on Equity We define adjusted return on equity as adjusted net income expressed on an annualized basis as a percentage of average beginning and ending stockholders’ equity during the period. We use adjusted return on equity as an internal performance measure in the management of our operations because we believe it gives our management and other users of our financial information useful insight into our results of operations and our underlying business performance. Adjusted return on equity should not be viewed as a substitute for return on equity calculated in accordance with GAAP, and other companies may define adjusted return on equity differently. Adjusted Combined Ratio We define adjusted combined ratio as the sum of the loss ratio and the expense ratio calculated excluding the impact of certain items that may not be indicative of underlying business trends, operating results, or future outlook. We use adjusted combined ratio as an internal performance measure in the management of our operations because we believe it gives our management and other users of our financial information useful insight into our results of operations and our underlying business performance. Adjusted combined ratio should not be viewed as a substitute for combined ratio calculated in accordance with GAAP, and other companies may define adjusted combined ratio differently. Diluted adjusted earnings per share We define diluted adjusted earnings per share as adjusted net income divided by the weighted-average common shares outstanding for the period, reflecting the dilution which could occur if equity-based awards are converted into common share equivalents as calculated using the treasury stock method. We use diluted adjusted earnings per share as an internal performance measure in the management of our operations because we believe it gives our management and other users of our financial information useful insight into our results of operations and our underlying business performance. Diluted adjusted earnings per share should not be viewed as a substitute for diluted earnings per share calculated in accordance with GAAP, and other companies may define diluted adjusted earnings per share differently. Tangible Stockholders’ Equity We define tangible stockholders’ equity as stockholders’ equity less intangible assets. Our definition of tangible stockholders’ equity may not be comparable to that of other companies, and it should not be viewed as a substitute for stockholders’ equity calculated in accordance with GAAP. We use tangible stockholders’ equity internally to evaluate the strength of our balance sheet and to compare returns relative to this measure. Liquidity and Capital Resources Sources and Uses of Funds We operate as a holding company with no business operations of our own. Consequently, our ability to pay dividends to stockholders and pay taxes and administrative expenses is largely dependent on dividends or other distributions from our subsidiaries and affiliates, whose ability to pay us is highly regulated. Our U.S. insurance company subsidiary is restricted by statute as to the amount of dividends that it may pay without the prior approval of the Oregon and California Insurance Commissioners. Generally, insurers may pay dividends without advance regulatory approval only from earned surplus and only to the extent that all dividends paid in the twelve months ending on the date of the proposed dividend do not exceed the greater of (i) 10% of their policyholders’ surplus as of December 31 of the preceding year or (ii) 100% of their net income (excluding realized investment gains or losses) for the calendar year preceding the year in which the value is being determined. In addition, a domestic insurer may only declare a dividend from earned surplus, which does not include surplus arising from unrealized capital gains or revaluation of assets. A domestic insurer may declare a dividend from other than earned surplus only if the Insurance Commissioner approves the declaration prior to payment of the dividend. Our U.S. insurance company subsidiary may pay a dividend or distribution no greater than $10.3 million to us in 2020 without the prior approval of the Oregon and California Insurance Commissioners due to our U.S. Insurance Company Subsidiary’s earned surplus of $10.3 million as of December 31, 2019. In addition, there is no assurance that dividends of the maximum amount calculated under any applicable formula would be permitted by state insurance regulators. In the future, state insurance regulatory authorities may adopt statutory provisions more restrictive than those currently in effect. Insurance companies in the United States are also required by state law to maintain a minimum level of policyholder’s surplus. Oregon and California’s state insurance regulators have a risk-based capital standard designed to identify property and casualty insurers that may be inadequately capitalized based on inherent risks of the insurer’s assets and liabilities and its mix of net written premium. Insurers falling below a calculated threshold may be subject to varying degrees of regulatory action. As of December 31, 2019 and December 31, 2018, the total adjusted capital of our U.S. insurance subsidiary was in excess of its respective prescribed risk-based capital requirements. Under the Insurance Act and related regulations, our Bermuda reinsurance subsidiary is required to maintain certain solvency and liquidity levels, which it maintained as of December 31, 2019 and December 31, 2018. Our Bermuda reinsurance subsidiary maintains a Class 3A license and thus must maintain a minimum liquidity ratio in which the value of its relevant assets is not less than 75% of the amount of its relevant liabilities for general business. Relevant assets include cash and cash equivalents, fixed maturity securities, accrued interest income, premiums receivable, losses recoverable from reinsurers, and funds withheld. The relevant liabilities include total general business insurance reserves and total other liabilities, less sundry liabilities. As of December 31, 2019 and December 31, 2018, we met the minimum liquidity ratio requirement. Bermuda regulations limit the amount of dividends and return of capital paid by a regulated entity. A Class 3A insurer is prohibited from declaring or paying a dividend if it is in breach of its minimum solvency margin, its enhanced capital requirement, or its minimum liquidity ratio, or if the declaration or payment of such dividend would cause such a breach. If a Class 3A insurer has failed to meet its minimum solvency margin on the last day of any financial year, it will also be prohibited, without the approval of the BMA, from declaring or paying any dividends during the next financial year. Furthermore, the Insurance Act limits the ability of our Bermuda reinsurance subsidiary to pay dividends or make capital distributions by stipulating certain margin and solvency requirements and by requiring approval from the BMA prior to a reduction of 15% or more of a Class 3A insurer’s total statutory capital as reported on its prior year statutory balance sheet. Moreover, an insurer must submit an affidavit to the BMA, sworn by at least two directors and the principal representative in Bermuda of the Class 3A insurer, at least seven days prior to payment of any dividend which would exceed 25% of that insurer’s total statutory capital and surplus as reported on its prior year statutory balance sheet. The affidavit must state that in the opinion of those swearing the declaration of such dividend has not caused the insurer to fail to meet its relevant margins. Further, under the Companies Act, our Bermuda reinsurance subsidiary may only declare or pay a dividend, or make a distribution out of contributed surplus, if it has no reasonable grounds for believing that: (1) it is, or would after the payment be, unable to pay its liabilities as they become due or (2) the realizable value of its assets would be less than its liabilities. Pursuant to Bermuda regulations, the maximum amount of dividends and return of capital available to be paid by a reinsurer is determined pursuant to a formula. Under this formula, the maximum amount of dividends and return of capital available from our Bermuda subsidiary during 2020 is calculated to be approximately $5.7 million. However, this dividend amount is subject to annual enhanced solvency requirement calculations. During 2018, our Bermuda subsidiary paid $13.7 million in dividends to the Company, which were approved by the Bermuda Monetary Authority. There were no dividends approved or paid in 2019. Cash Flows Our primary sources of cash flow are written premiums, investment income, reinsurance recoveries, sales and redemptions of investments, and proceeds from offerings of debt and equity securities. We use our cash flows primarily to pay operating expenses, losses and loss adjustment expenses, and income taxes. Our cash flows from operations may differ substantially from our net income due to non-cash charges or due to changes in balance sheet accounts. The timing of our cash flows from operating activities can also vary among periods due to the timing by which payments are made or received. Some of our payments and receipts, including loss settlements and subsequent reinsurance receipts, can be significant. Therefore, their timing can influence cash flows from operating activities in any given period. The potential for a large claim under an insurance or reinsurance contract means that our insurance subsidiaries may need to make substantial payments within relatively short periods of time, which would have a negative impact on our operating cash flows. We generated positive cash flows from operations for each of the years ended December 31, 2019, 2018 and 2017. Management believes that cash receipts from premium, proceeds from investment sales and redemptions, and investment income and reinsurance recoveries, if necessary, are sufficient to cover cash outflows in the foreseeable future. The following table summarizes our cash flows for the years ended December 31, 2019, 2018 and 2017: Our cash flow from operating activities has been positive in each of the last three years. Variations in operating cash flow between periods are primarily driven by variations in our gross and ceded written premiums and the volume and timing of premium receipts, claim payments, and reinsurance payments. In addition, fluctuations in losses and loss adjustment expenses and other insurance operating expenses impact operating cash flow. Cash used in investing activities for each of the last three years related primarily to purchases of fixed income and equity securities in excess of sales and maturities. Cash provided by financing activities for the year ended December 31, 2019 was related to the receipt of $87.4 million in net proceeds from our IPO in April 2019, offset by $20.0 million of cash paid to redeem our Floating Rate Notes in May 2019 and a one-time cash distribution of $5.1 million to our then sole stockholder, GC Palomar Investor LP in March 2019. Cash provided by financing activities in 2018 was related to the issuance of Floating Rate Notes and the payoff of surplus notes in September 2018. There was no cash flow from financing activities in 2017. We do not have any current plans for material capital expenditures other than current operating requirements. We believe that we will generate sufficient cash flows from operations to satisfy our liquidity requirements for at least the next 12 months and beyond. The key factor that will affect our future operating cash flows is the frequency and severity of catastrophic loss events. To the extent our future operating cash flows are insufficient to cover our net losses from catastrophic events, we had $272.8 million in cash and investment securities available at December 31, 2019. We also have the ability to access additional capital through pursuing third-party borrowings, sales of our equity or debt securities or entrance into a reinsurance arrangement. Notes Payable Surplus Notes Prior to September 2018, the Company had $17.5 million in outstanding surplus notes which had been issued by PSIC on February 3, 2015 for a term of seven years. The surplus notes bore interest at the rate of LIBOR plus 8.00% and had restrictions as to payments of interest and principal. Any such payments required the prior approval of the Oregon Insurance Commissioners before such payments could be made. Such payments could only be made from surplus. Floating Rate Notes In September 2018, the Company completed a private placement financing of $20.0 million floating rate senior secured notes (the “Floating Rate Notes”), bearing interest at the three-month treasury rate plus 6.50% per annum. As part of the financing agreement, the Company immediately used surplus funds to pay down the existing $17.5 million in surplus notes. As part of this pre-payment, the Company incurred a penalty of $0.1 million which, along with unamortized debt issuance costs of $0.4 million, was charged to income in 2018. The Floating Rate Notes were redeemed pursuant to their terms on May 23, 2019, at a redemption price equal to 102% of the principal amount of the Floating Rate Notes, or $20.4 million (plus $0.3 million of accrued and unpaid interest thereon). The Company recognized a charge of $1.3 million upon redemption with $0.4 million due to the redemption premium and $0.9 million due to the write-off of unamortized debt issuance costs. The $0.4 million redemption premium was recognized as a component of interest expense and the $0.9 million issuance cost write-off was recognized as a component of other underwriting expenses in the Company’s consolidated statements of income and comprehensive income. The Company incurred $1.1 million in interest expense related to the Floating Rate Notes for the year ended December 31, 2019 (inclusive of the $0.4 million redemption premium) and $0.6 million for the year ended December 31, 2018 and paid $1.2 million and $0.5 million for each period, respectively. The Company incurred $1.2 million and $1.6 million in interest expense related to the surplus notes for the year ended December 31, 2018 and 2017, respectively and paid $1.2 million and $1.6 million in each period, respectively. Contractual Obligations and Commitments The following table illustrates our contractual obligations and commercial commitments by due date as of December 31, 2019: The reserve for losses and loss adjustment expenses represent management’s estimate of the ultimate cost of settling losses. As more fully discussed in “-Critical Accounting Policies-Reserve for Losses and Loss Adjustment Expenses” below, the estimation of the reserve for losses and loss adjustment expenses is based on various complex and subjective judgments. Actual losses paid may differ, perhaps significantly, from the reserve estimates reflected in our consolidated financial statements. Similarly, the timing of payment of our estimated losses is not fixed and there may be significant changes in actual payment activity. The assumptions used in estimating the likely payments due by period are based on our historical claims payment experience and industry payment patterns, but due to the inherent uncertainty in the process of estimating the timing of such payments, there is a risk that the amounts paid can be significantly different from the amounts disclosed above. The amounts in the above table represent our gross estimates of known liabilities as of December 31, 2019 and do not include any allowance for claims for future events within the time period specified. Accordingly, it is highly likely that the total amounts of obligations paid by us in the time periods shown will be greater than those indicated in the table. Financial Condition Stockholders’ Equity At December 31, 2019 total stockholders’ equity was $218.6 million and tangible stockholders’ equity was $217.8 million, compared to total stockholders’ equity of $96.3 million and tangible stockholders’ equity of $95.5 million as of December 31, 2018. Stockholders’ equity increased for the year ended December 31, 2019 primarily due to the receipt of $87.4 million in net proceeds from our IPO. Stockholders’ equity also increased due to $24.1 million stock-based compensation expense, which was treated as additional paid in capital. In addition, stockholder’s equity increased due to $10.6 of net income and $5.2 million of unrealized gain on fixed maturity investments. These items were offset by a $5.1 million cash distribution to our principal stockholder. Tangible stockholders’ equity is a non-GAAP financial measure. See “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of stockholders’ equity in accordance with GAAP to tangible stockholders’ equity. Investment Portfolio Our primary investment objectives are to maintain liquidity, preserve capital and generate a stable level of investment income. We purchase securities that we believe are attractive on a relative value basis and seek to generate returns in excess of predetermined benchmarks. Our Board of Directors approves our investment guidelines in compliance with applicable regulatory restrictions on asset type, quality and concentration. Our current investment guidelines allow us to invest in taxable and tax-exempt fixed maturities, as well as publicly traded mutual funds and common stock of individual companies. Our cash and invested assets consist of cash and cash equivalents, fixed maturity securities, and equity securities. As of December 31, 2019, the majority of our investment portfolio, or $217.2 million, was comprised of fixed maturity securities that are classified as available-for-sale and carried at fair value with unrealized gains and losses on these securities, net of applicable taxes, reported as a separate component of accumulated other comprehensive income. Also included in our investment portfolio were $22.3 million of equity securities, primarily comprised of mutual funds that provide exposure to the U.S. investment-grade bond market. In addition, we maintained a non-restricted cash and cash equivalent balance of $33.1 million at December 31,2019. Our fixed maturity securities, including cash equivalents, had a weighted average effective duration of 3.49 and 3.93 years and an average rating of A1/A+ and “Aa3/AA−” at December 31, 2019 and December 31, 2018, respectively. Our fixed income investment portfolio had a book yield of 2.9% as of December 31, 2019, compared to 3.0% as of December 31, 2018. At December 31, 2019 and December 31, 2018 the amortized cost and fair value on available-for-sale securities were as follows: The following tables provide the credit quality of investment securities as of December 31, 2019 and December 31, 2018: The amortized cost and fair value of our available-for-sale investments in fixed maturity securities summarized by contractual maturity as of December 31, 2019 were as follows: Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations. See “Critical Accounting Policies and Estimates- Investment Valuation and Impairment” for discussion of investment valuation and impairment considerations. Critical Accounting Policies and Estimates We identified the accounting estimates below as critical to the understanding of our financial position and results of operations. Critical accounting estimates are defined as those estimates that are both important to the portrayal of our financial condition and results of operations and which require us to exercise significant judgment. We use significant judgment concerning future results and developments in applying these critical accounting estimates and in preparing our consolidated financial statements. These judgments and estimates affect the reported amounts of assets, liabilities, revenue and expenses and the disclosure of material contingent assets and liabilities. Actual results may differ materially from the estimates and assumptions used in preparing the consolidated financial statements. We evaluate our estimates regularly using information that we believe to be relevant. For a detailed discussion of our accounting policies, see the Notes to Consolidated Financial Statements included in this Annual Report on Form 10-K. Reserve for Losses and Loss Adjustment Expenses The reserve for losses and loss adjustment expenses represents our estimated ultimate cost of all reported and unreported losses and loss adjustment expenses incurred and unpaid at the balance sheet date. We do not discount this reserve. We seek to establish reserves that will ultimately prove to be adequate. We categorize our reserves for unpaid losses and loss adjustment expenses into two types: case reserves and reserves for incurred but not yet reported losses (“IBNR”). Through our TPAs, we generally are notified of losses by our insureds or their agents or brokers. Based on the information provided by the TPAs, we establish initial case reserves by estimating the ultimate losses from the claim, including administrative costs associated with the ultimate settlement of the claim. Our claims department personnel use their knowledge of the specific claim along with internal and external experts, including underwriters and legal counsel, to estimate the expected ultimate losses. With the assistance of an independent, actuarial firm, we also use statistical analysis to estimate the cost of losses and loss adjustment expenses related to IBNR. Those estimates are based on our historical information, industry information and estimates of trends that may affect the ultimate frequency of incurred but not reported claims and changes in ultimate claims severity. We regularly review our reserve estimates and adjust them as necessary as experience develops or as new information becomes known to us. Such adjustments are included in current operations. During the loss settlement period, if we have indications that claims frequency or severity exceeds our initial expectations, we generally increase our reserves for losses and loss adjustment expenses. Conversely, when claims frequency and severity trends are more favorable than initially anticipated, we generally reduce our reserves for losses and loss adjustment expenses once we have sufficient data to confirm the validity of the favorable trends. Even after such adjustments, the ultimate liability may exceed or be less than the revised estimates. Accordingly, the ultimate settlement of losses and the related loss adjustment expenses may vary significantly from the estimate included in our consolidated financial statements. The following tables summarize our gross and net reserves for unpaid losses and loss adjustment expenses at December 31, 2019 and 2018. The process of estimating the reserves for losses and loss adjustment expenses requires a high degree of judgment and is subject to several variables. On a quarterly basis, we perform an analysis of our loss development and select the expected ultimate loss ratio for each of our product lines by accident year. In our actuarial analysis, we use input from our TPAs and our underwriting and claims departments, including premium pricing assumptions and historical experience. Multiple actuarial methods are used to estimate the reserve for losses and loss adjustment expenses. These methods utilize, to varying degrees, the initial expected loss ratio, detailed statistical analysis of past claims reporting and payment patterns, claims frequency and severity, paid loss experience, industry loss experience, and changes in market conditions, policy forms, exclusions, and exposures. The actuarial methods used to estimate loss and loss adjustment expenses reserves are: · Reported and/or Paid Loss Development Methods-Ultimate losses are estimated based on historical reported and/or paid loss reporting patterns. Reported losses are the sum of paid and case losses. Industry development patterns are substituted for historical development patterns when sufficient historical data is not available. · Reported Bornhuetter-Ferguson Severity Method-Under this method, ultimate losses are estimated as the sum of cumulative reported losses and estimated IBNR losses. IBNR losses are estimated based on expected average severity, estimated ultimate claim counts and the historical development patterns of reported losses. · Paid Bornhuetter-Ferguson Pure Premium Method-Under this method, ultimate losses are estimated as the sum of cumulative reported losses and estimated IBNR losses. IBNR losses are estimated based on expected pure premium and on the historical development patterns of reported losses. The method(s) used vary based on the line of business and the loss event. Considering each of the alternative ultimate estimates, we select an estimate of ultimate loss for each line of business. For Earthquake and “Difference in Conditions” policies, more emphasis is placed on reported methods. For the remainder, a weighted average is selected. Loss Adjustment Expense reserves were estimated based on the ratio of paid loss adjustment expense to paid loss, which was estimated for Wellington, York (Commercial All Risk, DIC, Flood, Inland Marine -Builders Risk), and Cabrillo claims separately as well as split by hurricane and excluding hurricane. We then applied this ratio to our estimated unpaid loss, by multiplying the ratio times 50% of loss case reserves and 100% of loss IBNR reserves. This was applied by line of business and accident year to arrive at estimated unpaid loss adjustment expense on a gross basis. We then added the estimated unpaid loss adjustment expense on a gross basis to the paid loss adjustment expense to calculate estimated ultimate loss adjustment expense. On a quarterly basis, the Chief Executive Officer, President, Chief Risk Officer, Chief Financial Officer, Chief Accounting Officer, and Vice President Legal-Compliance & Claims, meet to review the recommendations made by the independent actuarial consultant and use their best judgment to determine the best estimate to be recorded for the reserve for losses and loss adjustment expenses on our balance sheet. Our reserves are driven by several important factors, including litigation and regulatory trends, legislative activity, climate change, social and economic patterns and claims inflation assumptions. Our reserve estimates reflect current inflation in legal claims’ settlements and assume we will not be subject to losses from significant new legal liability theories. Our reserve estimates assume that there will not be significant changes in the regulatory and legislative environment. The impact of potential changes in the regulatory or legislative environment is difficult to quantify in the absence of specific, significant new regulation or legislation. In the event of significant new regulation or legislation, we will attempt to quantify its impact on our business, but no assurance can be given that our attempt to quantify such inputs will be accurate or successful. The table below quantifies the impact of potential reserve deviations from our carried reserve at December 31, 2019. We applied sensitivity factors to incurred losses for the three most recent accident years and to the carried reserve for all prior accident years combined. We believe that potential changes such as these would not have a material impact on our liquidity. *Effective tax rate estimated to be 21% The amount by which estimated losses differ from those originally reported for a period is known as “development.” Development is unfavorable when the losses ultimately settle for more than the amount reserved or subsequent estimates indicate a basis for reserve increases on unresolved claims. Development is favorable when losses ultimately settle for less than the amount reserved, or subsequent estimates indicate a basis for reducing loss reserves on unresolved claims. We reflect favorable or unfavorable development of loss reserves in the results of operations in the period the estimates are changed. The following tables present the development of our loss reserves by accident year on a gross basis and net of reinsurance recoveries during each of the below calendar years: During the year ended December 31, 2019, our gross incurred losses for accident years 2018 and prior developed favorably by $1.0 million. This favorable development was due to reported losses emerging at a lower level than expected, primarily in our Specialty Homeowners business. The net favorable development of $0.2 million reflects the effect of our reinsurance program. During the year ended December 31, 2018, our gross incurred losses for accident years 2017 and prior developed favorably by $3.2 million. This favorable development was due to reported losses emerging at a lower level than expected, primarily in our Specialty Homeowners business. The net favorable development of $1.9 million reflects the effect of our reinsurance program. During the year ended December 31, 2017, our gross incurred losses for accident years 2016 and prior developed favorably by $1.0 million. This favorable development was due to reported losses emerging at a lower level than expected, primarily in our Specialty Homeowners business. The net favorable development of $0.1 million reflects the effect of our reinsurance program. Although we believe that our reserve estimates are reasonable, it is possible that our actual loss experience may not conform to our assumptions. Specifically, our actual ultimate loss ratio could differ from our initial expected loss ratio or our actual reporting and payment patterns could differ from our expected reporting and payment patterns, which are based on our own data and industry data. Accordingly, the ultimate settlement of losses and the related loss adjustment expenses may vary significantly from the estimates included in our financial statements. We regularly review our estimates and adjust them as necessary as experience develops or as new information becomes known to us. Such adjustments are included in the results of current operations. Investment Valuation and Impairment Fair value measurements We invest in a variety of investment grade fixed maturity securities, including U.S. government issues, state government issues, mortgage and asset-backed obligations, and corporate bonds. All of our investments in fixed maturity securities and equity securities are carried at fair value, defined as the price that we would receive upon selling an investment in an orderly transaction to an independent buyer in the principal or most advantageous market of the investment. Market participants are assumed to be independent, knowledgeable, able and willing to transact an exchange and not acting under duress. In our disclosure of the fair value of our investments, we utilize a hierarchy based on the quality of inputs used to measure 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). Adjustments to transaction prices or quoted market prices may be required in illiquid or disorderly markets in order to estimate fair value. The three levels of the fair value hierarchy are described below: Level 1-Unadjusted quoted prices are available in active markets for identical investments as of the reporting date. Level 2-Pricing inputs are quoted prices for similar investments in active markets; quoted prices for identical or similar investments in inactive markets; or valuations based on models where the significant inputs are observable or can be corroborated by observable market data. Level 3-Pricing inputs into models are unobservable for the investment. The unobservable inputs require significant management judgment or estimation. We use independent pricing sources to obtain the estimated fair values of investments. The fair value is based on quoted market prices, where available. In cases where quoted market prices are not available, the fair value is based on a variety of valuation techniques depending on the type of investment. The fair values obtained from independent pricing sources are reviewed for reasonableness and any discrepancies are investigated for final valuation. The fair value of our investments in fixed maturity securities is estimated using relevant inputs, including available market information, benchmark curves, benchmarking of like securities, sector groupings, and matrix pricing. An Option Adjusted Spread model is also used to develop prepayment and interest rate scenarios. These fair value measurements are estimated based on observable, objectively verifiable market information rather than market quotes; therefore, these investments are classified and disclosed in Level 2 of the hierarchy. The fair value of our investments in equity securities is based on quoted prices available in active markets and classified and disclosed in Level 1 of the hierarchy. Investment securities are subject to fluctuations in fair value due to changes in issuer-specific circumstances, such as credit rating, and changes in industry-specific circumstances, such as movements in credit spreads based on the market’s perception of industry risks. In addition, fixed maturities are subject to fluctuations in fair value due to changes in interest rates. As a result of these potential fluctuations, it is possible to have significant unrealized gains or losses on a security. Unrealized gains and losses on our fixed maturity securities are included in accumulated other comprehensive income as a separate component of total stockholders’ equity. Equity securities are carried at fair value with unrealized gains and losses included as a component of net income on the Company’s consolidated statement of income. Prior to 2018, unrealized gains and losses on equity securities were included in accumulated other comprehensive income as a separate component of stockholders’ equity. Impairment We review all securities with unrealized losses on a quarterly basis to assess whether the decline in the securities fair value is deemed to be other-than-temporary. This decision requires judgement and we consider the following factors in determining whether declines in the fair value of investments are other-than-temporary: · The significance of the decline in fair value compared to the cost basis; · The time period during which there has been a significant decline in fair value; · Whether the unrealized loss is credit-driven or a result of changes in market interest rates; · A fundamental analysis of the business prospects and financial condition of the issuer; · Our intent to sell the securities as of each reporting date; and · If we do not expect to recover the entire amortized cost basis or cost of the investment; Other-than-temporary declines in fair value of fixed maturity securities are evaluated for amounts considered credit losses by comparing the expected present value of cash flows to be collected to the amortized cost of the security. Once the amount of other-than-temporary impairment (“OTTI”) related to the credit loss is determined, the unrealized loss is then bifurcated into the credit-related loss and the loss related to all other factors. The credit-related OTTI loss is recognized as a realized loss in the statement of comprehensive income and the cost basis of the security is reduced. The OTTI related to other factors remain in accumulated other comprehensive income. Other-than-temporary declines in the fair value of equity securities are recorded as realized losses in the consolidated statement of comprehensive income and the cost basis of the security is reduced. In our review as of December 31, 2019 and 2018, we determined that, for fixed maturity securities in an unrealized loss position, the unrealized losses were primarily the result of the interest rate environment and not the credit quality of the issuers. None of the fixed maturity securities were determined to be other-than-temporarily impaired; therefore, none of the fixed maturity securities were written down during the respective years. In our review as of December 31, 2017, we determined that the unrealized losses of the equity securities lots were considered to be temporary due to the severity of the declines therefore, none of the equity securities were written down, and any remaining unrealized losses of equity securities at that time were recognized to retained earnings upon adoption of ASU 2016-01 on January 1, 2018. See “Note 2-Recent Accounting Pronouncements” in the Notes to Consolidated Financial Statements included in this Annual Report on Form 10-K for a discussion of accounting pronouncements recently adopted and recently issued accounting pronouncements not yet adopted and their potential impact to our financial statements. Deferred Income Taxes We account for taxes under the asset and liability method, under which we record deferred income taxes as assets or liabilities on our balance sheet to reflect the net tax effect of the temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and their respective tax bases. Deferred tax assets and liabilities are measured by applying enacted tax rates in effect for the years in which such differences are expected to reverse. Our deferred tax assets result from temporary differences primarily attributable to unearned premiums and net operating losses. Our deferred tax liabilities result primarily from deferred acquisition costs and unrealized gains in the investment portfolio. On a quarterly basis, we review our deferred tax assets and, if we determine that it is more likely than not that some portion or all of the deferred tax assets will not be realized, we reduce our deferred tax asset with a valuation allowance. The assessment requires significant judgement. We recorded a valuation allowance in 2017 due to 3-year cumulative losses and a large catastrophe event during 2017. We increased the valuation allowance by $0.7 million in 2018. The amount of our deferred tax assets considered realizable could be adjusted if estimates of future taxable income during the carryforward period are increased or if objective negative evidence in the form of cumulative losses is no longer present. On December 22, 2017, the President of the United States signed into law the Tax Act. The legislation significantly changes U.S. tax law by, among other things, lowering corporate income tax rates from 35% to 21%, effective January 1, 2018. U.S. GAAP requires companies to recognize the effect of tax law changes in the period of enactment. We evaluated all available information and made reasonable estimates of the impact of tax reform to substantially all components of our net deferred tax assets as of December 31, 2017. We finalized our accounting for the Tax Act during 2018 with no significant impact to earnings or deferred taxes. Prior to March 2019, the Company was a Cayman Islands incorporated holding company with U.K. tax residency. On March 14, 2019, the Company implemented a domestication (the Domestication) pursuant to Section 388 of the Delaware General Corporation Law and Section 206 of the Companies Law (2018 Revision), as amended, of the Cayman Islands pursuant to which it became a Delaware corporation and no longer subject to the laws of the Cayman Islands. Historically, the Company’s Bermuda based subsidiary, PSRE, was not required to pay any taxes on its income or capital gains but was subject to a 1% U.S. federal excise tax on reinsurance premiums assumed. As a result of the Domestication, PSRE’s income is subject to U.S. federal income tax in 2019. Prior to 2019, the Company maintained a valuation allowance on the U.S. tax attributes due to significant negative evidence, including cumulative U.S. losses in the most recent three-year period and our assessment that the realization of the net deferred tax assets did not meet the “more likely than not” criteria under ASC 740, Income Taxes. Management assessed available positive and negative evidence to estimate whether sufficient future taxable income would be generated to permit use of the existing deferred tax assets. The projected reversal of temporary differences, the Domestication, and projected future operating income in the U.S. represents significant positive evidence, which outweighed the historical negative evidence. Based on this evidence, management determined it was more likely than not that the federal deferred tax assets are recoverable and therefore the associated valuation allowance was released as of March 31, 2019. State NOL carryforwards, due to the limited carryforward period, do not meet the “more likely than not” criteria and we will continue to maintain a valuation allowance on the associated deferred tax assets. We decreased the valuation allowance on the federal deferred tax assets by $1.7 million as a result of this analysis. The amount of the deferred tax asset considered realizable, however, could be adjusted if estimates of future taxable income during the carryforward period change or if objective negative evidence in the form of cumulative losses is no longer present. For the year ended December 31, 2019 tax expense differs from the expected tax computed at the statutory tax rate of 21% primarily due to a U.S. tax benefit of $1.7 million for the reversal of a significant portion of our U.S. deferred tax valuation allowance offset by tax expense of $4.8 million from the addback related to the stock compensation charge recognized during the first quarter that is not deductible for tax purposes. Recent Accounting Pronouncements See “Note 2-Recent Accounting Pronouncements” in the Notes to Consolidated Financial Statements included in this Annual Report on Form 10-K for a discussion of accounting pronouncements recently adopted and recently issued accounting pronouncements not yet adopted and their potential impact to our financial statements. 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.

<s>[INST] Overview We are a rapidly growing and profitable company focused on the provision of specialty property insurance. We focus on certain markets that we believe are underserved by other insurance companies, such as the markets for earthquake, wind and flood insurance. We provide specialty property insurance products in our target markets to both individuals and businesses. We use proprietary data analytics and a modern technology platform to offer our customers flexible products with customized and granular pricing on an admitted basis. We distribute our products through multiple channels, including retail agents, program administrators, wholesale brokers, and in partnership with other insurance companies. Our business strategy is supported by a comprehensive risk transfer program with reinsurance coverage that we believe provides both consistency of earnings and appropriate levels of protection in the event of a major catastrophe. Our management team combines decades of insurance industry experience across specialty underwriting, reinsurance, program administration, distribution, and analytics. Founded in 2014, we have significantly grown our business and have generated attractive returns. We have organically increased gross written premiums from $16.6 million for the year ended December 31, 2014, our first year of operations, to $252.0 million for the year ended December 31, 2019, a compound annual growth rate of approximately 72%. For the year ended December 31, 2019, we experienced average monthly premium retention rates above 93% for our Residential Earthquake and Hawaii Hurricane lines and approximately 88% overall across all lines of business, providing strong visibility into future revenue. In February 2014, Palomar Specialty Insurance Company was awarded an “A−” (Excellent) (Outlook Stable) rating from A.M. Best Company (“A.M. Best”), a leading rating agency for the insurance industry. In February 2019, A.M. Best affirmed our “A−” (Excellent) (Outlook Stable) rating for Palomar Specialty Insurance Company and affirmed our “A−” (Excellent) (Outlook Stable) group rating for Palomar Holdings, Inc. This rating reflects A.M. Best’s opinion of our financial strength, operating performance and ability to meet obligations to policyholders and is not an evaluation directed towards the protection of investors. We believe that our market opportunity, distinctive products, and differentiated business model position us to grow our business profitably. On April 22, 2019, we completed our IPO, and the underwriters in the IPO purchased 6,468,750 shares, including the full exercise of their option to purchase additional shares of common stock. The net proceeds were approximately $87.4 million, after deducting underwriting discounts and commissions and offering costs. On September 30, 2019, certain selling stockholders completed the September 2019 Secondary Offering of 6,037,500 shares of our common stock. We did not receive any proceeds from the September 2019 Secondary Offering or incur underwriters’ discounts or commissions on the sale. On January 9, 2020, we, along with certain selling stockholders, completed the January 2020 Secondary Offering of 5,750,000 shares of common stock at a public offering price of $49.00 per share. Of the 5,750,000 shares sold, 750,000 represented the underwriters’ exercise of their option to purchase additional shares. The offering was comprised of 5,000,000 shares sold by certain selling stockholders and 750,000 shares sold by us. Our net proceeds from the January 2020 Secondary Offering were approximately $35.4 million, after deducting underwriting discounts and commissions and offering costs. Components of Our Results of Operations Gross Written Premiums Gross written premiums are the amounts received or to be received for insurance policies written or assumed by us during a specific period of time without reduction for policy acquisition costs, reinsurance costs or other deductions. The volume of our gross written premiums [/INST] Negative. </s>

Arcturus Therapeutics Holdings 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 together with the consolidated financial statements and related notes included elsewhere herein. This report includes forward-looking statements which, although based on assumptions that we consider reasonable, are subject to risks and uncertainties which could cause actual events or conditions to differ materially from those currently anticipated and expressed or implied by such forward-looking statements. Overview We are an mRNA medicines company focused on significant opportunities within liver and respiratory rare diseases, and the development of infectious disease vaccines utilizing our STARR technology. In addition to our internal mRNA platform, our proprietary lipid nanoparticle delivery system, LUNAR, enables multiple nucleic acid medicines. The genetic medicines industry is constantly struggling to identify non-viral delivery solutions for large RNA molecules to different cell types. Our LUNAR delivery technology is lipid mediated - and non-viral. LUNAR is versatile, compatible with various types of RNA -- and has been shown to deliver large RNA to different cell types including liver hepatocytes, liver stellate cells, muscle cells (myocytes), and lung cells (including bronchial epithelial cells). Our activities since inception have consisted principally of performing research and development activities, general and administrative activities and raising capital to fund those efforts. Our activities are subject to significant risks and uncertainties, including failing to secure additional funding before we achieve sustainable revenues and profit from operations. As of December 31, 2019, we had an accumulated deficit of $71.7 million. Liquidity and Capital Resources The following table shows a summary of our cash flows for the year ended December 31, 2019 and 2018 (in thousands): Operating Activities Our primary use of cash is to fund operating expenses, which consist mainly of research and development and general and administrative expenditures. We have incurred significant expenses which have been partially offset by cash collected through our collaboration agreements. Cash collections under the collaboration agreements can vary from year to year depending on the terms of the agreement and work performed. These changes on cash flows primarily relate to the timing of cash receipts for upfront payments, reimbursable expenses and achievement of milestones under these collaborative agreements. Net cash used in operating activities was $6.4 million on a net loss of $26.0 million for the year ended December 31, 2019, compared to net cash used of $20.8 million on a net loss of $21.8 million for the year ended December 31, 2018. Adjustments for non-cash charges which includes share-based compensation and depreciation and amortization were $3.6 million and $2.2 million for the year ended December 31, 2019 and 2018, respectively. Changes in working capital resulted in adjustments to operating net cash inflows of $16.0 million for the year ended December 31, 2019, and net cash outflows of $1.2 million for the year December 31, 2018. The significant adjustments to operating net cash inflows for the year ended December 31, 2019 were primarily due to the Third Amendment to the collaboration agreement with Ultragenyx during the second quarter of 2019 along with increased accounts payable and accrued liabilities from LUNAR-OTC (ARCT-810), which expenses were incurred as discussed below. Investing Activities Net cash used in investing activities of $0.8 million for the year ended December 31, 2019 reflected the acquisition of property and equipment. Net cash provided by investing activities of $22.1 million for the year ended December 31, 2018 reflected proceeds from the maturities of our short-term investments of $30.2 million, offset by purchases of short-term investments of $6.6 million, and cash used to purchase property and equipment of $1.5 million. Financing Activities Net cash provided by financing activities of $41.9 million for the year ended December 31, 2019 consisted of net proceeds from the issuance of common stock of $15.5 million to Ultragenyx, net proceeds from the issuance of common stock of $21.3 million related to public offerings, net proceeds from long-term debt of $4.9 million, and proceeds from the exercise of stock options of $0.1 million. Net cash provided by financing activities of $10.2 million for the year ended December 31, 2018 consisted of net proceeds from the exercise of stock options of $0.3 million and net proceeds from long-term debt of $9.9 million. Funding Requirements We anticipate that we will continue to generate annual net losses for the foreseeable future, and we expect the losses to increase as we continue the development of, and seek regulatory approvals for, our product candidates, and begin commercialization of our products. As a result, we will require additional capital to fund our operations in order to support our long-term plans. We believe that our current cash position will be sufficient to meet our anticipated cash requirements through the first quarter of 2021, assuming, among other things, no significant unforeseen expenses, continued funding from partners at anticipated levels and our payment obligations under our long-term credit facility referenced in Note 7 to our Consolidated Financial Statements continuing to follow the current maturity schedule. We intend to seek additional capital through equity and/or debt financings, collaborative or other funding arrangements with partners or through other sources of financing. Should we seek additional financing from outside sources, we may not be able to raise such financing on terms acceptable to us or at all. If we are unable to raise additional capital when required or on acceptable terms, we may be required to scale back or discontinue the advancement of product candidates, reduce headcount, liquidate our assets, file for bankruptcy, reorganize, merge with another entity, or cease operations. Our future funding requirements are difficult to forecast and will depend on many factors, including the following: • the achievement of milestones under our strategic alliance agreements; • the terms and timing of any other strategic alliance, licensing and other arrangements that we may establish; • the initiation, progress, timing and completion of preclinical studies and clinical trials for our product candidates; • the number and characteristics of product candidates that we pursue; • the outcome, timing and cost of regulatory approvals; • delays that may be caused by changing regulatory requirements; • the cost and timing of hiring new employees to support our continued growth; • the costs involved in filing and prosecuting patent applications and enforcing and defending patent claims; • the costs and timing of procuring clinical and commercial supplies of our product candidates; • the costs and timing of establishing sales, marketing and distribution capabilities; • the costs associated with legal proceedings; • the costs associated with potential litigation related to collaboration agreements; and • the extent to which we acquire or invest in businesses, products or technologies. Going Concern and Management’s Plans Our products that are being developed have not generated significant revenue. As a result, we have suffered recurring losses and require significant cash resources to execute our business plans. These losses are expected to continue for an extended period of time. Based on our current planned operations and clinical development plans, and giving effect to our planned pace of research, our current overhead, personnel costs and obligations under our credit facility, and possible limited access to working capital, we believe there is substantial doubt that our current cash and cash equivalents balances will be sufficient to fund our operations for at least twelve months after the date the consolidated financial statements are filed. In drawing this conclusion we do not consider our ability to raise additional capital through equity, debt, collaborations or other funding arrangements with partners or through other sources of financing or to reduce the pace or scope of our activities. These conditions raise substantial doubt about our ability to continue as a going concern for a period of one year from the date of the issuance of our 2019 consolidated financial statements. The accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The financial statements do not include any adjustments relating to the recoverability and classification of asset amounts or the classification of liabilities that might be necessary should we be unable to continue as a going concern within one year after the date the financial statements are issued. Historically, our major sources of cash have comprised proceeds from collaboration partners, various public and private offerings of our common stock, option and warrant exercises, and interest income. From inception through December 2019, we raised approximately $210.4 million in gross proceeds from various public and private offerings of our common stock, debt issuances, collaboration agreements, and the merger with Alcobra Ltd. As of December 31, 2019, we had approximately $71.5 million in cash, restricted cash and cash equivalents. Our plans to mitigate an expected shortfall of capital, to support future operations, include raising additional funds. We also recognize we will need to raise additional capital in order to continue to execute our business plan in the future. There is no assurance that additional financing will be available when needed or that management will be able to obtain financing on terms acceptable to us or whether we will become profitable and generate positive operating cash flow. If we are unable to raise sufficient additional funds, we will have to scale back our operations. Overview Since our inception, we have funded our operations principally with proceeds from the sale of capital stock, convertible notes and revenues earned through collaborative agreements. At December 31, 2019, we had $71.4 million in unrestricted cash and cash equivalents. On October 12, 2018, we entered into a Loan and Security Agreement with Western Alliance Bank whereby we received gross proceeds of $10.0 million under a long-term debt agreement (the “Loan”). The Loan has a maturity date of October 1, 2022 and carries interest at the U.S. prime rate plus 1.25%. The loan has an interest-only period of 19 months, which could be extended by an additional 6 months if certain conditions are met, followed by an amortization period of 30 months, or 24 months if the interest-only period is extended. Upon maturity or prepayment, we will be required to pay a 3% fee, or a 2% fee if the U.S. Food and Drug Administration accepts certain Investigational New Drug applications prior to maturity. On October 30, 2019, we and the Bank entered into a Third Amendment (the “Third Amendment”) to the Loan and Security Agreement dated as of October 12, 2018 (as amended, the “Loan Agreement”). Pursuant to the amendment, the Bank agreed to make a term loan to us on October 30, 2019, in the amount of $15 million (the “Term Loan”). The resulting net increase in the indebtedness of us was $5 million. The Term Loan bears interest at a floating rate ranging from 1.25% to 2.75% above the prime rate. The amendment further provides that the Term Loan has a maturity date of October 30, 2023. We shall make monthly payments of interest only until the interest-only end date of April 1, 2021, which is subject to extension to October 1, 2021 upon the occurrence of an equity or expansion event and the absence of an event of default, and thereafter shall make monthly payments of principal and interest during a 30-month amortization period. The Term Loan also includes covenants which include our submission of a clinical candidate for IND application, made to the U.S. Food and Drug Administration by May 31, 2020 and obtaining acceptance by June 30, 2020. If we are unable to maintain sufficient financial resources, our business, financial condition and results of operations will be materially and adversely affected. There can be no assurance that we will be able to obtain the needed financing on acceptable terms or at all. Additionally, equity or debt financings may have a dilutive effect on the holdings of our existing shareholders. Our future capital requirements are difficult to forecast and will depend on many factors. We expect to continue to incur additional losses for the foreseeable future, and we will need to raise additional debt or equity financing or enter into additional partnerships to fund development. The ability of our Company to transition to profitability is dependent on identifying and developing successful mRNA drug candidates. In the near future, if we are not able to achieve planned milestones, incur costs in excess of our forecasts, or do not meet covenant requirements of our debt, we will need to reduce discretionary spending, discontinue the development of some or all of our products, which will delay part of our development programs, all of which will have a material adverse effect on our ability to achieve our intended business objectives. There can be no assurances that additional financing will be secured or, if secured, will be on favorable terms. These conditions raise substantial doubt about the business, results of operations, financial condition and/or our ability to fund scheduled obligations on a timely basis or at all. The accompanying financial statements have been prepared assuming that we will continue as a going concern, which contemplates the realization of assets and the settlement of liabilities and commitments in the normal course of business. The consolidated financial statements do not reflect any adjustments related to the recoverability and classification of assets or the amounts and classification of liabilities that might be necessary if we are unable to continue as a going concern. Results of Operations The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the consolidated financial statements included in this annual report. Our historical results of operations and the year-to-year comparisons of our results of operations that follow are not necessarily indicative of future results. Revenues We enter into arrangements with pharmaceutical and biotechnology partners that may contain upfront payments, license fees for research and development arrangements, research and development funding, milestone payments, option exercise and exclusivity fees and royalties on future sales. The following table summarizes our total revenues for the periods indicated (in thousands): Collaboration revenue increased by $5.0 million during the year ended December 31, 2019 as compared to the year ended December 31, 2018. The increase in revenue during the year was caused by a ramp up in activities on the Janssen collaboration agreement which led to an increase in revenue of $1.7 million. Additionally, an increase of $2.2 million was due to settling the terminated co-development program with CureVac (as discussed in the following paragraph) along with an increase in amortized revenue that was previously deferred. Lastly, there was an increase in revenue from Synthetic Genomics Inc. of $2.1 million due to recognizing revenue related to a sublicense payment during the year. These increases were primarily offset by negligible decreases from various programs and decreased revenue of $0.9 million associated with Ultragenyx as the collaboration agreement had less activity compared to the prior year. On February 11, 2019, we announced the termination of the obligations of CureVac for preclinical development, effective 180 days from February 5, 2019 and the re-assumption by us of the worldwide rights thereto. We reassumed 100% of the global rights of our flagship asset and clinical development candidate, a messenger RNA (mRNA) drug to treat ornithine transcarbamylase (OTC) deficiency. Operating Expenses Our operating expenses consist of research and development and general and administrative expenses. The following table presents our total research and development expenses by category: * Greater than 100% Research and Development Expenses, net Our research and development expenses consist primarily of external manufacturing costs, in-vivo research studies performed by contract research organizations, clinical and regulatory consultants, and laboratory supplies for research and development activities. LUNAR-OTC (ARCT-810) expenses for the year ended December 31, 2019 increased by $11.9 million, from $3.7 million in 2018 to $15.6 million in 2019. The increase in LUNAR-OTC (ARCT-810) expenses was due primarily to preparation for an IND application, which was submitted during the first quarter of 2020. Lunar-CF expenses for the year ended December 31, 2019 increased by $0.5 million, from $0.3 million in 2018 to $0.8 million in 2019. This amount was offset with funds awarded by the CFF. The increase in LUNAR-CF expenses was due primarily to the amendment to the CFF Agreement executed in July 2019, and we expect that our development efforts and associated costs will increase over the next several years as the LUNAR-CF program moves toward expected IND submission in 2021. Discovery technologies represents our efforts to expand our product pipeline. Discovery technology expenses for the year ended December 31, 2019 increased by $1.0 million, or 33.8%, from $2.9 million in 2018 to $3.9 million in 2019. The increase in discovery technology expenses was due to additional efforts to add new capabilities necessary to expand our future platform technology and discovery of our next programs. These efforts have resulted in new programs such as STARR technology. Partnered discovery technologies expenses for the year ended December 31, 2019 were $1.9 million, approximately the same as in 2018. We expect partnered discovery technologies expenses to fluctuate based on the needs of our collaboration partners. Personnel related expenses for the year ended December 31, 2019 increased by $2.5 million, or 37.8% from $6.5 million in 2018 to $9.0 million in 2019. The increase in personnel related expenses was due primarily to increased headcount necessary to advance our external pipeline and platform efforts, and was offset by $0.9 million of funds received from the CFF. We expect personnel related expenses to increase in 2020 as we expand our headcount to execute our business plan. Facilities and equipment expenses for the year ended December 31, 2019 increased by $0.9 million, or 59.3%, from $1.5 million in 2018 to $2.4 million in 2019. The increase in facilities and equipment expenses was due primarily to higher rent and related costs associated with our new headquarter lease. General and Administrative Expenses General and administrative expenses consist primarily of salaries and related benefits for our executive, administrative and accounting functions and professional service fees for legal and accounting services as well as other general and administrative expenses. General and administrative expenses for the year ended December 31, 2019 decreased by $7.9 million, or 38.5%, from $20.5 million in 2018 to $12.6 million in 2019. The decrease in general and administrative expenses was primarily due to (i) non-recurring proxy, legal and related costs incurred in 2018 of $7.3 million, which did not recur in 2019, and (ii) an insurance settlement of $2.4 million relating to the proxy matter that was recorded as contra-G&A expense when it was received in 2019, offset by increases in personnel costs of $1.1 million, public company related expenses of $0.4 million, and facilities and other costs of $0.3 million. Without the effect of the one-time proxy costs, general and administrative expenses would have been relatively consistent with the prior year. Finance income (expense), net * Greater than 100% Interest income is generated on cash and cash equivalents. For the year ended December 31, 2019, the decrease in interest income compared to the year ended December 31, 2018 resulted from decreased investments. Interest expense relates to the long-term debt with Western Alliance Bank. The increase in interest expense for the year ended 2019 as compared to 2018 was due to an entire year of interest incurred during 2019 versus one quarter of interest incurred during the fourth quarter of 2018. Critical Accounting Policies and Estimates We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the United States (“U.S. GAAP”). As such, we make certain estimates, judgements and assumptions that we believe are reasonable, based upon information available to us. These judgements involve making estimates about the effect of matters that are inherently uncertain and may significantly impact our results of operations and financial condition. We describe our significant accounting policies more fully in Note 2 to our consolidated financial statements for the year ended December 31, 2019. In the following paragraphs, we describe the specific risks associated with these critical accounting policies and we caution that future events may not reflect exactly as one may expect, and that best estimates may require adjustment. The following are our significant accounting policies which we believe are the most critical to aid in fully understanding and evaluating our reported financial results. Revenue Recognition Research and development revenue under collaborative agreements We recognize R&D revenue from several collaboration agreements. Our collaboration agreements typically contain promised goods and services, including technology licenses or options to obtain technology licenses, R&D services, and manufacturing services. Upon entering into a collaboration agreement, we are required to make the following judgements: Identifying the performance obligations contained in the agreement Our assessment of what constitutes a separate performance obligation requires us to apply judgement. Specifically, we are required to identify which goods and services we are required to provide under the contract are distinct, if any. Determining the transaction price, including any variable consideration To determine the transaction price, we review the amount of consideration we are eligible to earn under the agreement. We do not typically include any payments we may receive in the future in our initial transaction price since the payments are typically not probable because they are contingent upon certain future events. We are required to reassess the total transaction price at each reporting period to determine if we should include additional payments that have become probable in the transaction price. Allocating the transaction price to each of our performance obligations If we were to allocate the transaction price to more than one performance obligation, we would make estimates of the relative stand-alone selling price of each performance obligation, as it is not typical for us to sell our goods or services on a stand-alone basis. The estimate of the relative stand-alone selling price would require us to make significant judgements. To date, we have not entered into a collaboration agreement with more than one performance obligation. The R&D revenue we recognize each period is comprised of several types of revenue, including amortization from upfront payments, milestone payments, option exclusivity fees and other services. Each of these types of revenue require us to make various judgements and estimates. Amortization from Upfront Payments For certain agreements, we recognize revenue from the amortization of upfront payments as we perform R&D services. We use an input method to estimate the amount of revenue to recognize each period. This method requires us to make estimates of the total costs we expect to incur in order to complete our promised R&D services or the total length of time it will take us to complete our promised R&D services. If we change our estimates, we may have to adjust our revenue. Milestone Payments When recognizing revenue related to milestone payments, we typically judge and estimate whether the milestone payment is probable (discussed in detail above under “Determining the transaction price, including any variable consideration”). Off-balance sheet arrangements None.

<s>[INST] This report includes forwardlooking statements which, although based on assumptions that we consider reasonable, are subject to risks and uncertainties which could cause actual events or conditions to differ materially from those currently anticipated and expressed or implied by such forwardlooking statements. Overview We are an mRNA medicines company focused on significant opportunities within liver and respiratory rare diseases, and the development of infectious disease vaccines utilizing our STARR technology. In addition to our internal mRNA platform, our proprietary lipid nanoparticle delivery system, LUNAR, enables multiple nucleic acid medicines. The genetic medicines industry is constantly struggling to identify nonviral delivery solutions for large RNA molecules to different cell types. Our LUNAR delivery technology is lipid mediated and nonviral. LUNAR is versatile, compatible with various types of RNA and has been shown to deliver large RNA to different cell types including liver hepatocytes, liver stellate cells, muscle cells (myocytes), and lung cells (including bronchial epithelial cells). Our activities since inception have consisted principally of performing research and development activities, general and administrative activities and raising capital to fund those efforts. Our activities are subject to significant risks and uncertainties, including failing to secure additional funding before we achieve sustainable revenues and profit from operations. As of December 31, 2019, we had an accumulated deficit of $71.7 million. Liquidity and Capital Resources The following table shows a summary of our cash flows for the year ended December 31, 2019 and 2018 (in thousands): Operating Activities Our primary use of cash is to fund operating expenses, which consist mainly of research and development and general and administrative expenditures. We have incurred significant expenses which have been partially offset by cash collected through our collaboration agreements. Cash collections under the collaboration agreements can vary from year to year depending on the terms of the agreement and work performed. These changes on cash flows primarily relate to the timing of cash receipts for upfront payments, reimbursable expenses and achievement of milestones under these collaborative agreements. Net cash used in operating activities was $6.4 million on a net loss of $26.0 million for the year ended December 31, 2019, compared to net cash used of $20.8 million on a net loss of $21.8 million for the year ended December 31, 2018. Adjustments for noncash charges which includes sharebased compensation and depreciation and amortization were $3.6 million and $2.2 million for the year ended December 31, 2019 and 2018, respectively. Changes in working capital resulted in adjustments to operating net cash inflows of $16.0 million for the year ended December 31, 2019, and net cash outflows of $1.2 million for the year December 31, 2018. The significant adjustments to operating net cash inflows for the year ended December 31, 2019 were primarily due to the Third Amendment to the collaboration agreement with Ultragenyx during the second quarter of 2019 along with increased accounts payable and accrued liabilities from LUNAROTC (ARCT810), which expenses were incurred as discussed below. Investing Activities Net cash used in investing activities of $0.8 million for the year ended December 31, 2019 reflected the acquisition of property and equipment. Net cash provided by investing activities of $22.1 million for the year ended December 31, 2018 reflected proceeds from the maturities of our shortterm investments of $30.2 million, offset by purchases of shortterm investments of $6.6 million, and cash used to purchase property and equipment of $1.5 million. Financing Activities Net cash provided by financing activities of $41.9 million for the year ended December 31, 2019 consisted of net proceeds from the issuance of common stock of $15.5 million to Ultragenyx, net proceeds from the issuance of common stock of $21.3 million related to public offerings, [/INST] Positive. </s>

Alpine Income Property Trust, Inc.

2020-02-21

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statements When we refer to “we,” “us,” “our,” “PINE,” or “the Company,” we mean Alpine Income Property Trust, Inc. and its consolidated subsidiaries. References to “Notes to Financial Statements” refer to the Notes to the Consolidated Financial Statements of Alpine Income Property Trust, Inc. included in Item 8 of this Annual Report on Form 10-K. Also, when the Company uses any of the words “anticipate,” “assume,” “believe,” “estimate,” “expect,” “intend,” or similar expressions, the Company is making forward-looking statements. Although management believes that the expectations reflected in such forward-looking statements are based upon present expectations and reasonable assumptions, the Company’s actual results could differ materially from those set forth in the forward-looking statements. Certain factors that could cause actual results or events to differ materially from those the Company anticipates or projects are described in “Item 1A. Risk Factors” of this Annual Report on Form 10-K. Given these uncertainties, readers are cautioned not to place undue reliance on such statements, which speak only as of the date of this Annual Report on Form 10-K or any document incorporated herein by reference. The Company undertakes no obligation to publicly release any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date of this Annual Report on Form 10-K. OVERVIEW We are a newly organized real estate company that owns and operates a high-quality portfolio of single-tenant commercial properties all located in the United States. All of the properties in our initial portfolio are leased on a long-term basis and located primarily in or in close proximity to major metropolitan statistical areas, or MSAs, and in growth markets and other markets in the United States with favorable economic and demographic conditions. Eighteen of the 20 properties in our initial portfolio, representing approximately 81% of our initial portfolio’s annualized base rent (as of December 31, 2019), are leased on a triple-net basis. Our properties are primarily leased to industry leading, creditworthy tenants, many of which operate in industries we believe are resistant to the impact of e-commerce. Our initial portfolio consists of 20 single-tenant, primarily net leased retail and office properties located in 15 markets in ten states, which we acquired from Consolidated-Tomoka Land Co. (“CTO”), a public company listed on the NYSE American under the symbol “CTO”, in our Formation Transactions, described hereinafter, utilizing approximately $125.9 million of proceeds from our initial public offering of our common stock (our “IPO”) and the issuance of 1,223,854 units of our Operating Partnership (the “OP Units”) that had an initial value of approximately $23.3 million based on our IPO price of $19.00 per share (the “IPO Price”). For two of our properties in our initial portfolio, we are the lessor in a long-term ground lease to the tenant. Our initial portfolio is comprised of single-tenant retail and office properties primarily located in or in close proximity to major MSAs, growth markets and other markets in the United States with favorable economic and demographic conditions and leased to tenants with favorable credit profiles or performance attributes. All of the properties in our initial portfolio are subject to long-term, primarily triple-net leases, which generally require the tenant to pay all of the property operating expenses such as real estate taxes, insurance, assessments and other governmental fees, utilities, repairs and maintenance and certain capital expenditures. We intend to elect to be taxed as a REIT for U.S. federal income tax purposes commencing with our short taxable year ended December 31, 2019 upon the filing of our tax return for such taxable year. We believe that, commencing with such taxable year, we have been organized and have operated in such a manner as to qualify for taxation as a REIT under the U.S. federal income tax laws, and we intend to continue to be organized and to operate in such a manner. Our objective is to maximize cash flow and value per share by generating stable and growing cash flows and attractive risk-adjusted returns through owning, operating and growing a diversified portfolio of high-quality single-tenant, net leased commercial properties with strong long-term real estate fundamentals. The 20 properties in our initial portfolio are 100% occupied and represent approximately 817,000 of gross rentable square feet with leases that have a weighted average lease term of approximately 8.0 years (based on annualized base rent as of December 31, 2019). None of our leases expire prior to January 31, 2024. We seek to acquire, own and operate primarily freestanding, single-tenant commercial real estate properties primarily located in our target markets leased primarily pursuant to triple-net, long-term leases. Within our target markets, we will focus on investments in single-tenant retail and office properties. We will target tenants in industries that we believe are favorably impacted by current macroeconomic trends that support consumer spending, such as strong and growing employment and positive consumer sentiment, as well as tenants in industries that have demonstrated resistance to the impact of the growing e-commerce retail sector. We also will seek to invest in properties that are net leased to tenants that we determine have attractive credit characteristics, stable operating histories and healthy rent coverage levels, are well-located within their market and have rent levels at or below market rent levels. Furthermore, we believe that the size of our company will, for at least the near term, allow us to focus our investment activities on the acquisition of single properties or smaller portfolios of properties that represent a transaction size that most of our publicly-traded net lease REIT peers will not pursue on a consistent basis. Our strategy for investing in income-producing properties is focused on factors including, but not limited to, long-term real estate fundamentals and target markets, including major markets or those markets experiencing significant economic growth. We employ a methodology for evaluating targeted investments in income-producing properties which includes an evaluation of: (i) the attributes of the real estate (e.g., location, market demographics, comparable properties in the market, etc.); (ii) an evaluation of the existing tenant(s) (e.g., credit-worthiness, property level sales, tenant rent levels compared to the market, etc.); (iii) other market-specific conditions (e.g., tenant industry, job and population growth in the market, local economy, etc.); and (iv) considerations relating to the Company’s business and strategy (e.g., strategic fit of the asset type, property management needs, alignment with the Company’s structure, etc.). As of December 31, 2019, the Company owned 20 single-tenant income properties in ten states. Following is a summary of these properties: (1) Tenant, or tenant parent, rated entity. (2) Annualized straight-line base rental income in place as of December 31, 2019. (3) The Alpine Valley Music Theatre, leased to Live Nation Entertainment, Inc., is an entertainment venue consisting of a two-sided, open-air, 7,500-seat pavilion; an outdoor amphitheater with capacity for 37,000; and over 150 acres of green space. (4) We are the lessor in a ground lease with the tenant. The rentable square feet represents the improvements on the property that revert to us at the expiration of the lease. Subsequent to December 31, 2019 we completed the following acquisitions of income properties: · Acquired two corporate operated 7-Eleven convenience stores in the Austin, Texas market under new 15-year triple-net leases, including rent escalations during the initial lease term for combined purchase price of approximately $10.2 million. · Acquired a property leased to Conn’s HomePlus in the Dallas/Fort Worth Texas Metroplex, with 11.6 years a remaining on the initial lease term for $6.1 million. · Acquired a BP branded convenience store leased to Lehigh Gas Wholesale Services, Inc., a subsidiary of CrossAmerica Partners, a publicly traded company, in Highland Heights, Kentucky, with approximately 10.8 years remaining on the initial lease term for $4.3 million. · Acquired a 12-screen theater leased to American Multi-Cinema, Inc., a subsidiary of AMC Entertainment Holdings, Inc., a publicly traded company, in Tyngsboro, Massachusetts, with approximately 10.1 years remaining on the lease term for $7.1 million. RESULTS OF OPERATIONS FOR THE PERIOD FROM NOVEMBER 26, 2019 TO DECEMBER 31, 2019, FOR THE PERIOD FROM JANUARY 1, 2019 TO NOVEMBER 25, 2019, AND FOR THE YEAR ENDED DECEMBER 31, 2018(1) (1) Results of operations prior to November 25, 2019 represent the Predecessor activity of Consolidated-Tomoka Land Co. Subsequent to November 26, 2019, upon the acquisition of the Initial Portfolio from Consolidated-Tomoka Land Co., the results of operations are presented on a new basis of accounting pursuant to ASC 805. General and Administrative Expenses for the Period from November 26, 2019 to December 31, 2019, for the Period from January 1, 2019 to November 25, 2019 and for the Year Ended December 31, 2018: (1) For the Predecessor periods presented, stock compensation expense represents an allocation from Consolidated-Tomoka Land Co. Revenue and Direct Cost of Revenues Total revenue from our income property operations totaled approximately $1.4 million during the period from November 26, 2019 to December 31, 2019 and approximately $11.8 million during the Predecessor period from January 1, 2019 to November 25, 2019 and approximately $11.7 million during the Predecessor year ended December 31, 2018. The increase in the respective revenues during the periods presented is reflective of both the time periods presented as well as an increase in revenue from properties which were acquired by the Predecessor during the period from January 1, 2019 to November 25, 2019. The direct costs of revenues for our income property operations totaled approximately $373,000 during the period from November 26, 2019 to December 31, 2019 and approximately $1.7 million during the Predecessor period from January 1, 2019 to November 25, 2019 and approximately $1.6 million during the Predecessor year ended December 31, 2018. The increase in the direct cost of revenues during the periods presented is reflective of both the time periods presented as well as an increase related to common area maintenance costs incurred related to the acquisition by the Predecessor of two ground leases in Jacksonville, Florida in October 2018. Depreciation and Amortization Depreciation and amortization expense totaled approximately $687,000 during the period from November 26, 2019 to December 31, 2019 and approximately $4.9 million during the Predecessor period from January 1, 2019 to November 25, 2019 and approximately $4.9 million during the Predecessor year ended December 31, 2018. The increase in the depreciation and amortization expense during the periods presented is reflective of both the time periods presented as well as an increase related to the properties which were acquired by the Predecessor during the period from January 1, 2019 to November 25, 2019. General and Administrative Expenses General and administrative expenses reflected in the statement of operations totaled approximately $339,000 during the period from November 26, 2019 to December 31, 2019 and approximately $1.7 million during the Predecessor period from January 1, 2019 to November 25, 2019 and approximately $1.2 million during the Predecessor year ended December 31, 2018. Changes in general and administrative expenses during the periods presented is reflective of both the time periods presented, as well as changes in the nature of general and administrative expenses, as the Predecessor periods represent an allocation of the parent company expenses versus actual general and administrative expenses incurred by the Company. The Predecessor general and administrative expenses are not indicative of the amount of general and administrative expenses we expect to incur on an annual basis subsequent to 2019. Net Income (Loss) The statement of operations for the period from November 26, 2019 to December 31, 2019 reflects a loss of approximately $45,000 while the statement of operations for the Predecessor period from January 1, 2019 to November 25, 2019 and for the year ended December 31, 2018 reflected net income of approximately $3.6 million and $4.0 million, respectively. The decrease in net income for the period from November 26, 2019 to December 31, 2019 as compared to the Predecessor periods presented does not reflect a decrease of income directly attributable to the Predecessor portfolio and thus the Company’s operations, but rather a decrease of the Predecessor’s parent company income. LIQUIDITY AND CAPITAL RESOURCES Cash totaled approximately $12.3 million at December 31, 2019, and we had no restricted cash. As of December 31, 2019, the Company had no outstanding indebtedness. Credit Facility. The Company’s revolving $100 million credit facility (the “Credit Facility”), with Bank of Montreal (“BMO”) serving as the administrative agent for the lenders thereunder, is unsecured with regard to our income property portfolio but is guaranteed by certain wholly owned subsidiaries of the Company. The Credit Facility bank group is led by BMO and also includes Raymond James. The Credit Facility has a total borrowing capacity of $100.0 million with the ability to increase that capacity up to $150.0 million during the term, subject to lender approval. The Credit Facility provides the lenders with a secured interest in the equity of the Company subsidiaries that own the properties included in the borrowing base. The indebtedness outstanding under the Credit Facility accrues interest at a rate ranging from the 30-day LIBOR plus 135 basis points to the 30-day LIBOR plus 195 basis points based on the total balance outstanding under the Credit Facility as a percentage of the total asset value of the Company, as defined in the Credit Facility. The Credit Facility also accrues a fee of 15 to 25 basis points for any unused portion of the borrowing capacity based on whether the unused portion is greater or less than 50% of the total borrowing capacity. At December 31, 2019, the current commitment level under the Credit Facility was $100.0 million. The available borrowing capacity under the Credit Facility was approximately $88.5 million, based on the level of borrowing base assets. As of December 31, 2019, the Credit Facility had no balance outstanding. The Credit Facility is subject to customary restrictive covenants including, but not limited to, limitations on the Company’s ability to: (a) incur indebtedness; (b) make certain investments; (c) incur certain liens; (d) engage in certain affiliate transactions; and (e) engage in certain major transactions such as mergers. In addition, the Company is subject to various financial maintenance covenants including, but not limited to, a maximum indebtedness ratio, a maximum secured indebtedness ratio, and a minimum fixed charge coverage ratio. The Credit Facility also contains affirmative covenants and events of default including, but not limited to, a cross default to the Company’s other indebtedness and upon the occurrence of a change in control. The Company’s failure to comply with these covenants or the occurrence of an event of default could result in acceleration of the Company’s debt and other financial obligations under the Credit Facility. Acquisitions and Investments. As noted previously, the Company’s operations commenced on November 26, 2019 and we did not acquire any single-tenant income properties during the period beginning with the commencement of our operations and December 31, 2019. We are targeting investments up to approximately $120.0 million in income-producing properties during 2020. As of February 21, 2020, we have acquired five single-tenant, net leased properties for a total investment of approximately $27.6 million. We expect to fund our acquisitions utilizing available capacity under the Credit Facility, cash from operations, and potentially the proceeds generated from future equity offerings or debt issuances. Capital Expenditures. As of December 31, 2019, the Company is obligated to fund approximately $708,000 to construct a new roof at the 102,019 square-foot property leased to Hilton Grand Vacations. A credit in the amount of approximately $708,000 was received from CTO at the closing of the acquisition of the property on November 26, 2019 and the Company has made payments through December 31, 2019 of approximately $81,000, leaving a remaining commitment of approximately $627,000 as of December 31, 2019. We believe we will have sufficient liquidity to fund our operations, capital requirements, maintenance, and debt service requirements over the next twelve months and into the foreseeable future, with cash on hand, cash flow from our operations and approximately $88.5 million of available capacity on the existing $100.0 million Credit Facility, based on our current borrowing base of income properties, as of December 31, 2019. Our Board of Directors and management consistently review the allocation of capital with the goal of providing the best long-term return for our stockholders. These reviews consider various alternatives, including increasing or decreasing regular dividends, repurchasing the Company’s securities, and retaining funds for reinvestment. Annually, the Board reviews our business plan and corporate strategies, and makes adjustments as circumstances warrant. Management’s focus is to continue our strategy of investing in single-tenant net leased income properties by utilizing the capital we raised in our IPO and available borrowing capacity from the Credit Facility to increase our portfolio of income-producing properties, providing stabilized cash flows with strong risk-adjusted returns primarily in larger metropolitan areas and growth markets. CONTRACTUAL OBLIGATIONS AND COMMITMENTS As of December 31, 2019, approximately $627,000 in contractual obligations related to the Hilton Grand Vacations property are recorded as liabilities in our consolidated financial statements. There are no development obligations, which are not recognized as liabilities in our consolidated financial statements. OFF-BALANCE SHEET ARRANGEMENTS None. CRITICAL ACCOUNTING POLICIES The consolidated condensed financial statements included in this Annual Report are prepared in conformity with U.S. generally accepted accounting principles (“GAAP”). 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 revenues and expenses. The development and selection of these critical accounting policies have been determined by management and the related disclosures have been reviewed with the Audit Committee of the Board of Directors of the Company. Actual results could differ from those estimates. Our significant accounting policies are more fully described in Note 3 “Summary of Significant Accounting Policies” to the consolidated financial statements included in Item 8, “Financial Statements and Supplementary Data” in this Annual Report on Form 10-K; however, the most critical accounting policies, which involve the use of estimates and assumptions as to future uncertainties and, therefore, may result in actual amounts that differ from estimates, are as follows: 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 financial statements, and the reported amounts of revenues and expenses during the reporting period presented. Actual results could differ from those estimates. Because of, among other factors, the fluctuating market conditions that currently exist in the national real estate markets, and the volatility and uncertainty in the financial and credit markets, it is possible that the estimates and assumptions, most notably those related to the Predecessor’s investment in income properties, could change materially due to the continued volatility of the real estate and financial markets or as a result of a significant dislocation in those markets. Long-Lived Assets. The Company Financial Accounting Standards Board (“FASB”) ASC Topic 360-10, Property, Plant, and Equipment in conducting its impairment analyses. The Company reviews the recoverability of long-lived assets, primarily real estate, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Examples of situations considered to be triggering events include: a substantial decline in operating cash flows during the period, a current or projected loss from operations, an income property not fully leased or leased at rates that are less than current market rates, and any other quantitative or qualitative events deemed significant by management. Long-lived assets are evaluated for impairment by using an undiscounted cash flow approach, which considers future estimated capital expenditures. Impairment of long-lived assets is measured at fair value less cost to sell. Purchase Accounting for Acquisitions of Real Estate Subject to a Lease. Upon acquisition of real estate, the Company determines whether the transaction is a business combination, which is accounted for under the acquisition method, or an acquisition of assets. For both types of transactions, the Company recognizes and measures identifiable assets acquired, liabilities assumed and any noncontrolling interests in the acquire based on their relative fair values. For business combinations, the Company recognizes and measures goodwill or gain from a bargain purchase, if applicable, and expenses acquisition-related costs in the periods in which the costs are incurred. For acquisitions of assets, acquisition-related costs are capitalized on the Company's consolidated and combined balance sheets. If the Company acquires real estate and simultaneously enters into a new lease of the real estate the acquisition will be accounted for as an asset acquisition. In accordance with the FASB guidance on business combinations, the fair value of the real estate acquired with in-place leases is allocated to the acquired tangible assets, consisting of land, building and tenant improvements, and identified intangible assets and liabilities, consisting of the value of above-market and below-market leases, the value of in-place leases, and the value of leasing costs, based in each case on their relative fair values. The fair value of the tangible assets of an acquired leased property is determined by valuing the property as if it were vacant, and the “as-if-vacant” value is then allocated to land, building and tenant improvements based on the determination of the fair values of these assets. In allocating the fair value of the identified intangible assets and liabilities of an acquired property, above-market and below-market in-place lease values are recorded as other assets or liabilities based on the present value (using an interest rate which reflects the risks associated with the leases acquired) of the difference between (i) the contractual amounts to be received pursuant to the in-place leases, and (ii) management’s estimate of fair market lease rates for the corresponding in-place leases, measured over a period equal to the remaining term of the lease, including the probability of renewal periods. The capitalized above-market lease values are amortized as a reduction of rental income over the remaining terms of the respective leases. The capitalized below-market lease values are amortized as an increase to rental income over the initial term unless the management believes that it is likely that the tenant will renew the option whereby the Predecessor amortizes the value attributable to the renewal over the renewal period. The aggregate value of other acquired intangible assets, consisting of in-place leases, is measured by the excess of (i) the purchase price paid for a property after adjusting existing in-place leases to market rental rates over (ii) the estimated fair value of the property as-if-vacant, determined as set forth above. The value of in-place leases exclusive of the value of above-market and below-market in-place leases is amortized to expense over the remaining non-cancelable periods of the respective leases. If a lease were to be terminated prior to its stated expiration, all unamortized amounts relating to that lease would be written off. The value of tenant relationships is reviewed on individual transactions to determine if future value was derived from the acquisition. Income Property Lease Revenue. The rental arrangements associated with the Company’s income property portfolio are classified as operating leases. The Company recognizes lease income on these properties on a straight-line basis over the term of the lease. Accordingly, contractual lease payment increases are recognized evenly over the term of the lease. The periodic difference between lease income recognized under this method and contractual lease payment terms (i.e., straight-line rent) is recorded as a deferred operating lease receivable and is included in Straight-line Rent Adjustment on the accompany consolidated and combined balance sheets as of December 31, 2019 and 2018. Stock-Based Compensation. The Company adopted the Individual Equity Incentive Plan and the Manager Equity Incentive Plan, which are collectively referred to herein as the Equity Incentive Plans, to provide equity incentive opportunities to members of our Manager’s management team and employees who perform services for us, our independent directors, advisers, consultants and other personnel, either individually or via grants of incentive equity to our Manager. The Company’s Equity Incentive Plans provide for grants of stock options, stock appreciation rights (“SARs”), stock awards, restricted stock units, cash awards, dividend equivalent rights, other equity-based awards, including long-term incentive plan (“LTIP”) units, and incentive awards. A total of 684,494 shares of Common Stock have been authorized for issuance under the Equity Incentive Plans. New Accounting Pronouncements. Refer to Note 3, “Summary of Significant Accounting Policies” to the consolidated financial statements included in Item 8, “Financial Statements and Supplementary Data” in this Annual Report on Form 10-K.

<s>[INST] When we refer to “we,” “us,” “our,” “PINE,” or “the Company,” we mean Alpine Income Property Trust, Inc. and its consolidated subsidiaries. References to “Notes to Financial Statements” refer to the Notes to the Consolidated Financial Statements of Alpine Income Property Trust, Inc. included in Item 8 of this Annual Report on Form 10K. Also, when the Company uses any of the words “anticipate,” “assume,” “believe,” “estimate,” “expect,” “intend,” or similar expressions, the Company is making forwardlooking statements. Although management believes that the expectations reflected in such forwardlooking statements are based upon present expectations and reasonable assumptions, the Company’s actual results could differ materially from those set forth in the forwardlooking statements. Certain factors that could cause actual results or events to differ materially from those the Company anticipates or projects are described in “Item 1A. Risk Factors” of this Annual Report on Form 10K. Given these uncertainties, readers are cautioned not to place undue reliance on such statements, which speak only as of the date of this Annual Report on Form 10K or any document incorporated herein by reference. The Company undertakes no obligation to publicly release any revisions to these forwardlooking statements that may be made to reflect events or circumstances after the date of this Annual Report on Form 10K. OVERVIEW We are a newly organized real estate company that owns and operates a highquality portfolio of singletenant commercial properties all located in the United States. All of the properties in our initial portfolio are leased on a longterm basis and located primarily in or in close proximity to major metropolitan statistical areas, or MSAs, and in growth markets and other markets in the United States with favorable economic and demographic conditions. Eighteen of the 20 properties in our initial portfolio, representing approximately 81% of our initial portfolio’s annualized base rent (as of December 31, 2019), are leased on a triplenet basis. Our properties are primarily leased to industry leading, creditworthy tenants, many of which operate in industries we believe are resistant to the impact of ecommerce. Our initial portfolio consists of 20 singletenant, primarily net leased retail and office properties located in 15 markets in ten states, which we acquired from ConsolidatedTomoka Land Co. (“CTO”), a public company listed on the NYSE American under the symbol “CTO”, in our Formation Transactions, described hereinafter, utilizing approximately $125.9 million of proceeds from our initial public offering of our common stock (our “IPO”) and the issuance of 1,223,854 units of our Operating Partnership (the “OP Units”) that had an initial value of approximately $23.3 million based on our IPO price of $19.00 per share (the “IPO Price”). For two of our properties in our initial portfolio, we are the lessor in a longterm ground lease to the tenant. Our initial portfolio is comprised of singletenant retail and office properties primarily located in or in close proximity to major MSAs, growth markets and other markets in the United States with favorable economic and demographic conditions and leased to tenants with favorable credit profiles or performance attributes. All of the properties in our initial portfolio are subject to longterm, primarily triplenet leases, which generally require the tenant to pay all of the property operating expenses such as real estate taxes, insurance, assessments and other governmental fees, utilities, repairs and maintenance and certain capital expenditures. We intend to elect to be taxed as a REIT for U.S. federal income tax purposes commencing with our short taxable year ended December 31, 2019 upon the filing of our tax return for such taxable year. We believe that, commencing with such taxable year, we have been organized and have operated in such a manner as to qualify for taxation as a REIT under the U.S. federal income tax laws, and we intend to continue to be organized and to operate in such a manner. Our objective is to maximize cash flow and value per share by generating stable and growing cash flows and attractive riskadjusted returns through owning, operating and growing [/INST] Positive. </s>

Walt Disney Co

2019-11-20

2019-09-28

ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations CONSOLIDATED RESULTS (in millions, except per share data) Organization of Information Management’s Discussion and Analysis provides a narrative on the Company’s financial performance and condition that should be read in conjunction with the accompanying financial statements. It includes the following sections: • Consolidated Results and Non-Segment Items • Business Segment Results - 2019 vs. 2018 • Business Segment Results - 2018 vs. 2017 • Corporate and Unallocated Shared Expenses • Restructuring in Connection With the Acquisition of TFCF • Significant Developments • Liquidity and Capital Resources • Contractual Obligations, Commitments and Off Balance Sheet Arrangements • Critical Accounting Policies and Estimates • Forward-Looking Statements CONSOLIDATED RESULTS AND NON-SEGMENT ITEMS The Company’s financial results for fiscal 2019 are presented in accordance with new accounting guidance for revenue recognition (ASC 606) that we adopted at the beginning of fiscal 2019. Prior period results have not been restated to reflect this change in accounting guidance. Segment operating income for fiscal 2019 includes a $91 million benefit from the adoption of ASC 606 primarily due to the timing of recognition of TV/SVOD distribution revenue at Studio Entertainment. Further information about our adoption of ASC 606 is provided in Note 3 to the Consolidated Financial Statements. 2019 vs. 2018 As discussed in Note 4 to the Consolidated Financial Statements, the Company acquired TFCF on March 20, 2019. Additionally, in connection with the acquisition of TFCF, we acquired a controlling interest in Hulu. The Company began consolidating the results of TFCF and Hulu effective March 20, 2019. Revenues for fiscal 2019 increased 17%, or $10.1 billion, to $69.6 billion; net income attributable to Disney decreased 12%, or $1.5 billion, to $11.1 billion; and diluted earnings per share from continuing operations attributable to Disney (EPS) decreased 25%, or $2.09 to $6.27. The decrease in EPS was due to the comparison to a benefit in fiscal 2018 from U.S. federal income tax legislation (Tax Act), which was enacted in fiscal 2018 (See Note 10 to the Consolidated Financial Statements), amortization expense on intangibles and the fair value step-up on film and television costs from the TFCF acquisition and consolidation of Hulu, an increase in shares outstanding and restructuring costs incurred in connection with the acquisition and integration of TFCF. The increase in shares outstanding was due to shares that were issued in connection with the acquisition of TFCF. Additionally, the decrease in EPS reflected lower segment operating income, which included a $0.5 billion adverse impact from the consolidation of TFCF and Hulu in the current year, the absence of a gain recognized in the prior year on the sale of real estate, a charge in the current year for the extinguishment of debt and higher interest expense. These decreases were partially offset by a non-cash gain recognized in the current year in connection with the acquisition of a controlling interest in Hulu (Hulu Gain) (See Note 4 to the Consolidated Financial Statements). Segment operating income from our legacy operations decreased due to higher losses at Direct-to-Consumer & International and lower results at Media Networks, partially offset by growth at Parks, Experiences and Products. Revenues Service revenues for fiscal 2019 increased 19%, or $9.7 billion, to $60.5 billion, due to the consolidation of TFCF and Hulu’s operations and to a lesser extent, growth at our legacy operations. The increase at our legacy operations was due to higher guest spending at our theme parks and resorts, an increase in affiliate fees, higher theatrical distribution revenue and growth in merchandise licensing. These increases were partially offset by lower ABC Studios program sales. Service revenue reflected an approximate 1 percentage point decrease due to the movement of the U.S. dollar against major currencies including the impact of our hedging program (Foreign Exchange Impact). Product revenues for fiscal 2019 increased 5%, or $0.5 billion, to $9.0 billion, due to the consolidation of TFCF’s operations and growth at our legacy operations. The increase at our legacy operations was due to guest spending growth at our theme parks and resorts, partially offset by lower home entertainment volumes. Product revenue reflected an approximate 1 percentage point decrease due to an unfavorable Foreign Exchange Impact. Costs and expenses Cost of services for fiscal 2019 increased 32%, or $8.9 billion, to $36.5 billion, due to the consolidation of TFCF and Hulu’s operations and higher costs at our legacy operations. The increase in costs at our legacy operations reflected higher programming and production costs, labor cost inflation at our theme parks and resorts and an increase in film cost amortization. Cost of services reflected an approximate 1 percentage point decrease due to a favorable Foreign Exchange Impact. Cost of products for fiscal 2019 increased 7%, or $0.4 billion, to $5.6 billion, due to the consolidation of TFCF's operations and higher costs at our legacy operations. The increase in costs at our legacy operations was due to higher sales of food, beverage and merchandise and labor cost inflation at our theme parks and resorts, partially offset by a decrease in home entertainment volumes. Cost of products reflected an approximate 1 percentage point decrease due to a favorable Foreign Exchange Impact. Selling, general, administrative and other costs for fiscal 2019 increased 30%, or $2.7 billion, to $11.5 billion, due to the consolidation of TFCF and Hulu’s operations, and increases in marketing and compensation costs at our legacy operations. Selling, general, administrative and other costs reflected an approximate 2 percentage point decrease due to a favorable Foreign Exchange Impact. Depreciation and amortization costs increased 38%, or $1.1 billion, to $4.2 billion due to amortization of intangible assets arising from the acquisition of TFCF and consolidation of Hulu. Restructuring and Impairment Charges The Company recorded $1.2 billion and $33 million of restructuring and impairment charges in fiscal 2019 and 2018, respectively. Charges in fiscal 2019 were due to severance in connection with the acquisition and integration of TFCF. Charges in fiscal 2018 were due to severance costs. Other Income, net In fiscal 2019, the Company recognized a non-cash gain of $4,794 million in connection with the acquisition of a controlling interest in Hulu. In fiscal 2019 and fiscal 2018, the Company recorded insurance recoveries of $46 million and $38 million, respectively, in connection with the settlement of legal matters. In fiscal 2019, the Company recorded a charge of $511 million for the extinguishment of a portion of the debt originally assumed in TFCF acquisition. In fiscal 2019, the Company recorded a gain of $28 million on the deemed settlement of preexisting relationships with TFCF pursuant to acquisition accounting guidance. In fiscal 2018, the Company recorded gains of $560 million in connection with the sales of real estate and property rights in New York City and a $3 million adjustment to a fiscal 2017 non-cash net gain of $255 million recorded in connection with the acquisition of a controlling interest in BAMTech. Interest Expense, net The increase in interest expense was due to higher average debt balances as a result of the TFCF acquisition and to a lesser extent, higher average interest rates. These increases were partially offset by higher capitalized interest and a benefit from market value adjustments on pay-floating interest rate swap options. The increase in interest income, investment income and other for the year was due to a $102 million benefit related to pension and postretirement benefit costs, other than service cost, and higher interest income on cash balances. The comparable benefit related to pension and postretirement benefit costs of $30 million in the prior year was reported in “Costs and expenses.” The benefit in the current year was due to the expected return on pension plan assets exceeding interest expense on plan liabilities and amortization of prior net actuarial losses. Equity in the Loss of Investees Equity in the loss of investees of $103 million was comparable to the prior year as higher impairments in the current year were offset by lower equity losses from Hulu as a result of our consolidation of Hulu following the TFCF acquisition. Effective Income Tax Rate The increase in the effective income tax rate was due to the impact of the Tax Act, of which the most significant impacts were a $1.7 billion net benefit (11 percentage points) that was recognized in the prior year, partially offset by a current year benefit from a reduction in the Company’s U.S. statutory federal income tax rate to 21% in fiscal 2019 from 24.5% in fiscal 2018. Noncontrolling Interests Net income from continuing operations attributable to noncontrolling interests was comparable to the prior year as the accretion of the redeemable noncontrolling interest in Hulu (see Note 4 to the Consolidated Financial Statements) and a lower loss allocation to the noncontrolling interest holders of BAMTech were offset by a higher loss from our direct-to-consumer sports business. Net income attributable to noncontrolling interests is determined on income after royalties and management fees, financing costs and income taxes, as applicable. Discontinued Operations Net income from discontinued operations in fiscal 2019 reflected the operations of the RSNs. 2018 vs. 2017 Revenues for fiscal 2018 increased 8%, or $4.3 billion, to $59.4 billion; net income attributable to Disney increased 40%, or $3.6 billion, to $12.6 billion; and EPS for the year increased 47%, or $2.67 to $8.36. The EPS increase in fiscal 2018 was due to a benefit from the Tax Act, higher segment operating income, a decrease in weighted average shares outstanding as a result of our share repurchase program and gains on the sale of real estate and property rights. These increases were partially offset by the comparison to a fiscal 2017 non-cash net gain in connection with the acquisition of a controlling interest in BAMTech, impairments of our Vice and Villages Nature equity method investments in fiscal 2018 and higher net interest and corporate and unallocated shared expenses. The increase in segment operating income was due to growth at our Studio Entertainment, Parks, Experiences and Products and Media Networks segments, partially offset by lower results at our Direct-to-Consumer & International segment. In addition, net income attributable to Disney reflected an approximate 1 percentage point decrease due to an unfavorable Foreign Exchange Impact. Revenues Service revenues for fiscal 2018 increased 9%, or $4.0 billion, to $50.9 billion, due to higher theatrical distribution revenue, growth in guest spending and volumes at our theme parks and resorts, an increase in affiliate fees, increased TV/SVOD distribution revenue and the consolidation of BAMTech. In September 2017, the Company increased its ownership in BAMTech and began consolidating its results. These increases were partially offset by lower advertising revenue. Product revenues for fiscal 2018 increased 3%, or $0.3 billion, to $8.6 billion, due to guest spending and volume growth at our theme parks and resorts, partially offset by lower home entertainment volumes and a decrease in retail store sales. Product revenue reflected an approximate 1 percentage point increase due to a favorable Foreign Exchange Impact. Costs and expenses Cost of services for fiscal 2018 increased 9%, or $2.2 billion, to $27.5 billion, due to higher film and television cost amortization driven by an increase in theatrical and TV/SVOD distribution revenue and contractual rate increases for television programming. Costs of services also increased due to the consolidation of BAMTech and higher costs at our theme parks and resorts reflecting cost inflation, higher technology and operations support expenses and a special fiscal 2018 domestic employee bonus. Cost of products for fiscal 2018 increased 4%, or $0.2 billion, to $5.2 billion due to cost inflation and higher guest spending and volumes at our theme parks and resorts. Cost of products reflected an approximate 1 percentage point increase due to an unfavorable Foreign Exchange Impact. Selling, general, administrative and other costs for fiscal 2018 increased 8%, or $0.7 billion, to $8.9 billion, due to higher marketing spend, the consolidation of BAMTech, costs incurred in connection with the TFCF acquisition and an increase in compensation costs. Depreciation and amortization costs increased 8%, or $0.2 billion, to $3.0 billion primarily due to depreciation of new attractions at our theme parks and resorts and the consolidation of BAMTech. Depreciation and amortization costs reflected an approximate 1 percentage point increase due to an unfavorable Foreign Exchange Impact. Restructuring and Impairment Charges The Company recorded $33 million and $98 million of restructuring and impairment charges in fiscal 2018 and 2017, respectively. Charges in fiscal 2018 were due to severance costs. Charges in fiscal 2017 were due to severance costs and asset impairments. Other Income, net In fiscal 2017, the Company recorded a charge of $177 million in connection with the settlement of a litigation matter, net of committed insurance recoveries, and a gain of $255 million in connection with the acquisition of a controlling interest in BAMTech. Interest Expense, net The increase in interest expense was due to an increase in average interest rates, higher average debt balances and financing costs related to the acquisition of TFCF. The decrease in interest and investment income for fiscal 2018 was due to the comparison to gains on investments recognized in fiscal 2017, partially offset by an increase in interest income driven by higher average interest rates. Equity in the income (loss) of investees, net Equity in the income of investees decreased $422 million, to a loss of $102 million due to higher losses from Hulu, impairments of Vice and Villages Nature equity method investments and lower income from A+E. These decreases were partially offset by a favorable comparison to a loss from BAMTech in fiscal 2017. The decrease at Hulu was driven by higher programming, labor and marketing costs, partially offset by growth in subscription and advertising revenue. The decrease at A +E was due to lower advertising revenue and higher programming costs, partially offset by higher program sales. Effective Income Tax Rate The decrease in the effective income tax rate was due to the impact of the Tax Act, which included: • A net benefit of $1.7 billion, which reflected a $2.1 billion benefit from remeasuring our deferred tax balances to the new statutory rate (Deferred Remeasurement), partially offset by a charge of $0.4 billion for a one-time tax on certain accumulated foreign earnings (Deemed Repatriation Tax). This benefit had an impact of approximately 11.5 percentage points on the effective income tax rate. • A reduction in the Company’s fiscal 2018 U.S. statutory federal income tax rate to 24.5% from 35.0% in fiscal 2017. Net of state tax and other related effects, the reduction in the statutory rate had an impact of approximately 8.2 percentage points on the effective income tax rate. Noncontrolling Interests Net income attributable to noncontrolling interests for fiscal 2018 increased $82 million to $468 million due to lower tax expense at ESPN, largely due to the Tax Act, and the impact of the Company’s acquisition of the noncontrolling interest in Disneyland Paris in the third quarter of fiscal 2017. These increases were partially offset by losses at BAMTech. Certain Items Impacting Comparability Results for fiscal 2019 were impacted by the following: • The Hulu Gain of $4.8 billion • A benefit of $74 million consisting of $46 million from insurance recoveries related to a legal matter and a gain of $28 million recognized on the settlement of preexisting relationships with TFCF pursuant to acquisition accounting guidance • A benefit of $34 million from the Tax Act • Amortization of $1.6 billion related to TFCF and Hulu intangible assets and fair value step-up on film and television costs • Restructuring and impairment charges of $1.2 billion • Impairments of $538 million on equity investments • A charge of $511 million for the extinguishment of a portion of debt originally assumed in the TFCF acquisition Results for fiscal 2018 were impacted by the following: • A benefit of $1.7 billion from the Tax Act Deferred Remeasurement, net of the Deemed Repatriation Tax • A benefit of $601 million comprising $560 million in gains from the sales of real estate and property rights, $38 million from insurance recoveries in connection with the settlement of a fiscal 2017 litigation matter and $3 million from an adjustment related to a non-cash gain recognized in fiscal 2017 for the acquisition of a controlling interest in BAMTech • Impairments of $210 million for Vice and Villages Nature equity investments • Restructuring and impairment charges of $33 million Results for fiscal 2017 were impacted by the following: • A non-cash net gain of $255 million in connection with the acquisition of a controlling interest in BAMTech • A charge, net of committed insurance recoveries, of $177 million in connection with the settlement of litigation • Restructuring and impairment charges of $98 million A summary of the impact of these items on EPS is as follows: (1) Tax benefit/expense adjustments are determined using the tax rate applicable to the individual item affecting comparability. (2) EPS is net of noncontrolling interest share, where applicable. Total may not equal the sum of the column due to rounding. (3) Includes amortization of intangibles related to TFCF equity investees. BUSINESS SEGMENT RESULTS - 2019 vs. 2018 Below is a discussion of the major revenue and expense categories for our business segments. Costs and expenses for each segment consist of operating expenses, selling, general, administrative and other costs, and depreciation and amortization. Selling, general, administrative and other costs include third-party and internal marketing expenses. Our Media Networks segment generates revenue from affiliate fees, advertising (excluding addressable ad sales) and other revenues, which include the sale and distribution of television programs. Significant expenses include amortization of programming and production costs, participations and residuals expense, technical support costs, operating labor and distribution costs. Our Parks, Experiences and Products segment generates revenue from the sale of admissions to theme parks, the sale of food, beverage and merchandise at our theme parks and resorts, charges for room nights at hotels, sales of cruise vacations, sales and rentals of vacation club properties, royalties from licensing intellectual properties and sale of branded merchandise. Revenues are also generated from sponsorships and co-branding opportunities, real estate rent and sales, and royalties from Tokyo Disney Resort. Significant expenses include operating labor, costs of goods sold, infrastructure costs, depreciation and other operating expenses. Infrastructure costs include information systems expense, repairs and maintenance, utilities and fuel, property taxes, retail occupancy costs, insurance and transportation. Other operating expenses include costs for such items as supplies, commissions and entertainment offerings. Our Studio Entertainment segment generates revenue from the distribution of films in the theatrical, home entertainment and TV/SVOD markets, stage play ticket sales and licensing of our intellectual properties for use in live entertainment productions. Significant expenses include amortization of production, participations and residuals costs, marketing and sales costs, distribution expenses and costs of sales. Our Direct-to-Consumer & International segment generates revenue from affiliate fees, advertising sales (includes addressable ad sales), subscription fees for our DTC streaming and other services, and fees charged for technology support services. Significant expenses include operating expenses, selling general and administrative costs and depreciation and amortization. Operating expenses include programming and production costs (including programming, production and branded digital content obtained from other Company segments), technology support costs, operating labor and distribution costs. The Company evaluates the performance of its operating segments based on segment operating income, and management uses total segment operating income as a measure of the overall performance of the operating businesses. Total segment operating income is not a financial measure defined by GAAP, should be reviewed in conjunction with the relevant GAAP financial measure and may not be comparable to similarly titled measures reported by other companies. The Company believes that information about total segment operating income assists investors by allowing them to evaluate changes in the operating results of the Company’s portfolio of businesses separate from factors other than business operations that affect net income. The following table reconciles income from continuing operations before income taxes to total segment operating income. (1) Includes amortization of intangibles related to TFCF equity investees The following is a summary of segment revenue and operating income: Media Networks Operating results for the Media Networks segment are as follows: Revenues The increase in affiliate fees was due to increases of 8% from the consolidation of TFCF’s operations and 7% from higher contractual rates, partially offset by a decrease of approximately 2 and one-half percent from fewer subscribers. The increase in advertising revenues was due to increases of $374 million at Cable Networks, from $3,129 million to $3,503 million and $5 million at Broadcasting, from $3,457 million to $3,462 million. Cable Networks advertising revenue reflected increases of 11% from the consolidation of TFCF’s operations and 2% from higher impressions reflecting higher units delivered, partially offset by lower average viewership. Broadcasting advertising revenue was comparable to the prior-year period as increases of 7% from higher network rates and 2% from the consolidation of TFCF’s operations were offset by a decrease of 9% from average viewership. TV/SVOD distribution and other revenue increased $1,000 million, due to sales of TFCF programs, partially offset by a decrease in ABC Studios program sales. The decrease in ABC Studios program sales reflects the prior-year sales of Daredevil, Luke Cage and Iron Fist, partially offset by the current-year sale of The Punisher. Costs and Expenses Operating expenses include programming and production costs, which increased $2,142 million from $12,555 million to $14,697 million. At Cable Networks, programming and production costs increased $1,255 million due to the consolidation of TFCF’s operations and contractual rate increases for college sports, NFL, NBA and MLB programming. At Broadcasting, programming and production costs increased $887 million due to the consolidation of TFCF’s operations, partially offset by the impact of lower ABC Studios program sales. Selling, general, administrative and other costs increased from $1,899 million to $2,361 million due to the consolidation of TFCF’s operations. Segment Operating Income Segment operating income increased 2%, or $141 million, to $7,479 million due to the consolidation of TFCF’s operations, partially offset by lower income from ABC Studios program sales. The following table provides supplemental revenue and operating income detail for the Media Networks segment: Items Excluded from Segment Operating Income Related to Media Networks The following table presents supplemental information for items related to the Media Network segment that are excluded from segment operating income: (1) Amortization of step-up on film and television costs was $359 million and amortization of intangible assets was $325 million. Parks, Experiences and Products Operating results for the Parks, Experiences and Products segment are as follows: Revenues The increase in theme park admissions revenue was due to an increase of 8% from higher average ticket prices, partially offset by decreases of 2% from lower attendance and 1% from an unfavorable Foreign Exchange Impact. The decrease in attendance was due to lower attendance at Shanghai Disney Resort. Attendance at our domestic theme parks was comparable to the prior year. Parks & Experiences merchandise, food and beverage revenue growth was due to an increase of 6% from higher average guest spending, partially offset by a decrease of 1% from lower volumes. The increase in resorts and vacations revenue was primarily due to increases of 2% from higher average daily hotel room rates, 1% from an increase in average ticket prices for cruise line sailings and 1% from the consolidation of TFCF's operations. Merchandise licensing and retail revenue growth was due to increases of 3% from merchandise licensing, 1% from our retail stores, 1% from a favorable Foreign Exchange Impact and 1% from our publishing business due to the consolidation of TFCF's operations. The increase in merchandise licensing revenues was primarily due to higher revenue from products based on Toy Story, an increase in guaranteed shortfall recognition and higher revenues from Avengers and Frozen merchandise. These increases were partially offset by lower revenues from products based on Star Wars and Cars. Higher revenues at our retail stores were due to an increase in online sales. The increase in parks licensing and other revenue was due to the adoption of ASC 606 and higher real estate sales. The adoption of ASC 606 required certain cost reimbursements from licensees to be recognized as revenue rather than recorded as an offset to operating expenses. The following table presents supplemental park and hotel statistics: (1) Per room guest spending consists of the average daily hotel room rate as well as guest spending on food, beverage and merchandise at the hotels. Hotel statistics include rentals of Disney Vacation Club units. (2) Per capita guest spending growth rate is stated on a constant currency basis. Per room guest spending is stated at the fiscal 2018 average foreign exchange rate. Costs and Expenses Operating expenses include operating labor, which increased $237 million from $5,937 million to $6,174 million, cost of sales and distribution costs, which increased $154 million from $2,764 million to $2,918 million, and infrastructure costs, which increased $99 million from $2,370 million to $2,469 million. The increase in operating labor was due to inflation, including the impact of wage increases for union employees, partially offset by the comparison to a special domestic employee bonus that was recognized in fiscal 2018. The increase in cost of sales and distribution costs was driven by higher sales of food, beverage and merchandise at our theme parks and resorts. Higher infrastructure costs were due to an increase in technology spending and costs for new guest offerings, including expenses associated with Star Wars: Galaxy’s Edge. Other operating expenses, which include costs for such items as supplies, commissions and entertainment offerings, increased $199 million, from $2,255 million to $2,454 million, due to the recognition of certain cost reimbursements from licensees as revenue rather than recorded as an offset to operating expenses. Selling, general, administrative and other costs increased $203 million from $2,930 million to $3,133 million primarily due to inflation and higher marketing spend at our parks and resorts. Segment Operating Income Segment operating income increased 11%, or $663 million, to $6,758 million due to growth at our domestic theme parks and resorts and our consumer products businesses. The following table presents supplemental revenue and operating income detail for the Parks, Experiences and Products segment to provide continuity with our legacy reporting: Studio Entertainment Operating results for the Studio Entertainment segment are as follows: Revenues The increase in theatrical distribution revenue was due to the comparison of four significant Disney live-action titles, Lion King, Aladdin, Mary Poppins Returns and Dumbo in the current year to no significant Disney live-action titles in the prior year, and the consolidation of TFCF's operations. These increases were partially offset by two Marvel titles, Avengers: Endgame and Captain Marvel and no Star Wars title in the current year compared to four Marvel titles, Avengers: Infinity War, Black Panther, Thor: Ragnarok and Ant-Man and the Wasp, and two Star Wars titles, Star Wars: The Last Jedi and Solo: A Star Wars Story in the prior year. The current year also included Toy Story 4 and Ralph Breaks the Internet, while the prior year included Incredibles 2 and Coco. Higher home entertainment revenue was due to an increase of 16% from the consolidation of TFCF’s operations, partially offset by decreases of 9% from lower unit sales and 1% from a decrease in net effective pricing at our legacy operations. The decrease in unit sales was due to the release of Star Wars: The Last Jedi in the prior year compared to no Star Wars release in the current year. Other significant titles in release included Avengers: Endgame, Incredibles 2, Captain Marvel, Ant-Man and the Wasp, and Ralph Breaks the Internet in the current year and Avengers: Infinity War, Black Panther, Thor: Ragnarok, Coco and Cars 3 in the prior year. Higher TV/SVOD distribution and other revenue was due to an increase of 14% from TV/SVOD distribution, partially offset by a decrease of 2% from Lucasfilm’s special effects business due to fewer projects. The increase in TV/SVOD distribution was due to the consolidation of TFCF’s operations and, to a lesser extent, the impact of the adoption of ASC 606. Costs and Expenses Operating expenses include film cost amortization, which increased $575 million, from $3,187 million to $3,762 million, due to the consolidation of TFCF’s operations. Operating expenses also include cost of goods sold and distribution costs, which increased $163 million, from $1,262 million to $1,425 million, due to the consolidation of TFCF’s operations, partially offset by fewer projects at Lucasfilm’s special effects business. Selling, general, administrative and other costs increased $626 million from $2,493 million to $3,119 million due to the consolidation of TFCF’s operations. The increase in depreciation and amortization was due to the consolidation of TFCF’s operations. Segment Operating Income Segment operating income decreased 11%, or $318 million to $2,686 million due to the consolidation of TFCF’s operations and lower home entertainment results, partially offset by decreases in film impairments and write-offs from our legacy operations. Items Excluded from Segment Operating Income Related to Studio Entertainment The following table presents supplemental information for items related to the Studio Entertainment segment that are excluded from segment operating income: (1) Amortization of step-up on film and television costs was $179 million and amortization of intangible assets was $27 million. Direct-to-Consumer & International Operating results for the Direct-to-Consumer & International segment are as follows: Revenues The increase in affiliate fees was due to the consolidation of TFCF’s operations and to a lesser extent, higher rates at our legacy operations, partially offset by an unfavorable Foreign Exchange Impact. The increase in advertising revenues was due to increases of $1,178 million in addressable advertising sales, driven by the consolidation of Hulu’s operations, and $1,045 million at our International Channels, driven by the consolidation of TFCF’s operations. Subscription fees and other revenue increased due to the consolidation of Hulu’s operations and, to a lesser extent, the consolidation of TFCF's international program sales and higher subscription fees for ESPN+, which launched in April 2018. Costs and Expenses Operating expenses include an increase of $5,208 million in programming and production costs, from $1,572 million to $6,780 million, and an increase of $905 million in other operating expenses, from $812 million to $1,717 million. The increase in programming and production costs was due to the consolidation of Hulu and TFCF's operations and, to a lesser extent, the ramp up of our investment in ESPN+ and the upcoming launch of Disney+. Other operating expenses, which include technical support and distribution costs, increased due to the consolidation of Hulu and TFCF’s operations. Selling, general, administrative and other costs increased $1,105 million, from $1,003 million to $2,108 million, due to the consolidation of TFCF and Hulu’s operations. Depreciation and amortization increased $133 million, from $185 million to $318 million, due to the consolidation of TFCF and Hulu’s operations and increased investment in technology. Equity in the Loss of Investees Loss from equity investees decreased $340 million, from $580 million to $240 million, due to the consolidation of Hulu. Segment Operating Loss Segment operating loss increased from $738 million to $1,814 million due to the ramp up of our investment in ESPN+, which launched in April 2018, the consolidation of Hulu’s operations and costs associated with the upcoming launch of Disney+, partially offset by the consolidation of TFCF's operations. The following table presents supplemental revenue and operating income/(loss) detail for the Direct-to-Consumer & International segment. Fiscal 2019 includes revenues and operating income from the consolidation of TFCF and Hulu’s operations: Items Excluded from Segment Operating Loss Related to Direct-to-Consumer & International The following table presents supplemental information for items related to the Direct-to-Consumer & International segment that are excluded from segment operating loss: (1) Amortization of intangible assets was $687 million and amortization of step-up on film and television costs was $14 million. Eliminations Intersegment content transactions are as follows: Revenues and Operating Income The increase in the impact from eliminations was due to the elimination of sales of ABC Studios and Twentieth Century Fox Television programs to Hulu and the sales of films to Disney+. BUSINESS SEGMENT RESULTS - 2018 vs. 2017 Media Networks Operating results for the Media Networks segment are as follows: Revenues The increase in affiliate fees was due to an increase of 7% from higher contractual rates, partially offset by a decrease of 2% from fewer subscribers. The decrease in advertising revenues was due to decreases of $229 million at Cable Networks, from $3,358 million to $3,129 million and $123 million at Broadcasting, from $3,580 million to $3,457 million. The decrease at Cable Networks was due to a decrease of 6% from lower impressions as lower average viewership was partially offset by higher units delivered. The decrease at Broadcasting was due to decreases of 7% from lower network impressions and 2% from lower impressions at the owned television stations, both of which were driven by lower average viewership. The decrease was partially offset by an increase of 6% from higher network rates. TV/SVOD distribution and other revenue increased $392 million due to higher ABC Studios program sales driven by increased revenue from programs licensed to Hulu and higher sales of Grey’s Anatomy and Black-ish. Additionally, fiscal 2018 included the sales of Luke Cage, Daredevil and Jessica Jones compared to fiscal 2017 sales of The Punisher and The Defenders. Costs and Expenses Operating expenses include programming and production costs, which increased $486 million from $12,069 million to $12,555 million. At Broadcasting, programming and production costs increased $317 million due to higher program sales and a higher average cost of network programming, including the impact of American Idol, Roseanne and The Goldbergs in fiscal 2018. At Cable Networks, programming and production costs increased $169 million due to contractual rate increases for college sports, NFL, NBA and MLB programming, partially offset by lower production costs. Equity in the Income of Investees Income from equity investees decreased $55 million from $766 million to $711 million due to lower income from A+E driven by decreased advertising revenue and higher programming costs, partially offset by higher program sales. Segment Operating Income Segment operating income increased 2%, or $142 million, to $7,338 million due to higher program sales and an increase at the Domestic Disney Channels, partially offset by lower income from equity investees. The following table provides supplemental revenue and operating income detail for the Media Networks segment: Parks, Experiences and Products Operating results for the Parks, Experiences and Products segment are as follows: Revenues The increase in theme park admissions revenue was due to increases of 6% from higher average ticket prices, 4% from attendance growth and 1% from a favorable Foreign Exchange Impact. Attendance growth included a favorable comparison to the fiscal 2017 impacts of Hurricanes Irma and Matthew at Walt Disney World Resort. Parks & Experiences merchandise, food and beverage revenue growth was due to increases of 5% from higher average guest spending, 3% from volume growth and 2% from a favorable Foreign Exchange Impact. Volume growth included a benefit from the favorable comparison to the fiscal 2017 impacts of Hurricanes Irma and Matthew. The increase in resorts and vacations revenue was primarily due to increases of 3% from higher average daily hotel room rates, 1% from higher average ticket prices for cruise line sailings, 1% from a favorable Foreign Exchange Impact, 1% from an increase in passenger cruise ship days and 1% from higher occupied hotel room nights. Higher occupied hotel room nights were due to an increase at our international resorts, partially offset by a decrease at our domestic resorts, reflecting fewer available room nights at Walt Disney World Resort due to room refurbishments and conversions to vacation club units. Merchandise licensing and retail revenues were lower primarily due to decreases of 2% from licensing, 2% from lower retail sales and 1% from an unfavorable Foreign Exchange Impact. The decrease in revenue from licensing was driven by a decrease in licensee settlements and lower revenues from products based on Frozen, Cars and Princess, partially offset by an increase from products based on Mickey and Minnie and Avengers. Lower retail revenue was driven by a decrease in comparable store sales at The Disney Stores, partially offset by higher online revenue. The decrease in comparable store sales reflected lower sales of Star Wars and Moana merchandise in the fiscal 2018, partially offset by higher sales of Mickey and Minnie merchandise. The increase in parks licensing and other revenue was primarily due to an increase in real estate rental and sponsorship revenues. The following table presents supplemental park and hotel statistics: (1) Per room guest spending consists of the average daily hotel room rate as well as guest spending on food, beverage and merchandise at the hotels. Resort statistics include rentals of Disney Vacation Club units. (2) Per capita guest spending growth rate is stated on a constant currency basis. Per room guest spending is stated at the fiscal 2017 average foreign exchange rate. Costs and Expenses Operating expenses include operating labor, which increased $525 million from $5,412 million to $5,937 million, cost of goods sold and distribution costs, which increased $94 million from $2,670 million to $2,764 million and infrastructure costs, which increased $111 million from $2,259 million to $2,370 million. The increase in operating labor was due to inflation, higher volumes, an unfavorable Foreign Exchange Impact and a special fiscal 2018 domestic employee bonus. The increase in cost of goods sold and distribution costs was due to higher volumes and inflation. Higher infrastructure costs were driven by increased technology spending at our theme parks and resorts and inflation. Other operating expenses, which include costs such as supplies, commissions and entertainment offerings increased $141 million from $2,114 million to $2,255 million due to an unfavorable Foreign Exchange Impact, inflation and new guest offerings at our theme parks and resorts. Selling, general, administrative and other costs increased $34 million from $2,896 million to $2,930 million primarily due to inflation and higher technology spending, partially offset by lower costs at our games business. Depreciation and amortization increased $166 million from $2,161 million to $2,327 million primarily due to new attractions at our domestic parks and resorts and Hong Kong Disneyland Resort and asset impairments in fiscal 2018. Segment Operating Income Segment operating income increased 11%, or $608 million, to $6.1 billion due to growth at our domestic and international Parks & Experiences, partially offset by decreases at our merchandise licensing and retail businesses. The following table presents supplemental revenue and operating income detail for the Parks, Experiences and Products segment to provide continuity with our legacy reporting: Studio Entertainment Operating results for the Studio Entertainment segment are as follows: Revenues The increase in theatrical distribution revenue was due to the release of four Marvel titles in fiscal 2018 compared to two Marvel titles in fiscal 2017. The Marvel titles in fiscal 2018 were Avengers: Infinity War, Black Panther, Thor: Ragnarok and Ant-Man and the Wasp, whereas fiscal 2017 included Guardians of the Galaxy Vol. 2 and Doctor Strange. Other significant titles in fiscal 2018 included Star Wars: The Last Jedi, Incredibles 2 and Coco, while fiscal 2017 included Beauty and the Beast, Rogue One: A Star Wars Story, Pirates of the Caribbean: Dead Men Tell No Tales and Moana. Lower home entertainment revenue reflected a 5% decrease from lower unit sales, partially offset by an increase of 3% from higher average net effective pricing. Lower unit sales were driven by the success of Moana and Finding Dory in fiscal 2017 compared to Coco and Cars 3 in fiscal 2018. The decrease was also driven by three live-action titles in fiscal 2017 as compared to two live-action titles in fiscal 2018 and the carryover performance of fiscal 2016 new release titles in fiscal 2017 compared to the carryover performance of fiscal 2017 new release titles in fiscal 2018. These decreases were partially offset by the release of three Marvel titles and two Lucasfilm titles in fiscal 2018 compared to two Marvel titles and one Lucasfilm title in fiscal 2017. The increase in average net effective pricing was due to higher rates and a higher sales mix of Blu-ray discs, partially offset by a lower mix of new release titles. TV/SVOD distribution and other revenue reflected a 5% increase from TV/SVOD distribution and a 3% increase from stage plays. The increase in TV/SVOD distribution revenue was due to an increase in our free television business driven by new international agreements and the sale of Star Wars: The Force Awakens in fiscal 2018 with no comparable title in fiscal 2017. Higher stage play revenue was due to the opening of additional productions in fiscal 2018. Costs and Expenses Operating expenses include film cost amortization, which increased $625 million, from $2,562 million to $3,187 million and cost of goods sold and distribution costs, which increased $106 million, from $1,156 million to $1,262 million. Higher film cost amortization was due to the impact of higher theatrical distribution revenues. Higher cost of goods sold and distribution costs were due to an increase in stage play production and theatrical distribution costs. Selling, general, administrative and other costs increased $337 million from $2,156 million to $2,493 million primarily due to higher theatrical marketing costs reflecting more titles released in fiscal 2018 and, to a lesser extent, higher stage play marketing costs due to additional productions in fiscal 2018. Segment Operating Income Segment operating income increased 27%, or $641 million to $3,004 million due to an increase in theatrical distribution results. Direct-to-Consumer & International Operating results for the Direct-to-Consumer & International segment are as follows: Revenues The increase in affiliate fees was due to an increase of 5% from higher contractual rates, partially offset by a decrease of 2% from an unfavorable Foreign Exchange Impact. Advertising revenue increased 1% as higher addressable ad sales were largely offset by lower revenue generated from content distributed on YouTube. Other revenue increased $284 million due to the consolidation of BAMTech. In fiscal 2017, the Company acquired a controlling interest in BAMTech and began consolidating its results. The Company’s share of BAMTech’s results was previously reported in equity in the loss of investees. Costs and Expenses Operating expenses included a $147 million increase in programming and production costs, from $1,425 million to $1,572 million and a $254 million increase in other operating expenses, from $558 million to $812 million. The increase in programming and production costs was due to the consolidation of BAMTech, partially offset by lower talent costs for digital programming. Other operating costs, which include technical support and distribution costs, increased due to the consolidation of BAMTech. Selling, general, administrative and other costs increased $142 million from $861 million to $1,003 million due to the consolidation of BAMTech, partially offset by lower marketing costs at our International Channels. Depreciation and amortization increased $91 million from $94 million to $185 million due to the consolidation of BAMTech. Equity in the Loss of Investees Loss from equity investees increased $159 million from a loss of $421 million to a loss of $580 million primarily due to a higher loss from our investment in Hulu, partially offset by a favorable comparison to a loss from BAMTech in fiscal 2017. On September 25, 2017, the Company acquired a controlling interest in BAMTech and began consolidating its results. The Company’s share of BAMTech’s results was previously reported in equity in the loss of investees. The higher loss at Hulu was driven by higher programming, labor and marketing costs, partially offset by growth in subscription and advertising revenue. Segment Operating Loss Segment operating loss increased $454 million, to $738 million due to the consolidation of BAMTech and a higher loss from Hulu, partially offset by growth at our International Channels. The following table presents supplemental revenue and operating income/(loss) detail for the Direct-to-Consumer & International segment to provide information on International Channels that were historically reported in the Media Networks segment: Eliminations Intersegment content transactions are as follows: CORPORATE AND UNALLOCATED SHARED EXPENSES Corporate and unallocated shared expenses are as follows: The increases in corporate and unallocated shared expenses from fiscal 2018 to fiscal 2019 and from fiscal 2017 to fiscal 2018 were due to costs incurred in connection with the acquisition of TFCF and higher compensation costs. RESTRUCTURING IN CONNECTION WITH THE ACQUISITION OF TFCF As discussed in Note 18 to the Consolidated Financial Statements, in connection with the acquisition of TFCF the Company has begun implementing a restructuring and integration plan as a part of its initiative to realize cost synergies from the acquisition of TFCF. During fiscal 2019, we recorded charges of $1.2 billion, including $0.9 billion of severance and related costs in connection with the plan and $0.3 billion of equity-based compensation costs, primarily for TFCF awards that were accelerated to vest upon the closing of the TFCF acquisition. These charges are recorded in “Restructuring and impairment charges” in the Consolidated Statements of Income. Although our plans are not yet finalized, we anticipate that the total severance and related costs could be on the order of $1.5 billion. The Company may incur other restructuring costs, such as contract termination costs, but we expect these will not be material. For fiscal 2018, restructuring and impairment charges were not material. The following table summarizes the changes in restructuring reserves related to TFCF integration efforts in fiscal 2019: SIGNIFICANT DEVELOPMENTS In November 2019, the Company launched Disney+, a subscription based direct-to-consumer streaming service with Disney, Pixar, Marvel, Star Wars and National Geographic branded programming in the U.S. and four other countries. Further launches are planned for Western Europe in spring 2020, Latin America in fall 2021, Eastern Europe starting in late 2020 and continuing in 2021, and various Asia-Pacific territories throughout 2020 and 2021. As we will use our branded film and television content on the Disney+ service, we expect to forgo licensing revenue from the sale of this content to third parties in TV/SVOD markets. In addition, we anticipate an increase in programming and production investments to create exclusive content for Disney+. Due to the circumstances in Hong Kong, we have seen a significant decrease in tourism from China and other parts of Asia to Hong Kong Disneyland Resort. If current trends continue, Hong Kong Disneyland Resort's fiscal 2020 operating income could decrease by approximately $275 million compared to fiscal 2019. LIQUIDITY AND CAPITAL RESOURCES The change in cash, cash equivalents and restricted cash is as follows: Operating Activities Continuing operations Cash provided by operating activities for fiscal 2019 decreased 58% or $8.3 billion to $6.0 billion compared to fiscal 2018 due to the payment of approximately $7.6 billion of tax obligations that arose from the spin-off of Fox Corporation in connection with the TFCF acquisition and the sale of the RSNs acquired with TFCF, higher pension plan contributions and higher interest payments. Lower operating cash flows at our DTCI and Media Networks segments were largely offset by increases at Parks, Experiences and Products and Studio Entertainment. The decreases at DTCI and Media Networks were due to higher film and television spending and operating disbursements, partially offset by higher operating cash receipts driven by increases in revenue. The increases at Studio Entertainment and Parks, Experiences and Products were due to higher operating cash receipts driven by increases in revenue. The increase at Studio Entertainment was partially offset by higher operating cash disbursements driven by higher marketing expenses. The increase at Parks, Experiences and Products was partially offset by higher operating cash disbursements driven by cost inflation and higher marketing expenses. Cash provided by operating activities for fiscal 2018 increased 16% or $2.0 billion to $14.3 billion compared to fiscal 2017 due to a decrease in tax payments resulting from the Tax Act, a decrease in pension plan contributions and higher operating cash flows at Studio Entertainment and Parks, Experiences and Products, partially offset by lower operating cash flows at Media Networks and DTCI and a payment for the rights to develop a real estate property in New York. The increase in operating cash flow at Studio Entertainment was due to higher operating cash receipts driven by an increase in revenue, partially offset by higher operating cash disbursements driven by higher marketing expenses. Parks, Experiences and Products cash flow reflected higher operating cash receipts due to increased revenue, partially offset by higher payments for labor and other costs. Lower operating cash flow at Media Networks was due to higher television production spending. The decrease in operating cash flow at DTCI was due to higher operating cash disbursements. Depreciation expense is as follows: Amortization of intangible assets is as follows: The Company’s Studio Entertainment, Media Networks and DTCI segments incur costs to acquire and produce feature film and television programming. Film and television production costs include all internally produced content such as live-action and animated feature films, animated direct-to-video programming, television series, television specials, theatrical stage plays or other similar product. Programming costs include film or television product licensed for a specific period from third parties for use on the Company’s broadcast, cable networks, television stations or DTC services. Programming assets are generally recorded when the programming becomes available to us with a corresponding increase in programming liabilities. Accordingly, we analyze our programming assets net of the related liability. The Company’s film and television production and programming activity related to continuing operations for fiscal 2019, 2018 and 2017 are as follows: Discontinued operations Cash provided by operating activities for discontinued operations in fiscal 2019 reflected the operations of the RSNs. Investing Activities Continuing operations Investing activities consist principally of investments in parks, resorts and other property and acquisition and divestiture activity. The Company’s investments in parks, resorts and other property for fiscal 2019, 2018 and 2017 are as follows: Capital expenditures for the Parks, Experiences and Products segment are principally for theme park and resort expansion, new attractions, cruise ships, capital improvements and systems infrastructure. The increase in capital expenditures at our domestic parks and resorts in fiscal 2019 compared to fiscal 2018 was due to higher spending on new attractions at Walt Disney World Resort, partially offset by lower spending on new attractions at Disneyland Resort, while the increase in fiscal 2018 compared to fiscal 2017 was due to spending on new attractions at Walt Disney World Resort and Disneyland Resort, including Star Wars: Galaxy’s Edge. The increase in capital expenditures at our international parks and resorts in fiscal 2019 compared to fiscal 2018 was due to higher spending at Disneyland Paris, while the decrease in fiscal 2018 compared to fiscal 2017 was due to lower spending at Shanghai Disney Resort and Hong Kong Disneyland Resort. Capital expenditures at Media Networks primarily reflect investments in facilities and equipment for expanding and upgrading broadcast centers, production facilities and television station facilities. Capital expenditures at DTCI primarily reflect investments in technology. The increase in fiscal 2019 compared to fiscal 2018 and 2018 compared to fiscal 2017 was due to spending on technology to support our DTC services. Capital expenditures at Corporate primarily reflect investments in corporate facilities, information technology infrastructure and equipment. The increase in fiscal 2019 compared to fiscal 2018 was driven by investments in corporate facilities. The Company currently expects its fiscal 2020 capital expenditures will be approximately $0.5 billion higher than fiscal 2019 capital expenditures of $4.9 billion due to increased spending on technology and facilities at DTCI and Corporate. Other Investing Activities The fiscal 2019 spending of $9.9 billion on acquisitions reflects $35.7 billion of cash paid to acquire TFCF less $25.7 billion of cash acquired in the transaction (See Note 4 to the Consolidated Financial Statements). Cash used in other investing activities of $319 million in fiscal 2019 reflects contributions of $347 million to Hulu prior to the consolidation of Hulu. The fiscal 2018 spending of $1.6 billion on acquisitions was for the September 2017 acquisition of an additional 42% of BAMTech. Cash provided by other investing activities of $710 million in fiscal 2018 reflected $1.2 billion of cash received in connection with the sales of real estate and property rights, partially offset by contributions of $442 million to Hulu. The fiscal 2017 spending of $417 million on acquisitions was for the January 2017 acquisition of additional interests in BAMTech net of cash assumed upon the consolidation of BAMTech. Cash used in other investing activities of $71 million in fiscal 2017 reflected $266 million of contributions to joint ventures and investment purchases, partially offset by $173 million of proceeds from investment dispositions. Discontinued operations Cash provided by investing activities from discontinued operations in fiscal 2019 reflects the sale of the RSNs. Financing Activities Continuing operations Cash used in financing activities was $0.5 billion in fiscal 2019 compared to $8.8 billion in fiscal 2018. The net use of cash in the current year was due to $2.9 billion in dividends and $1.4 billion in acquisitions of noncontrolling interests, partially offset by proceeds from borrowing of $3.7 billion. The decrease in cash used in financing activities in fiscal 2019 compared to fiscal 2018 was due to a net increase in borrowings in the current year compared to net repayments in the prior year ($3.7 billion borrowing in fiscal 2019 compared to $2.6 billion repayment in fiscal 2018) and the absence of common stock repurchases in the current year (compared to $3.6 billion in fiscal 2018), partially offset by acquisitions of noncontrolling interests in the current year ($1.4 billion in fiscal 2019). Cash used in financing activities was $8.8 billion in fiscal 2018 compared to $9.0 billion in fiscal 2017. The net use of cash in fiscal 2018 was due to $3.6 billion of common stock repurchases, $2.5 billion in dividends and a net repayment of borrowings of $2.6 billion. Cash used in financing activities was comparable to fiscal 2017 as lower common stock repurchases ($3.6 billion in fiscal 2018 compared to $9.4 billion in fiscal 2017) and higher contributions from noncontrolling interest holders of $0.4 billion was essentially offset by a net repayment of borrowings in fiscal 2018 compared to a net increase in borrowings in fiscal 2017 ($2.6 billion repayment in fiscal 2018 compared to $3.7 billion borrowing in fiscal 2017). Discontinued operations Cash used in financing activities by discontinued operations in fiscal 2019 was due to redemption of noncontrolling interests of the RSNs. Borrowings activities and other During the year ended September 28, 2019, the Company’s borrowing activity was as follows: (1) Borrowings and reductions of borrowings are reported net. (2) The other activity is due to market value adjustments for debt with qualifying hedges. (3) The other activity is due to the sale of the RSNs in fiscal 2019. See Note 9 to the Consolidated Financial Statements for information regarding the Company’s bank facilities. The Company may use commercial paper borrowings up to the amount of its unused bank facilities, in conjunction with term debt issuance and operating cash flow, to retire or refinance other borrowings before or as they come due. See Note 12 to the Consolidated Financial Statements for a summary of the Company’s dividends and share repurchases in fiscal 2019, 2018 and 2017. We believe that the Company’s financial condition is strong and that its cash balances, other liquid assets, operating cash flows, access to debt and equity capital markets and borrowing capacity, taken together, provide adequate resources to fund ongoing operating requirements and future capital expenditures related to the expansion of existing businesses and development of new projects. However, the Company’s operating cash flow and access to the capital markets can be impacted by macroeconomic factors outside of its control. In addition to macroeconomic factors, the Company’s borrowing costs can be impacted by short- and long-term debt ratings assigned by nationally recognized rating agencies, which are based, in significant part, on the Company’s performance as measured by certain credit metrics such as interest coverage and leverage ratios. As of September 28, 2019, Moody’s Investors Service’s long- and short-term debt ratings for the Company were A2 and P-1, respectively, Standard and Poor’s long- and short-term debt ratings for the Company were A and A-1, and Fitch’s long- and short-term debt ratings for the Company were A and, respectively. The Company’s bank facilities contain only one financial covenant, relating to interest coverage, which the Company met on September 28, 2019, by a significant margin. The Company’s bank facilities also specifically exclude certain entities, including the Asia Theme Parks, from any representations, covenants or events of default. CONTRACTUAL OBLIGATIONS, COMMITMENTS AND OFF BALANCE SHEET ARRANGEMENTS The Company has various contractual obligations, which are recorded as liabilities in our consolidated financial statements. Other items, such as certain purchase commitments and other executory contracts, are not recognized as liabilities in our consolidated financial statements but are required to be disclosed in the footnotes to the financial statements. For example, the Company is contractually committed to acquire broadcast programming and make certain minimum lease payments for the use of property under operating lease agreements. The following table summarizes our significant contractual obligations and commitments on an undiscounted basis at September 28, 2019 and the future periods in which such obligations are expected to be settled in cash. In addition, the table reflects the timing of principal and interest payments on outstanding borrowings based on their contractual maturities. Additional details regarding these obligations are provided in the Notes to the Consolidated Financial Statements, as referenced in the table: (1) Excludes market value adjustments, which reduce recorded borrowings by $31 million. Includes interest payments based on contractual terms for fixed rate debt and on current interest rates for variable rate debt. In 2023, the Company has the ability to call a debt instrument prior to its scheduled maturity, which if exercised by the Company would reduce future interest payments by $1.0 billion. (2) Primarily contracts for the construction of three new cruise ships, creative talent and employment agreements and unrecognized tax benefits. Creative talent and employment agreements include obligations to actors, producers, sports, television and radio personalities and executives. (3) Contractual commitments include the following: The Company also has obligations with respect to its pension and postretirement medical benefit plans. See Note 11 to the Consolidated Financial Statements. Contingent Commitments and Contractual Guarantees See Notes 4, 7 and 15 to the Consolidated Financial Statements for information regarding the Company’s contingent commitments and contractual guarantees. Legal and Tax Matters As disclosed in Notes 10 and 15 to the Consolidated Financial Statements, the Company has exposure for certain tax and legal matters. CRITICAL ACCOUNTING POLICIES AND ESTIMATES We believe that the application of the following accounting policies, which are important to our financial position and results of operations require significant judgments and estimates on the part of management. For a summary of our significant accounting policies, including the accounting policies discussed below, see Note 2 to the Consolidated Financial Statements. Film and Television Revenues and Costs We produce films and television series for distribution in the theatrical and television markets and on our DTC streaming services. We expense the production, participation and residual costs over the applicable product life cycle based upon the ratio of the current period’s revenues to the estimated remaining total revenues (Ultimate Revenues) for each production. If our estimate of Ultimate Revenues decreases, amortization of film and television costs may be accelerated. Conversely, if our estimate of Ultimate Revenues increases, film and television cost amortization may be slowed. For film productions, Ultimate Revenues include revenues from all sources that will be earned within ten years from the date of the initial theatrical release. For television series, Ultimate Revenues include revenues that will be earned within ten years from delivery of the first episode, or if still in production, five years from delivery of the most recent episode, if later. With respect to films intended for theatrical release, the most sensitive factor affecting our estimate of Ultimate Revenues (and therefore affecting future film cost amortization and/or impairment) is theatrical performance. Revenues derived from other markets subsequent to the theatrical release (e.g. the home entertainment or television markets) have historically been highly correlated with the theatrical performance. Theatrical performance varies primarily based upon the public interest and demand for a particular film, the popularity of competing films at the time of release and the level of marketing effort. Upon a film’s release and determination of the theatrical performance, the Company’s estimates of revenues from succeeding windows and markets are revised based on historical relationships and an analysis of current market trends. The most sensitive factor affecting our estimate of Ultimate Revenues for released films is the level of expected home entertainment sales. Home entertainment sales vary based on the number and quality of competing home entertainment products, as well as the manner in which retailers market and price our products. With respect to television series or other television productions intended for broadcast, the most sensitive factors affecting estimates of Ultimate Revenues are program ratings and the strength of the advertising market. Program ratings, which are an indication of market acceptance, directly affect the Company’s ability to generate advertising revenues during the airing of the program. In addition, television series with greater market acceptance are more likely to generate incremental revenues through the licensing of program rights worldwide to television distributors, SVOD services and in home entertainment formats. Alternatively, poor ratings may result in cancellation of the program, which would require an immediate write-down of any unamortized production costs. A significant decline in the advertising market would also negatively impact our estimates. We expense the cost of television broadcast rights for acquired series, movies and other programs based on an accelerated or straight-line basis over the useful life or over the number of times the program is expected to be aired, as appropriate. Amortization of those television programming assets being amortized on a number of airings basis may be accelerated if we reduce the estimated future airings and slowed if we increase the estimated future airings. The number of future airings of a particular program is impacted primarily by the program’s ratings in previous airings, expected advertising rates and availability and quality of alternative programming. Accordingly, planned usage is reviewed periodically and revised if necessary. We amortize rights costs for multi-year sports programming arrangements during the applicable seasons based on the estimated relative value of each year in the arrangement. The estimated value of each year is based on our projections of revenues over the contract period, which include advertising revenue and an allocation of affiliate revenue. If the annual contractual payments related to each season approximate each season’s estimated relative value, we expense the related contractual payments during the applicable season. If planned usage patterns or estimated relative values by year were to change significantly, amortization of our sports rights costs may be accelerated or slowed. We also acquire, license and produce films and television series for our direct-to-consumer streaming platforms. We expense these costs based on historical and estimated viewing patterns, which may be on an accelerated or straight-line basis, as appropriate. Costs of film and television productions are subject to regular recoverability assessments, which compare the estimated fair values with the unamortized costs. The net realizable values of television broadcast program licenses and rights are reviewed using a daypart methodology. A daypart is defined as an aggregation of programs broadcast during a particular time of day or programs of a similar type. The Company’s dayparts are: primetime, daytime, late night, news and sports (includes broadcast and cable networks). The net realizable values of other cable programming assets are reviewed on an aggregated basis for each cable network. Individual programs are written off when there are no plans to air or sublicense the program. Estimated values are based upon assumptions about future demand and market conditions. If actual demand or market conditions are less favorable than our projections, film, television and programming cost write-downs may be required. For film and television series that are exploited on our direct-to-consumer streaming services, the unamortized costs are reviewed for impairment on an aggregate basis for each service. Fixed license fees charged for the right to use our television and motion picture productions are recognized as revenue when the content is available for use by the licensee. TV/SVOD distribution contracts may contain more than one title and/or provide that certain titles are only available for use during defined periods of time during the contract term. In these instances, each title and/or period of availability is generally considered a separate performance obligation. For these contracts, license fees are allocated to each title and period of availability at contract inception based on relative standalone selling price using management's best estimate. Estimates used to determine a performance obligation's standalone selling price impact the timing of revenue recognition, but not the total revenue to be recognized under the arrangements. Revenue Recognition The Company has revenue recognition policies for its various operating segments that are appropriate to the circumstances of each business. We have updated our revenue recognition policies in conjunction with our adoption of the new revenue recognition guidance as further described in Note 2 to the Condensed Consolidated Financial Statements. Pension and Postretirement Medical Plan Actuarial Assumptions The Company’s pension and postretirement medical benefit obligations and related costs are calculated using a number of actuarial assumptions. Two critical assumptions, the discount rate and the expected return on plan assets, are important elements of expense and/or liability measurement, which we evaluate annually. Other assumptions include the healthcare cost trend rate and employee demographic factors such as retirement patterns, mortality, turnover and rate of compensation increase. The discount rate enables us to state expected future cash payments for benefits as a present value on the measurement date. A lower discount rate increases the present value of benefit obligations and increases pension expense. The guideline for setting this rate is a high-quality long-term corporate bond rate. We reduced our discount rate to 3.22% at the end of fiscal 2019 from 4.31% at the end of fiscal 2018 to reflect market interest rate conditions at our fiscal 2019 year-end measurement date. The Company’s discount rate was determined by considering yield curves constructed of a large population of high-quality corporate bonds and reflects the matching of the plans’ liability cash flows to the yield curves. A one percentage point decrease in the assumed discount rate would increase total benefit expense for fiscal 2020 by approximately $313 million and would increase the projected benefit obligation at September 28, 2019 by approximately $3.6 billion. A one percentage point increase in the assumed discount rate would decrease total benefit expense and the projected benefit obligation by approximately $273 million and $3.0 billion, respectively. To determine the expected long-term rate of return on the plan assets, we consider the current and expected asset allocation as well as historical and expected returns on each plan asset class. Our expected return on plan assets is 7.25%. A lower expected rate of return on pension plan assets will increase pension expense, while a higher expected rate of return on pension plan assets will decrease pension expense. A one percentage point change in the long-term asset return assumption would impact fiscal 2020 annual benefit expense by approximately $157 million. Goodwill, Other Intangible Assets, Long-Lived Assets and Investments The Company is required to test goodwill and other indefinite-lived intangible assets for impairment on an annual basis and if current events or circumstances require, on an interim basis. Goodwill is allocated to various reporting units, which are an operating segment or one level below the operating segment. The Company compares the fair value of each reporting unit to its carrying amount, and to the extent the carrying amount exceeds the fair value, an impairment of goodwill is recognized for the excess up to the amount of goodwill allocated to the reporting unit. The impairment test for goodwill requires judgment related to the identification of reporting units, the assignment of assets and liabilities to reporting units including goodwill, and the determination of fair value of the reporting units. To determine the fair value of our reporting units, we generally use a present value technique (discounted cash flows) corroborated by market multiples when available and as appropriate. We apply what we believe to be the most appropriate valuation methodology for each of our reporting units. The discounted cash flow analyses are sensitive to our estimates of future revenue growth and margins for these businesses. In times of adverse economic conditions in the global economy, the Company’s long-term cash flow projections are subject to a greater degree of uncertainty than usual. In addition, the projected cash flows of our reporting units reflect intersegment revenues and expenses for the sale and use of intellectual property as if it was licensed to an unrelated third party. We believe our estimates are consistent with how a marketplace participant would value our reporting units. The Company is required to compare the fair values of other indefinite-lived intangible assets to their carrying amounts. If the carrying amount of an indefinite-lived intangible asset exceeds its fair value, an impairment loss is recognized for the excess. Fair values of other indefinite-lived intangible assets are determined based on discounted cash flows or appraised values, as appropriate. The Company tests long-lived assets, including amortizable intangible assets, for impairment whenever events or changes in circumstances (triggering events) indicate that the carrying amount may not be recoverable. Once a triggering event has occurred, the impairment test employed is based on whether the intent is to hold the asset for continued use or to hold the asset for sale. The impairment test for assets held for use requires a comparison of cash flows expected to be generated over the useful life of an asset group to the carrying value of the asset group. An asset group is established by identifying the lowest level of cash flows generated by a group of assets that are largely independent of the cash flows of other assets and could include assets used across multiple businesses or segments. If the carrying value of an asset group exceeds the estimated undiscounted future cash flows, an impairment would be measured as the difference between the fair value of the group’s long-lived assets and the carrying value of the group’s long-lived assets. The impairment is allocated to the long-lived assets of the group on a pro rata basis using the relative carrying amounts, but only to the extent the carrying value of each asset is above its fair value. For assets held for sale, to the extent the carrying value is greater than the asset’s fair value less costs to sell, an impairment loss is recognized for the difference. Determining whether a long-lived asset is impaired requires various estimates and assumptions, including whether a triggering event has occurred, the identification of the asset groups, estimates of future cash flows and the discount rate used to determine fair values. The Company tested its goodwill and other indefinite-lived intangible assets and long-lived assets for impairment. The impairment charges recorded for fiscal 2019, 2018 and 2017 were not material. For fiscal 2019, the fair value of our International Channels reporting unit exceeds its carrying value by less than 10%. Our International Channels reporting unit comprises the Company’s international cable networks that provide programming under multi-year licensing agreements with MVPDs. A majority of the operations in this reporting unit consist of businesses acquired in the TFCF acquisition and therefore the fair value approximates carrying value. Goodwill of this reporting unit is approximately $3 billion. Changes to key assumptions, market trends, or macroeconomic events could produce test results in the future that differ, and we could be required to record an impairment charge. The Company has investments in equity securities. For equity securities that do not have a readily determinable fair value, we consider forecasted financial performance of the investee companies, as well as volatility inherit in the external markets for these investments. If these forecasts are not met, impairment charges may be recorded. The Company tested its investments for impairment and recorded non-cash impairment charges of $538 million and $210 million in fiscal 2019 and 2018, respectively. The fiscal 2019 and fiscal 2018 impairment charges were recorded in “Equity in the income (loss) of investees, net” in the Consolidated Statements of Income. The fiscal 2017 impairment charges recorded were not material. Allowance for Doubtful Accounts We evaluate our allowance for doubtful accounts and estimate collectability of accounts receivable based on our analysis of historical bad debt experience in conjunction with our assessment of the financial condition of individual companies with which we do business. In times of domestic or global economic turmoil, our estimates and judgments with respect to the collectability of our receivables are subject to greater uncertainty than in more stable periods. If our estimate of uncollectible accounts is too low, costs and expenses may increase in future periods, and if it is too high, costs and expenses may decrease in future periods. Contingencies and Litigation We are currently involved in certain legal proceedings and, as required, have accrued estimates of the probable and estimable losses for the resolution of these proceedings. These estimates are based upon an analysis of potential results, assuming a combination of litigation and settlement strategies and have been developed in consultation with outside counsel as appropriate. From time to time, we may also be involved in other contingent matters for which we have accrued estimates for a probable and estimable loss. It is possible, however, that future results of operations for any particular quarterly or annual period could be materially affected by changes in our assumptions or the effectiveness of our strategies related to legal proceedings or our assumptions regarding other contingent matters. See Note 15 to the Consolidated Financial Statements for more detailed information on litigation exposure. Income Tax Audits As a matter of course, the Company is regularly audited by federal, state and foreign tax authorities. From time to time, these audits result in proposed assessments. The acquisition of TFCF increased the Company’s uncertain tax benefits as the Company assumed the tax liabilities of TFCF. The Company is still obtaining information related to the evaluation of the income tax impact of certain pre-acquisition transactions of TFCF which may result in adjustments to the recorded amount of uncertain tax benefits. Our determinations regarding the recognition of income tax benefits are made in consultation with outside tax and legal counsel, where appropriate, and are based upon the technical merits of our tax positions in consideration of applicable tax statutes and related interpretations and precedents and upon the expected outcome of proceedings (or negotiations) with taxing and legal authorities. The tax benefits ultimately realized by the Company may differ from those recognized in our future financial statements based on a number of factors, including the Company’s decision to settle rather than litigate a matter, relevant legal precedent related to similar matters and the Company’s success in supporting its filing positions with taxing authorities. New Accounting Pronouncements See Note 20 to the Consolidated Financial Statements for information regarding new accounting pronouncements. FORWARD-LOOKING STATEMENTS The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements made by or on behalf of the Company. We may from time to time make written or oral statements that are “forward-looking,” including statements contained in this report and other filings with the SEC and in reports to our shareholders. Such statements may, for example, express expectations or projections about future actions that we may take, including restructuring or strategic initiatives, or about developments beyond our control including changes in domestic or global economic conditions. These statements are made on the basis of management’s views and assumptions as of the time the statements are made and we undertake no obligation to update these statements. There can be no assurance, however, that our expectations will necessarily come to pass. Significant factors affecting these expectations are set forth under Item 1A - Risk Factors of this Report on Form 10-K as well as in this Item 7 - Management’s Discussion and Analysis and Item 1 - Business.

<s>[INST] (in millions, except per share data) Organization of Information Management’s Discussion and Analysis provides a narrative on the Company’s financial performance and condition that should be read in conjunction with the accompanying financial statements. It includes the following sections: Consolidated Results and NonSegment Items Business Segment Results 2019 vs. 2018 Business Segment Results 2018 vs. 2017 Corporate and Unallocated Shared Expenses Restructuring in Connection With the Acquisition of TFCF Significant Developments Liquidity and Capital Resources Contractual Obligations, Commitments and Off Balance Sheet Arrangements Critical Accounting Policies and Estimates ForwardLooking Statements CONSOLIDATED RESULTS AND NONSEGMENT ITEMS The Company’s financial results for fiscal 2019 are presented in accordance with new accounting guidance for revenue recognition (ASC 606) that we adopted at the beginning of fiscal 2019. Prior period results have not been restated to reflect this change in accounting guidance. Segment operating income for fiscal 2019 includes a $91 million benefit from the adoption of ASC 606 primarily due to the timing of recognition of TV/SVOD distribution revenue at Studio Entertainment. Further information about our adoption of ASC 606 is provided in Note 3 to the Consolidated Financial Statements. 2019 vs. 2018 As discussed in Note 4 to the Consolidated Financial Statements, the Company acquired TFCF on March 20, 2019. Additionally, in connection with the acquisition of TFCF, we acquired a controlling interest in Hulu. The Company began consolidating the results of TFCF and Hulu effective March 20, 2019. Revenues for fiscal 2019 increased 17%, or $10.1 billion, to $69.6 billion; net income attributable to Disney decreased 12%, or $1.5 billion, to $11.1 billion; and diluted earnings per share from continuing operations attributable to Disney (EPS) decreased 25%, or $2.09 to $6.27. The decrease in EPS was due to the comparison to a benefit in fiscal 2018 from U.S. federal income tax legislation (Tax Act), which was enacted in fiscal 2018 (See Note 10 to the Consolidated Financial Statements), amortization expense on intangibles and the fair value stepup on film and television costs from the TFCF acquisition and consolidation of Hulu, an increase in shares outstanding and restructuring costs incurred in connection with the acquisition and integration of TFCF. The increase in shares outstanding was due to shares that were issued in connection with the acquisition of TFCF. Additionally, the decrease in EPS reflected lower segment operating income, which included a $0.5 billion adverse impact from the consolidation of TFCF and Hulu in the current year, the absence of a gain recognized in the prior year on the sale of real estate, a charge in the current year for the extinguishment of debt and higher interest expense. These decreases were partially offset by a noncash gain recognized in the current year in connection with the acquisition of a controlling interest in Hulu (Hulu Gain) (See Note 4 to the Consolidated Financial Statements). Segment operating income from our legacy operations decreased due to higher losses at DirecttoConsumer & International and lower results at Media Networks, partially offset by growth at Parks, Experiences and Products. Revenues Service revenues for fiscal 2019 increased 19%, or $9.7 billion, to $60.5 billion, due to the consolidation of TFCF and Hulu’s operations and to a lesser extent, growth at our legacy operations. The increase at our legacy operations was due to higher guest spending at our theme parks and resorts, an increase in affiliate fees, higher theatrical distribution revenue and growth in merchandise licensing. These increases were partially offset by lower ABC Studios program sales. Service revenue reflected an approximate 1 percentage point decrease [/INST] Negative. </s>

TransMedics Group, Inc.

2020-03-17

2019-12-28

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. 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 “Item 1.A. 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 a commercial-stage medical technology company transforming organ transplant therapy for end-stage organ failure patients across multiple disease states. We developed the OCS to replace a decades-old standard of care that we believe is significantly limiting access to life-saving transplant therapy for hundreds of thousands of patients worldwide. Our innovative OCS technology replicates many aspects of the organ’s natural living and functioning environment outside of the human body. As such, the OCS represents a paradigm shift that transforms organ preservation for transplantation from a static state to a dynamic environment that enables new capabilities, including organ optimization and assessment. We believe our substantial body of clinical evidence has demonstrated the potential for the OCS to significantly increase the number of organ transplants and improve post-transplant outcomes. We developed the OCS to comprehensively address the major limitations of cold storage. The OCS is a portable organ perfusion, optimization and monitoring system that utilizes our proprietary and customized technology to replicate near-physiologic conditions for donor organs outside of the human body. We designed the OCS technology platform to perfuse donor organs with warm, oxygenated, nutrient-enriched blood, while maintaining the organs in a living, functioning state; the lung is breathing, the heart is beating and the liver is producing bile. Because the OCS significantly reduces injurious ischemic time on donor organs as compared to cold storage and enables the optimization and assessment of donor organs, it has demonstrated improved clinical outcomes relative to cold storage and offers the potential to significantly improve donor organ utilization. We designed the OCS to be a platform that allows us to leverage core technologies across products for multiple organs. To date, we have developed three OCS products, one for each of lung, heart and liver transplantations, making the OCS the only multi-organ technology platform. Our OCS products have been used for over 1,500 human organ transplants. During our clinical trials, we established relationships with over 55 leading transplant programs worldwide. We have commercialized the OCS Lung and OCS Heart outside of the United States and received our first PMA approval from the FDA in March 2018 for the use in the United States of the OCS Lung for donor lungs currently utilized for transplantation and since May 2019, for donor lungs currently unutilized for transplantation. We expect FDA action over the next six months on additional applications for PMAs we have submitted in connection with our other OCS products. Since our inception, we have focused substantially all of our resources on designing, developing and building our proprietary OCS technology platform and organ-specific OCS products; obtaining clinical evidence for the safety and effectiveness of our OCS products through clinical trials; securing regulatory approval; organizing and staffing our company; planning our business; raising capital; and providing general and administrative support for these operations. To date, we have funded our operations primarily with proceeds from sales of preferred stock and borrowings under loan agreements, proceeds from the sale of common stock in our IPO and revenue from clinical trials and commercial sales of our OCS products. Since our inception, we have incurred significant operating losses. Our ability to generate net revenue sufficient to achieve profitability will depend on the successful further development and commercialization of our products. We generated net revenue of $23.6 million and $13.0 million for the fiscal years ended December 28, 2019 and December 29, 2018, respectively. We incurred net losses of $33.5 million and $23.8 million, respectively, for those same years. As of December 28, 2019, we had an accumulated deficit of $369.5 million. We expect to continue to incur net losses for the foreseeable future as we focus on growing commercial sales of our products in both the U.S. and select non-U.S. markets, including growing our sales and clinical adoption team, which will pursue increasing commercial sales and clinical adoption of our OCS products; scaling our manufacturing operations; continuing research, development and clinical trial efforts; and seeking regulatory clearance for new products and product enhancements, including new indications, in both the U.S. and select non-U.S. markets. Further, following the closing of our IPO we have incurred and expect to continue to incur additional costs associated with operating as a public company. As a result, we will need substantial additional funding for expenses related to our operating activities, including selling, general and administrative expenses and research, development and clinical trials expenses. On May 6, 2019, we completed our IPO, pursuant to which we issued and sold 6,543,500 shares of common stock, inclusive of 853,500 shares we sold pursuant to the full exercise of the underwriters’ option to purchase additional shares. The aggregate net proceeds received by us from the IPO were $91.4 million, after deducting underwriting discounts and commissions as well as other offering costs of $6.0 million. On May 6, 2019, immediately prior to the completion of our IPO, we completed a corporate reorganization whereby TransMedics, Inc., the direct parent of TransMedics Group, Inc. prior to the corporate reorganization, became a direct, wholly-owned subsidiary of TransMedics Group, Inc. pursuant to the merger of TMDX, Inc., a direct, wholly-owned subsidiary of TransMedics Group, Inc. prior to the corporate reorganization, merged with and into TransMedics, Inc., with TransMedics, Inc. as the surviving corporation. As part of the transactions, each outstanding share of capital stock of TransMedics, Inc. was converted into shares of common stock of TransMedics Group, Inc. each outstanding option to purchase shares of common stock of TransMedics, Inc. was converted into an outstanding option to purchase shares of common stock of TransMedics Group, Inc. and each outstanding warrant to purchase shares of preferred stock of TransMedics, Inc. was converted into a warrant to purchase shares of common stock of TransMedics Group, Inc.. Because of the numerous risks and uncertainties associated with product development and commercialization, 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. Until such time, if ever, as we can generate substantial net revenue sufficient to achieve profitability, we expect to finance our operations through a combination of equity offerings, debt financings and strategic alliances. 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 are unable to raise capital or enter into such agreements as, and when, needed, we may have to significantly delay, scale back or discontinue the further development and commercialization efforts of one or more of our products, or may be forced to reduce or terminate our operations. We believe that the net proceeds from our IPO, together with our cash and cash equivalents, and marketable securities, will enable us to fund our operating expenses, capital expenditure requirements and debt service payments for at least the next 12 months. 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.” Components of Our Results of Operations Net Revenue We generate revenue primarily from sales of our single-use, organ-specific disposable sets (i.e., our organ-specific OCS Perfusion Sets sold together with our organ-specific OCS Solutions) used on our organ-specific OCS Consoles, each being a component of our OCS products. To a lesser extent, we also generate revenue from the sale of OCS Consoles to customers and from the implied rental of OCS Consoles loaned to customers at no charge. For each new transplant procedure, customers purchase an additional OCS disposable set for use on the customer’s existing organ-specific OCS Console. All of our revenue has been generated by sales to transplant centers in the United States, Europe and Asia-Pacific, or, in some cases, to distributors selling to transplant centers in select countries. Substantially all of our customer arrangements have multiple-performance obligations that contain deliverables consisting of OCS Perfusion Sets and OCS Solutions. In some of those multiple-element arrangements, the deliverables also include an OCS Console, whether sold or loaned to the customer. Some of our revenue has been generated from products sold in conjunction with the clinical trials conducted for our OCS products, under arrangements referred to as customer clinical trial agreements. Under most of these customer clinical trial agreements, we place an organ-specific OCS Console at the customer site for its use free of charge for the duration of the clinical trial, and the customer separately purchases from us the OCS disposable sets used in each transplant procedure during the clinical trial. When we loan the OCS Console to the customer, we retain title to the console at all times and do not require minimum purchase commitments from the customer related to any OCS products. In such cases, we invoice the customer for OCS disposable sets based on customer orders received for each new transplant procedure and the prices set forth in the customer agreement. Over time, we typically recover the cost of the loaned OCS Console through the customer’s continued purchasing and use of additional OCS disposable sets. For these reasons, we have determined that part of the arrangement consideration for the disposable set is an implied rental payment for use of the OCS Console. We intend to continue to loan OCS Consoles to some of our customers during commercialization of our OCS products. Because all elements of a customer order are delivered and recognized as revenue at the same time and because revenue allocated to elements other than OCS disposable sets, such as implied rental income and service revenue, is insignificant, all elements of revenue from customer arrangements are classified as a single category of revenue in our consolidated statements of operations. Under some of our customer clinical trial agreements, we make payments to our customers for reimbursements of clinical trial materials and for specified clinical documentation related to their use of our OCS products. Because some of these payments do not provide us with a separately identifiable benefit, we record such payments as a reduction of revenue from the customer, resulting in our net revenue presentation. We recorded reimbursable clinical trial costs as a reduction of revenue of $2.2 million and $1.6 million for the fiscal years ended December 28, 2019 and December 29, 2018, respectively. Prior to the fourth quarter of 2018, all of our net revenue in the United States had been generated from sales of OCS disposable sets sold in conjunction with clinical trials conducted for our OCS products. In March 2018, we received our first PMA for the OCS Lung, and we began commercial sales of this product in the United States during the fourth quarter of 2018. Therefore, commencing in the fourth quarter of 2018, our net revenue in the United States is derived from both clinical trial sales and commercial sales and consists primarily of sales of OCS disposable sets and, to a much lesser extent, sales of OCS Consoles. In May 2019, we received our second FDA PMA approval for the OCS Lung for additional clinical indications. We expect to continue to have U.S. clinical trial sales for our OCS Heart and OCS Liver products until we receive similar FDA PMA approvals for those products. Historically, our net revenue in the United States fluctuated from period to period as a result of the timing of patient enrollment in our clinical trials. Our net revenue during periods of patient enrollment has been higher due to the sale of OCS disposable sets for use during these clinical trials, as compared to periods during which our clinical trials were not actively enrolled. Our OCS Heart EXPAND Trial began patient enrollment in September 2015 and completed patient enrollment in March 2018. Our Liver PROTECT Trial began enrollment in January 2016 and completed enrollment in October 2019. Our OCS Lung EXPAND II Trial began patient enrollment in March 2018 and has stopped enrollment as of June 24, 2019 since we received FDA PMA approval for the OCS Lung EXPAND indication. Our OCS Heart EXPAND CAP Trial and our OCS Heart DCD Trial began patient enrollment in May 2019 and December 2019, respectively, and are currently enrolling patients. Our OCS Liver PROTECT CAP Trial began patient enrollment in February 2020 and is currently enrolling patients. Our net revenue may continue to fluctuate from period to period as a result of the timing of ongoing clinical trials in which our OCS products are used. Through December 28, 2019, all of our sales outside of the United States have been commercial sales (unrelated to any clinical trials) and our net revenue has been generated primarily from sales of OCS disposable sets and, to a much lesser extent, sales of OCS Consoles. Commercial sales of OCS disposable sets generally have a higher average selling price than clinical trial sales of OCS disposable sets. We expect that our net revenue will increase in the future as a result of receiving our first two FDA PMA approvals for the OCS Lung in the United States in March 2018 and May 2019 and any potential future FDA approvals in the United States for OCS Heart and OCS Liver. We also expect that our net revenue will increase as a result of anticipated growth in non-U.S. sales if national healthcare systems begin to reimburse transplant centers for the use of the OCS, if transplant centers utilize the OCS in more transplant cases, and if more transplant centers adopt the OCS in their programs. Our consolidated financial results for the fiscal year ended December 28, 2019 reflect our adoption of ASC 606, Revenue from Contracts with Customers, as of December 30, 2018, applied using the modified retrospective method. Under this method, (i) the new guidance was applied to customer contracts that were not yet completed as of December 29, 2018, with the cumulative effect of initially applying the new guidance being recorded as an adjustment to accumulated deficit on the effective date of adoption, and (ii) our historical results for all periods prior to December 30, 2018, including for the fiscal year ended December 29, 2018 are not adjusted. Our adoption of ASC 606 did not have a material impact on our consolidated financial statements, and the revenue recognition of our OCS products remained substantially unchanged. The impact of the adoption of ASC 606 on our consolidated financial statements is described in Note 2 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. Cost of Revenue, Gross Profit and Gross Margin Cost of revenue consists primarily of costs of components of our OCS Consoles and disposable sets, costs of direct materials, labor and the manufacturing overhead that directly supports production, and costs related to the depreciation of OCS Consoles loaned to customers. When we loan an OCS Console to a customer for its use free of charge, we capitalize as property and equipment the cost of our OCS Console and depreciate these assets over the five-year estimated useful life of the console. Included in the cost of disposable sets is the cost of our OCS Lung, OCS Heart and OCS Liver Solutions. In the fiscal year ended December 29, 2018, if we did not meet our annual obligation to purchase minimum quantities from our supplier of OCS Lung Solution, we were obligated to pay a premium equal to the order shortfall multiplied by a specified price. We capitalized any estimated premium we expected to pay at the end of each year as an adjustment to the inventory cost of OCS Lung Solution ordered during that year. The capitalized inventory adjustment is recognized as a component of cost of revenue when related OCS disposable sets are sold. We expect that cost of revenue will increase in absolute dollars primarily as, and to the extent that, our net revenue increases. Gross profit is the amount by which our net revenue exceeds our cost of revenue in each reporting period. We calculate gross margin as gross profit divided by net revenue. Our gross margin has been and will continue to be affected by a variety of factors, primarily production volumes, the cost of components and direct materials, manufacturing costs, headcount, the selling price of our OCS products and fluctuations in amounts paid by us to customers related to reimbursements of their clinical trial expenses. We expect that cost of revenue as a percentage of net revenue will decrease and gross margin and gross profit will increase over the long term as our sales and production volumes increase and our cost per unit of our disposable sets decreases due to efficiencies of scale. We intend to use our design, engineering and manufacturing capabilities to further advance and improve the efficiency of our manufacturing processes, which we believe will reduce costs and increase our gross margin. As utilization by customers of our OCS products increases, we expect that a greater number of OCS disposable sets will be used per year on the same OCS Console, thereby driving overall gross margin improvement. Because we expect that the number of OCS disposable sets sold over time will be significantly greater than the number of OCS Consoles sold or loaned to customers over that same period, we expect that our gross margin improvement will not be significantly affected by the number of OCS Consoles that we sell or loan to customers. While we expect gross margin to increase over the long term, it will likely fluctuate from quarter to quarter. Operating Expenses Research, Development and Clinical Trials Expenses Research, development and clinical trials expenses consist primarily of costs incurred for our research activities, product development, hardware and software engineering, clinical trials to develop clinical evidence of our products’ safety and effectiveness, regulatory expenses, testing, consultant services and other costs associated with our OCS technology platform and OCS products, which include: • employee-related expenses, including salaries, related benefits and stock-based compensation expense for employees engaged in research, hardware and software development, regulatory and clinical trial functions; • expenses incurred in connection with the clinical trials of our products, including under agreements with third parties, such as consultants, contractors and data management organizations; • the cost of maintaining and improving our product designs, including the testing of materials and parts used in our products; • laboratory supplies and research materials; and • facilities, depreciation and other expenses, which include direct and allocated expenses for rent and maintenance of facilities and insurance. We expense research, development and clinical trials costs as incurred. In the future, we expect that research, development and clinical trials expenses will increase due to ongoing product development and approval efforts. We expect to continue to perform activities related to obtaining additional regulatory approvals for expanded indications in the United States and to developing the next generation of our OCS technology platform. Selling, General and Administrative Expenses Selling, general and administrative expenses consist primarily of salaries and related costs, including stock-based compensation, for personnel in our sales and clinical adoption team and personnel in executive, marketing, finance and administrative functions. Selling, general and administrative expenses also include direct and allocated facility-related costs, promotional activities, marketing, conferences and trade shows as well as professional fees for legal, patent, consulting, investor and public relations, accounting and audit services. We expect to continue to increase headcount in our sales and clinical adoption team and increase marketing efforts as we continue to grow commercial sales of our OCS products in both U.S. and select non-U.S. markets. We expect that our selling, general and administrative expenses will increase as we increase our headcount to support the expected continued sales growth of our OCS products. 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) Interest Expense Interest expense consists of interest expense associated with outstanding borrowings under a prior loan agreement and our existing loan agreement as well as the amortization of debt discount associated with such agreements. We expect our interest expense will increase in connection with our Credit Agreement with OrbiMed, under which we borrowed $35.0 million in June 2018. At that time, we repaid the remaining $6.7 million of principal that had been outstanding under our prior loan and security agreement with Hercules Technology Growth Capital, or Hercules, thereby increasing our total debt by $28.3 million. Change in Fair Value of Preferred Stock Warrant Liability In connection with our prior loan and security agreement, as amended, with Hercules, we issued warrants to purchase 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. On May 6, 2019, immediately prior to the closing of our IPO, the warrants to purchase preferred stock were converted into warrants to purchase common stock, and the fair value of the warrant liability at that time was reclassified to common stock. As a result, subsequent to the closing of our IPO, we no longer remeasure the fair value of the warrant liability at each reporting date. Other Income (Expense), Net Other income (expense), net includes interest income, foreign currency transaction gains and losses and other non-operating income and expense items unrelated to our core operations, including the loss on extinguishment of debt that we recognized in June 2018 in connection with our repayment of borrowings under our loan and security agreement with Hercules. Interest income consists of interest earned on our invested cash balances. Foreign currency transaction gains and losses result from intercompany transactions as well as transactions with customers or vendors denominated in currencies other than the functional currency of the legal entity in which the transaction is recorded. Provision for Income Taxes Since our inception, we have not recorded any U.S. federal or state income tax benefits for the net operating losses we have incurred in each year or for the research and development tax credits we generated in the United States, as we believe, based upon the weight of available evidence, that it is more likely than not that all of our net operating loss carryforwards and tax credits will not be realized. In reporting periods subsequent to 2016, we have recorded provisions for foreign income taxes of an insignificant amount related to the operations of one of our foreign subsidiaries. As of December 28, 2019, we had U.S. federal and state net operating loss carryforwards of $287.8 million and $217.8 million, respectively, which may be available to offset future taxable income and begin to expire in 2020 and 2030 respectively. Our federal net operating losses include $72.8 million, which can be carried forward indefinitely. As of December 28, 2019, we also had U.S. federal and state research and development tax credit carryforwards of $7.0 million and $4.7 million, respectively, which may be available to offset future tax liabilities and begin to expire in 2020 and 2024, respectively. As of December 28, 2019, we had no foreign net operating loss carryforwards. We have recorded a full valuation allowance against our net deferred tax assets at each balance sheet date. Results of Operations Our fiscal year ends on the last Saturday in December, and we report fiscal years using a 52/53-week convention. Under this convention, certain fiscal years contain 53 weeks. Each fiscal year is typically composed of four 13-week fiscal quarters, but in years with 53 weeks, the fourth quarter is a 14-week period. Our fiscal year ended December 28, 2019 and December 29, 2018 included 52 weeks. Comparison of the Fiscal Years Ended December 28, 2019 and December 29, 2018 The following table summarizes our results of operations for the fiscal years ended December 28, 2019 and December 29, 2018: Net Revenue, Cost of Revenue and Gross Profit Net revenue increased by $10.6 million in the fiscal year ended December 28, 2019 compared to the fiscal year ended December 29, 2018 primarily as a result of an increase in the number of OCS disposable sets sold to customers globally. Net revenue from customers in the United States was $16.3 million in the fiscal year ended December 28, 2019 and increased by $9.7 million in the fiscal year ended December 28, 2019 compared to the fiscal year ended December 29, 2018. The increase in net revenue from customers in the United States was primarily due to commercial sales of OCS Lung products, sales of OCS disposable sets for use in our OCS Heart EXPAND CAP Trial and OCS Heart DCD Trial and sales of OCS disposable sets to customers for use in our OCS Liver PROTECT Trial. Net revenue from sales of OCS Lung products in the United States increased from $4.4 million in the fiscal year ended December 29, 2018 to $8.0 million in the fiscal year ended December 28, 2019, and the increase was due to sales of OCS Lung disposable sets. Net revenue from OCS Heart disposable sets sold to customers for use in our OCS Heart EXPAND CAP Trial and OCS Heart DCD Trial increased from $0.0 million in the fiscal year ended December 29, 2018 to $4.7 million in the fiscal year ended December 28, 2019. Net revenue from OCS Liver disposable sets sold to customers for use in our OCS Liver PROTECT Trial increased from $2.0 million in the fiscal year ended December 29, 2018 to $3.5 million in the fiscal year ended December 28, 2019. In addition, the U.S. selling price of OCS disposable sets sold in the fiscal year 2019 was approximately 17% higher than the U.S. selling prices of OCS disposable sets sold in the fiscal year 2018, which accounted for $3.8 million of the overall $9.7 million increase in net revenue in the United States in the fiscal year 2018 to the fiscal year 2019. Net revenue from customers outside the U.S. was $7.4 million in the fiscal year ended December 28, 2019 and increased by $0.9 million compared to the fiscal year ended December 29, 2018. The increase in net revenue from customers outside the United States was primarily due to sales of OCS Heart disposable sets to existing customers along with the addition of several new customers in the year. The increases in net revenue by OCS product (i.e., OCS Lung, OCS Heart and OCS Liver) in the fiscal year ended December 28, 2019 compared to the fiscal year ended December 29, 2018 were each primarily due to an increase in the number of OCS disposable sets sold for each organ-specific OCS product. Cost of Revenue, Gross Profit and Gross Margin Cost of revenue increased by $2.5 million in the fiscal year ended December 28, 2019 compared to the fiscal year ended December 29, 2018. Gross profit increased by $8.1 million in the fiscal year ended December 28, 2019 compared to the fiscal year ended December 29, 2018. Gross margin was 59% and 44% for the fiscal year ended December 28, 2019 and December 29, 2018, respectively. Gross profit and gross margin increased primarily as a result of a higher average selling price of OCS disposable sets sold in the United States in the fiscal year ended December 28, 2019 relative to the average selling price of OCS disposable sets in the fiscal year ended December 29, 2018 and overall higher sales, which resulted in a reduction of the impact of fixed costs in our manufacturing operation. Operating Expenses Research, Development and Clinical Trials Expenses Total research, development and clinical trials expenses increased by $6.2 million from $13.7 million in the fiscal year ended December 29, 2018 to $19.9 million in the fiscal year ended December 28, 2019. Clinical trials costs increased by $2.1 million, primarily due to clinical trial activity in our active clinical trials; the OCS Liver PROTECT Trial, the OCS Heart EXPAND CAP Trial and the OCS Heart DCD Trial. Consulting and third-party testing costs increased by $2.0 million primarily due to clinical trial activity and new product development. Personnel related costs increased $0.6 million primarily due to additional resources supporting clinical trials and new product development. Selling, General and Administrative Expenses Total selling, general and administrative expenses increased by $11.3 million from $12.3 million in the fiscal year ended December 29, 2018 to $23.6 million in the fiscal year ended December 28, 2019 primarily due to increases in personnel-related costs and professional and consultant fees as we hired additional resources and engaged consultants to support commercial sales of our OCS Lung product in the United States and to support our operation as a public company. All other costs also increased by $3.0 million primarily as a result of increased costs to operate as a public company. Other Income (Expense) Interest Expense Interest expense for the fiscal year December 29, 2018 consisted of interest on the outstanding borrowings under our loan and security agreement with Hercules and our Credit Agreement with OrbiMed. Our loan and security agreement with Hercules was outstanding through June 22, 2018, when we terminated and repaid in full the borrowings under that agreement and entered into a new Credit Agreement with OrbiMed. Interest expense increased by $1.6 million in the fiscal year ended December 28, 2019 compared to the fiscal year ended December 29, 2018 primarily as a result of a $28.3 million increase in our total outstanding borrowings in June 2018. Change in Fair Value of Preferred Stock Warrant Liability The change in the fair value of our preferred stock warrant liability in the fiscal year ended December 29, 2018 was due primarily to the changes in the fair value of our preferred stock during those periods. On May 6, 2019, immediately prior to the closing of our IPO, the warrants to purchase preferred stock were converted into warrants to purchase common stock, and the fair value of the warrant liability at that time was reclassified to common stock. As a result, subsequent to the closing of our IPO, we no longer remeasure the fair value of the warrant liability at each reporting date. Other Income (Expense), Net Other income (expense), net for the fiscal years ended December 28, 2019 and December 29, 2018 included interest income of $1.0 million and $0.3 million, respectively, resulting from interest earned on invested cash balances, and included $0.2 million of foreign currency transaction losses in both periods. Additionally, other income (expense), net for the fiscal year ended December 29, 2018 included a loss on extinguishment of debt of $0.3 million that we recognized in connection with the prepayment of our borrowings under our loan and security agreement with Hercules upon entering into our new Credit Agreement with OrbiMed. Liquidity and Capital Resources Since our inception, we have incurred significant operating losses. To date, we have funded our operations primarily with proceeds from sales of preferred stock and borrowings under loan agreements, proceeds from the sale of common stock in our IPO and revenue from clinical trials and commercial sales of our OCS products. On May 6, 2019, we completed our IPO, pursuant to which we issued and sold 6,543,500 shares of common stock, inclusive of 853,500 shares we sold pursuant to the full exercise of the underwriters’ option to purchase additional shares. The aggregate net proceeds received by us from the IPO were $91.4 million, after deducting underwriting discounts and commissions as well as other offering costs of $6.0 million. As of December 28, 2019, we had cash, cash equivalents and marketable securities of $80.7 million. Cash Flows The following table summarizes our sources and uses of cash for each of the fiscal periods presented: Operating Activities During the fiscal year ended December 28, 2019, operating activities used $32.3 million of cash, primarily resulting from our net loss of $33.5 million and net cash used by changes in our operating assets and liabilities of $1.6 million, partially offset by net non-cash charges of $2.9 million. Net cash used by changes in our operating assets and liabilities for the fiscal year ended December 28, 2019 consisted primarily of a $4.1 million increase in inventory, a $3.2 million increase in accounts receivable all partially offset by a $5.9 million increase in accounts payable and accrued expenses and other current liabilities. During the fiscal year ended December 29, 2018, operating activities used $26.0 million of cash, primarily resulting from our net loss of $23.8 million and net cash used by changes in our operating assets and liabilities of $4.3 million, partially offset by net non-cash charges of $2.1 million. Net cash used by changes in our operating assets and liabilities for the fiscal year ended December 29, 2018 consisted primarily of a $2.7 million increase in inventory, a $2.5 million increase in accounts receivable and a $1.4 million increase in prepaid expenses and other current assets, all partially offset by a $2.5 million increase in accounts payable and accrued expenses and other current liabilities. Changes in accounts receivable, inventory, accounts payable, and accrued expenses and other current liabilities in each reporting period are generally due to growth in our business, including the growth in sales, expenses and employee headcount. Our deferred rent balance will continue to decrease in each reporting period during the remaining term of the leases for our leased property. Investing Activities During the fiscal year ended December 28, 2019, net cash used by investing activities was $60.5 million, primarily due to the purchases of marketable securities of $82.4 million and purchases of property and equipment of $0.2 million, partially offset by the proceeds from sales and maturities of marketable securities of $22.0 million. During the fiscal year ended December 29, 2018, net cash provided by investing activities was $12.3 million, due to the maturities of marketable securities of $12.7 million, partially offset by purchases of property and equipment of $0.4 million. Financing Activities During the fiscal year ended December 28, 2019, net cash provided by financing activities was $92.7 million, consisting primarily of net proceeds from issuance of common stock in our IPO that closed in May 2019, partially offset by payment of offering costs related to our IPO. During the fiscal year ended December 29, 2018, net cash provided by financing activities was $22.1 million, consisting primarily of net proceeds from borrowings under our Credit Agreement with OrbiMed of $33.4 million, partially offset by the repayment of our previously outstanding borrowings under our loan and security agreement with Hercules of $9.1 million, representing principal of $8.5 million and the end-of-term payment of $0.6 million, and the payment of $2.3 million of offering costs related to our IPO. Long-Term Debt In June 2018, TransMedics entered into the Credit Agreement with OrbiMed, pursuant to which it borrowed $35.0 million. Borrowings under the Credit Agreement bear interest at an annual rate equal to the LIBOR subject to a minimum of 1.0% and a maximum of 4.0%, plus 8.5%, or the Applicable Margin, subject in the aggregate to a maximum interest rate of 11.5%. In addition, borrowings under the Credit Agreement bear paid-in-kind, or PIK interest, at an annual rate equal to the amount by which LIBOR plus the Applicable Margin exceeds 11.5%, but not to exceed 12.5%. The PIK interest is added to the principal amount of the borrowings outstanding at the end of each quarter until the maturity date of the Credit Agreement in June 2023. Borrowings under the Credit Agreement are repayable in quarterly interest-only payments until the maturity date, at which time all principal and accrued interest is due and payable. At our option, we may prepay outstanding borrowings under the Credit Agreement, subject to a prepayment premium of 9.0% of the principal amount of any prepayment within the first three years, which percentage decreases annually until it reaches zero at the end of three years. We are also required to make a final payment in an amount equal to 3.0% of the principal amount of any prepayment or repayment, which we are accreting to interest expense over the term of the Credit Agreement using the effective interest method. All obligations under the Credit Agreement are guaranteed by us and each of our material subsidiaries. All obligations of us and each guarantor are secured by substantially all of our and each guarantor’s assets, including their intellectual property, subject to certain exceptions, including a perfected security interest in substantially all tangible and intangible assets of us and each guarantor. Under the Credit Agreement, we have agreed to certain affirmative and negative covenants to which we will remain subject until maturity. The covenants include maintaining a minimum liquidity amount of $3.0 million; the requirement, on an annual basis, to deliver to OrbiMed annual audited financial statements with an unqualified audit opinion from our independent registered public accounting firm; and restrictions on our activities, including limitations on dispositions, mergers or acquisitions; encumbering our intellectual property; incurring indebtedness or liens; paying dividends; making certain investments; and engaging in certain other business transactions. The obligations under the Credit Agreement are subject to acceleration upon the occurrence of specified events of default, including payment default, change in control, bankruptcy, insolvency, certain defaults under other material debt, certain events with respect to governmental approvals (if such events could cause a material adverse change in our business), failure to comply with certain covenants. including the minimum liquidity and unqualified audit opinion covenants, and a material adverse change in our business, operations or other financial condition. As of December 28, 2019, we were in compliance with all of the other covenants under the Credit Agreement. Upon the occurrence of an event of default and until such event of default is no longer continuing, the Applicable Margin will increase by 4.0% per annum. If an event of default (other than certain events of bankruptcy or insolvency) occurs and is continuing, OrbiMed may declare all or any portion of the outstanding principal amount of the borrowings plus accrued and unpaid interest to be due and payable. Upon the occurrence of certain events of bankruptcy or insolvency, all of the outstanding principal amount of the borrowings plus accrued and unpaid interest will automatically become due and payable. In addition, we may be required to prepay outstanding borrowings, subject to certain exceptions, with portions of net cash proceeds of certain asset sales and certain casualty and condemnation events. In June 2018, we repaid all amounts due under our 2015 loan and security agreement with Hercules and the loan and security agreement was terminated. Funding Requirements As we continue to pursue and increase commercial sales of our OCS products, we expect our costs and expenses to increase in the future, particularly as we expand our sales and clinical adoption team, scale our manufacturing operation, continue research, development and clinical trial efforts, and seek regulatory clearance for new products and product enhancements, including new indications, both in the United States and in select non-U.S. markets. In addition, following the closing of our IPO, we have incurred and expect to continue to incur additional costs associated with operating as a public company. The timing and amount of our operating and capital expenditures will depend on many factors, including: • the amount of net revenue generated by sales of our OCS Consoles, OCS disposable sets and other products that may be approved in the United States and select non-U.S. markets; • the costs and expenses of expanding our U.S. and non-U.S. sales and marketing infrastructure and our manufacturing operations; • the extent to which our OCS products are adopted by the transplant community; • the ability of our customers to obtain adequate reimbursement from third-party payors for procedures performed using the OCS products; • the degree of success we experience in commercializing our OCS products for additional indications; • the costs, timing and outcomes of any future clinical studies and regulatory reviews, including to seek and obtain approvals for new indications for our OCS products; • the emergence of competing or complementary technologies; • the number and types of future products we develop and commercialize; • the costs of preparing, filing and prosecuting patent applications and maintaining, enforcing and defending intellectual property-related claims; and • the level of our selling, general and administrative expenses. We believe that our existing cash, cash equivalents, and marketable securities will enable us to fund our operating expenses, capital expenditure requirements, and debt service payments for at least twelve months following the filing of our annual report on Form 10-K. We may need to raise additional funding, which might not be available on favorable terms or at all. See “Item 1.A. Risk Factors-Risks Related to Our Financial Position and Need for Additional Capital” in this Annual Report on Form 10-K. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 28, 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 Andover, Massachusetts under two operating lease agreements. On January 9, 2020, the Company amended these lease agreements to, among other things, extended the expiration date of each lease to December 2026, increase the rentable square feet subject to each lease, and increase annual base rent for each lease. For more information, see “Note 19. Subsequent Events” to the consolidated financial statements included in Part II, Item 8 of this Annual Report on Form 10-K. (2) Amounts in table reflect the contractually required principal and interest payments payable under the Credit Agreement, under which borrowings bear interest at a variable rate. For purposes of this table, the interest due under the Credit Agreement was calculated using an assumed interest rate of 10.63% per annum, which was the interest rate in effect as of December 28, 2019. Because such interest rate is below the PIK interest threshold of 11.5%, we did not include PIK in our calculated payments. As of December 29, 2018, we were obligated to pay financing fees of $1.5 million to our former financial advisors related to issuances of Series B preferred stock and Series D preferred stock in periods prior to 2016. These financing fees were contingently payable in cash only upon an initial public offering or certain alternative transactions, including a sale of our company. As a result of the IPO in May 2019, we became obligated to pay these previously accrued financing fees. We settled the obligations in full during the third and fourth quarter of the fiscal year ended December 28, 2019. We also enter into other contracts in the normal course of business with consulting firms, material suppliers and other third parties for 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. Inflation Risk We do not believe that inflation has had a material effect on our business, financial condition or results of operations. If our costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs through price increases. Our inability or failure to do so could harm our business, financial condition or results of operations. 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, assumptions and judgments that affect the reported amounts of assets, liabilities, revenue, costs and expenses, and related disclosures. We evaluate our estimates 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 included 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 generate revenue primarily from sales of our single-use, organ-specific disposable sets (i.e., our organ-specific OCS Perfusion Sets sold together with our organ-specific OCS Solutions) used on our organ-specific OCS Consoles, each being a component of our OCS products. To a lesser extent, we also generate revenue from the sale of OCS Consoles to customers and from the implied rental of OCS Consoles loaned to customers at no charge. For each new transplant procedure, customers purchase an additional OCS disposable set for use on the customer’s existing organ-specific OCS Console. On December 30, 2018, we adopted ASC 606, which amended revenue recognition principles and provides a single, comprehensive set of criteria for revenue recognition within and across all industries. The new revenue standard 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. We recognize revenue from sales to customers applying the following five steps: (1) identification of the contract, or contracts, with a customer, (2) identification of the performance obligations in the contract, (3) determination of the transaction price, (4) allocation of the transaction price to the performance obligations in the contract, and (5) recognition of revenue when, or as, performance obligations are satisfied. Because all performance obligations of a customer order are delivered and recognized as revenue at the same time and because revenue allocated to performance obligations other than OCS disposable sets, such as implied rental income and service revenue, is insignificant, all components of revenue from customer arrangements are classified as a single category of revenue in our consolidated statements of operations. Substantially all of our customer arrangements have multiple-performance obligations that contain deliverables consisting of OCS Perfusion Sets and OCS Solutions. In some of those multiple-performance obligation arrangements, the deliverables also include an OCS Console, whether sold or loaned to the customer. We evaluate each promise within a multiple-performance obligation arrangement to determine whether it represents a distinct performance obligation. A performance obligation is distinct if (1) the product or service is separately identifiable from other promises in the contract and (2) the customer can benefit from the product or service on its own or with other resources that are readily available to the customer. When a customer order includes an OCS Console, whether sold or loaned, we have determined that customer training and the equipment set-up of the OCS Console, each performed by us, are not distinct because they are not sold on a standalone basis and can only be performed by us in conjunction with a sale or loan of our OCS Console. In addition, we have determined that the OCS Console itself is not distinct because the customer cannot benefit from the OCS Console without the training and equipment set-up having been completed. As a result, when the order includes an OCS Console, we have concluded that training, OCS Console equipment set-up, and the OCS Console itself are highly interdependent and represent a single, combined performance obligation. Consequently, we do not recognize any revenue from any component of a customer order that includes an OCS Console, whether sold or loaned, until the OCS Console has arrived at the customer site and the training and equipment set-up have been completed by us. We have concluded that “transfer of control” of an OCS Console occurs only after the console has arrived at the customer site and the training and equipment set-up have been completed by us. Some of our revenue has been generated from products sold in conjunction with the clinical trials conducted for our OCS products, under arrangements referred to as customer clinical trial agreements. Under most of these customer clinical trial agreements, we place an organ-specific OCS Console at the customer site for its use free of charge for the duration of the clinical trial, and the customer separately purchases from us the OCS disposable sets used in each transplant procedure during the clinical trial. When we loan the OCS Console to the customer, we retain title to the console at all times and do not require minimum purchase commitments from the customer related to any OCS products. In such cases, we invoice the customer for OCS disposable sets based on customer orders received for each new transplant procedure and the prices set forth in the customer agreement. Over time, we typically recover the cost of the loaned OCS Console through the customer’s continued purchasing and use of additional OCS disposable sets. For these reasons, we have determined that part of the arrangement consideration for the disposable set is an implied rental payment for use of the OCS Console. When a customer arrangement contains multiple-performance obligations that include a loan of an OCS Console for the customer’s use at the customer site as well as OCS disposable sets that are delivered simultaneously, we allocate the arrangement consideration between the lease deliverables (i.e., the OCS Console) and non-lease deliverables (i.e., the OCS disposable sets) based on the relative estimated standalone selling price, or SSP, of each distinct performance obligation. To date, the amounts allocated to lease deliverables have been insignificant. In determining SSP, we maximize observable inputs and consider a number of data points, including: (1) the pricing of standalone sales (in instances where available), (2) the pricing established by management when setting prices for deliverables that are intended to be sold on a standalone basis, (3) contractually stated prices for deliverables that are intended to be sold on a standalone basis, and (4) other pricing factors, such as the geographical region in which the products are sold and expected discounts based on the customer size and type. Revenue is recognized when control of the OCS product or products is transferred to the customer in an amount that reflects the consideration we expect to be entitled to in exchange for the product or products. Performance Obligations The primary performance obligations in our customer arrangements from which we derive revenue are as follows: • OCS Console-The OCS Console is a medical device that houses and controls the function of the OCS. The performance obligation of the OCS Console includes customer training and equipment set-up. Revenue for each OCS Console is recognized at the point in time at which control is transferred to the customer, which is typically only after the console has arrived at the customer site and the training and equipment set-up have been completed by us because the customer cannot benefit from the OCS Console without the training and equipment set-up having been completed. At that time, we believe control has been transferred to the customer. • OCS Perfusion Set-The OCS Perfusion Set is a single-use disposable set that stores the organ and circulates blood. Revenue for each OCS Perfusion Set is recognized at the point in time at which control is transferred to the customer, which is when title transfers to the customer in connection with delivery. In most of our customer arrangements, title to the OCS Perfusion Set transfers when the OCS Perfusion Set arrives at the customer site. In limited instances, title transfers upon shipment by us to the customer. • OCS Solutions-The OCS Solutions are a set of nutrient-enriched solutions to optimize the organ’s condition outside the human body. Revenue for each OCS Solution is recognized at the point in time at which control is transferred to the customer, which is when title transfers to the customer in connection with delivery. In most of our customer arrangements, title to the OCS Solutions transfers when the OCS Solutions arrive at the customer site. In limited instances, title transfers upon shipment by us to the customer. Payments Made to Customers Under our customer arrangements that include a customer clinical trial agreement, we receive payments from sales to the customer of its OCS products and also make payments to that customer for reimbursements of clinical trial costs, materials, and for specified clinical documentation related to the customer’s use of our OCS products. We also make payments to customers involved in post-approval studies for information related to the transplant procedures performed. We determine the appropriate accounting treatments for these payments depending on the nature of the payment and whether they are for distinct goods or services. In these cases, we have determined that the payments made to the customer for reimbursement of clinical trial materials and its costs incurred to execute specific clinical trial protocols related to our OCS products do not provide us with a distinct good or service transferred by the customer, and, therefore, we record such payments as a reduction of revenue from the customer in our consolidated statements of operations. Reductions of revenue related to such payments made to customers for reimbursements are recognized when we recognize the revenue for the sale of our OCS disposable sets. For the fiscal years ended December 28, 2019 and December 29, 2018, we recorded as a reduction of revenue $2.2 million and $1.6 million, respectively, of reimbursable clinical trial costs. In these same cases, we have also determined that payments made to the customer to obtain information related to post-approval studies or existing standard-of-care protocols (i.e., unrelated to our OCS products) do meet the criteria to be classified as a cost because we receive a distinct good or service transferred by the customer separate from the customer’s purchase of our OCS products and the consideration paid represents the fair value of the distinct good or service received by us. As a result, these payments made by us to customers for information related to post-approval studies or standard-of-care protocols are recorded as research, development, and clinical trials expenses. For the fiscal years ended December 28, 2019 and December 29, 2018, we recorded as research, development and clinical trials expenses $1.2 million and $0.6 million, respectively, related to payments made to customers at clinical trial sites for information related to post-approval studies or existing standard-of-care protocols. Variable Consideration Revenue is reported net of any taxes assessed by a governmental authority that are directly imposed on a revenue-producing transaction (e.g., sales, use, and value added taxes). We only include estimated variable 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. Revenue from reimbursements of out-of-pocket expenses, including travel, lodging, and meals, is accounted for as variable consideration. We do not consider shipping to be a contract performance obligation. We record shipping costs billed to customers as revenue and records the associated costs incurred by us for those items as cost of revenue. Our adoption of ASC 606 as of December 30, 2018 (the beginning of our fiscal year 2019) did not substantially change the revenue recognition of our OCS products as applied under the applicable prior revenue recognition guidance, ASC 605. Stock-Based Compensation We measure stock-based option awards granted to employees and directors and, commencing December 30, 2018, to non-employees based on their fair value on the date of the grant using the Black-Scholes option-pricing model. Compensation expense for those awards is recognized over the requisite service which is generally the vesting period of the respective award. Generally, we issue awards with only service-based vesting conditions and record the expense for these awards using the straight-line method. We account for forfeitures as they occur and record compensation cost assuming all option holders will complete the requisite service period. If an award is forfeited, the Company reverses compensation expense previously recognized in the period the award is forfeited. Prior to our adoption of Accounting Standards Update No. 2018-07, Compensation-Stock Compensation (Topic 718), Improvements to Nonemployee Share-Based Payment Accounting, as of December 30, 2018, we measured the fair value of stock-based option awards granted to non-employees on the date that the related service was 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 completion of the service, 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. 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. Determination of Fair Value of Common Stock Prior to our IPO, the estimated fair value of our common stock had been determined by our board of directors as of the date of each option grant, 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 and which may have changed from the date of the most recent 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 common stock valuations were prepared using a Monte Carlo simulation method, which used either a market or income approach to estimate our enterprise value. A Monte Carlo simulation method is used to calculate the value of an enterprise (or other asset) with multiple sources of uncertainty or with complicated features and to allocate the total equity value among the various holders of a company’s securities upon the simulated exit using a waterfall. Under this method, the common stock has value only if the funds available for distribution to stockholders exceeded the value of the preferred stock liquidation preferences at the time of the liquidity event, such as a strategic sale or a merger. A discount for lack of marketability of the common stock is then applied to arrive at an indication of value for the common stock. These third-party valuations were performed at various dates, which resulted in valuations of our common stock of $2.21 per share as of May 12, 2016, $3.22 per share as of April 5, 2018 and $8.65 per share as of October 9, 2018 (each amount adjusted for the conversion ratio in the Corporate Reorganization). In addition to considering the results of these third-party valuations, 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 prices at which we sold shares of preferred stock and the superior rights and preferences of the preferred stock relative to our common stock at the time of each grant; • the progress of our research and development, including the status and results of clinical trials to develop clinical evidence of our products’ safety and effectiveness and progress of our development of our OCS products; • our stage of development and commercialization and our business strategy; • external market conditions affecting the medical device industry and trends within the medical device 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 and our preferred stock; • the likelihood of achieving a liquidity event, such as an initial public offering or sale of our company in light of prevailing market conditions; and • the analysis of initial public offerings and the market performance of similar companies in the medical device industry. The assumptions underlying these valuations represented management’s best estimate, which involved inherent uncertainties and the application of management’s judgment. As a result, if we had used significantly different assumptions or estimates, the fair value of our common stock and our stock-based compensation expense could have been materially different. Following our IPO, in connection with our accounting for granted stock options and other awards we may grant, the fair value of our common stock is determined based on the quoted market price of our common stock. Valuation of Warrants to Purchase Preferred Stock We classified warrants to purchase shares of our Series D and Series F preferred stock as liabilities on our consolidated balance sheets as these warrants were free-standing financial instruments that could have required us to transfer assets upon exercise. The warrant liability associated with each of these warrants was initially recorded at fair value on the issuance date of each warrant and was subsequently remeasured to fair value at each reporting date. Changes in fair value of the warrant liability were recognized as a component of other income (expense) in our consolidated statements of operations. We recognized changes in fair value of each warrant comprising the warrant liability until each respective warrant was exercised, expires or qualifies for equity classification. We utilized the Black-Scholes option-pricing model, which incorporated assumptions and estimates to value the preferred stock warrants. 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 Series D and Series F preferred stock, the remaining were contractual term of the warrants, risk-free interest rate, expected dividend yield and expected volatility of the price of the underlying preferred stock. The most significant assumption in the Black-Scholes option-pricing model impacting the fair value of the preferred stock warrants was the fair value of our preferred stock as of each remeasurement date. We determined the fair value per share of the underlying preferred stock by taking into consideration our most recent sales of our preferred stock, results obtained from third-party valuations and additional factors that we deemed relevant. As of December 29, 2018, the fair value of our Series D and Series F preferred stock was $6.21 per share and $5.73 per share, respectively. Prior to our IPO, we were 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 warrants. 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 warrants. We estimated a 0% dividend yield based on the expected dividend yield and the fact that we had never paid or declared dividends. On May 6, 2019, immediately prior to the closing of our IPO, the warrants to purchase preferred stock were converted into warrants to purchase common stock, and the fair value of the warrant liability at that time was reclassified to common stock. As a result, subsequent to the closing of our IPO, we no longer remeasure the fair value of the warrant liability at each reporting date. Valuation of Inventory We value inventory at the lower of cost or net realizable value, with cost computed using the first-in, first-out method. We regularly review inventory quantities on-hand for excess and obsolete inventory and, when circumstances indicate, record charges to write down inventories to their estimated net realizable value, after evaluating historical sales, future demand, market conditions and expected product life cycles. Such charges are classified as cost of revenue in our consolidated statements of operations. Any write-down of inventory to net realizable value creates a new cost basis. At the end of each reporting period, we assess whether losses should be accrued on long-term manufacturing purchase commitments in accordance with ASC 330, Inventory, which requires that losses that are expected to arise from firm, noncancelable and unhedged commitments for the future purchase of inventory, measured in the same way as inventory losses, should be recognized in the current period in the statements of operations unless they are deemed recoverable through firm sales contacts or when there are other circumstances that reasonably assure continuing sales without price decline. As of the end of each reporting period presented in our consolidated financial statements included elsewhere in this Annual Report on Form 10-K, we did not identify any potential losses arising from remaining future purchase commitments as compared to estimated future customer sales through the remainder of the term of the manufacturing purchase commitment and, as a result, did not recognize in a current period any loss provision for future-period remaining purchase commitments. Backlog We define backlog as contractually committed orders for our products for which the associated revenue has not been recognized and the customer has not been invoiced. Amounts that have been invoiced but not yet recognized as revenue are reported as deferred revenue on our consolidated balance sheets and are not included in our calculation of backlog. As of December 28, 2019 and December 29, 2018, we had backlog of $0.5 million and $1.2 million, respectively. Of the amount of backlog as of December 28, 2019, we expect that substantially all of it will be invoiced to customers within the following 12 months. However, because our customers may cancel, change or reschedule orders without penalty at any time prior to shipment, we have no assurance that we will be able to convert our backlog into shipped orders. 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 is disclosed in Note 2 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K.

<s>[INST] Overview We are a commercialstage medical technology company transforming organ transplant therapy for endstage organ failure patients across multiple disease states. We developed the OCS to replace a decadesold standard of care that we believe is significantly limiting access to lifesaving transplant therapy for hundreds of thousands of patients worldwide. Our innovative OCS technology replicates many aspects of the organ’s natural living and functioning environment outside of the human body. As such, the OCS represents a paradigm shift that transforms organ preservation for transplantation from a static state to a dynamic environment that enables new capabilities, including organ optimization and assessment. We believe our substantial body of clinical evidence has demonstrated the potential for the OCS to significantly increase the number of organ transplants and improve posttransplant outcomes. We developed the OCS to comprehensively address the major limitations of cold storage. The OCS is a portable organ perfusion, optimization and monitoring system that utilizes our proprietary and customized technology to replicate nearphysiologic conditions for donor organs outside of the human body. We designed the OCS technology platform to perfuse donor organs with warm, oxygenated, nutrientenriched blood, while maintaining the organs in a living, functioning state; the lung is breathing, the heart is beating and the liver is producing bile. Because the OCS significantly reduces injurious ischemic time on donor organs as compared to cold storage and enables the optimization and assessment of donor organs, it has demonstrated improved clinical outcomes relative to cold storage and offers the potential to significantly improve donor organ utilization. We designed the OCS to be a platform that allows us to leverage core technologies across products for multiple organs. To date, we have developed three OCS products, one for each of lung, heart and liver transplantations, making the OCS the only multiorgan technology platform. Our OCS products have been used for over 1,500 human organ transplants. During our clinical trials, we established relationships with over 55 leading transplant programs worldwide. We have commercialized the OCS Lung and OCS Heart outside of the United States and received our first PMA approval from the FDA in March 2018 for the use in the United States of the OCS Lung for donor lungs currently utilized for transplantation and since May 2019, for donor lungs currently unutilized for transplantation. We expect FDA action over the next six months on additional applications for PMAs we have submitted in connection with our other OCS products. Since our inception, we have focused substantially all of our resources on designing, developing and building our proprietary OCS technology platform and organspecific OCS products; obtaining clinical evidence for the safety and effectiveness of our OCS products through clinical trials; securing regulatory approval; organizing and staffing our company; planning our business; raising capital; and providing general and administrative support for these operations. To date, we have funded our operations primarily with proceeds from sales of preferred stock and borrowings under loan agreements, proceeds from the sale of common stock in our IPO and revenue from clinical trials and commercial sales of our OCS products. Since our inception, we have incurred significant operating losses. Our ability to generate net revenue sufficient to achieve profitability will depend on the successful further development and commercialization of our products. We generated net revenue of $23.6 million and $13.0 million for the fiscal years ended December 28, 2019 and December 29, 2018, respectively. We incurred net losses of $33.5 million and $23.8 million, respectively, for those same years. As of December 28, 2019, we had an accumulated deficit of $369.5 million. We expect to continue to incur net losses for the foreseeable future as we focus on growing commercial sales of our products in both the U.S. and select nonU.S. markets, including growing our sales and clinical adoption team, which will pursue increasing commercial sales and clinical adoption of our OCS products; scaling our manufacturing operations; continuing research, development and clinical trial efforts; and seeking regulatory clearance for new products and product enhancements, including new indications, in both the U.S. and select nonU.S. markets. Further, following the closing of our IPO we [/INST] Positive. </s>